The time decay on research articles is devastating when markets are like this. So this week we decided to corral just one, entertaining but less time-sensitive research piece rather than round up a posse of ephemeral articles.
ING’s Charles Robertson published a note on Monday asserting his long-held love of Abba’s music and enthusiasm for the euro-project. Apparently, “the former has outlived the latter”.
I refuse to be drawn on where I stand regarding the merits of the Swedish pop group, so let’s consider just the financial content of Robertson’s note.
It is generally assumed that there has been some lessening of appetite among the eurozone core for enlargement to the East. Estonia is admittedly an exception: it “was actually a very simple choice as it met all the criteria, its sovereign debt is among the lowest in the world, its currency peg has lasted since 1992, and Estonia is tiny”.
What has not been sufficiently questioned is whether or not the benefits, to other nations in the queue for euro admission, now sufficiently outweigh the fiscal sacrifice required and the possibility of “joining the eurozone and [having to bail out] richer southern Europeans”.
The main case in point is that: “Today Czechs can borrow more cheaply than the Spanish or Irish can in euros, while Hungarians are better off than Greeks. The convergence trade was once worth 500 basis points but is now arguably worth no more than 100bp.” Or, more simply: “Greek troubles have ruined the euro free-ride for central European countries with floating currencies.”
The benefits were once undeniable. Robertson shows that in 1999 “when Greece was trying to join the eurozone, its key policy rate was 12.0% compared to an ECB rate of 2.5%. Until 1997, market doubts about the long-term inflation outlook in Greece were so high that the country could not issue 10-year drachma debt.” By mid-1999 this had all changed: short-term interest rates plunged towards the ECB rate, Greek long-term bonds became interesting to investors and long bond yields fell from as much as 20% to 5%. The consequences of this change were equally dramatic: consumption by households and investment by companies both boomed and government borrowing costs fell, releasing as much as 8% of GDP to, theoretically, pay off debt.
But now the scenario has changed.
The Czech Republic could look to no more than a 100bp fall in longer-term yields and, at the shorter end, euro adoption might, in fact, mean an increase in rates.
For Hungary, with better public finances than Belgium but paying 430bp more, the appeal of the euro might be greater. But Robertson puts the yield down to the facts of Hungary’s dependence on IMF support, its inflation rate and its historically poorer fiscal record: “All Hungary has to do to dramatically reduce its borrowing costs is to dramatically reduce its borrowing. Adopting the euro now has little to do with it.”
For Poland, joining the euro could also be a negative (pleasingly, a thesis that theweeklyFiX suggested last week), its “real borrowing cost is arguably much less than it is in the Netherlands or Belgium.”
Robertson concludes that the benefits of euro adoption have fallen substantially and the sacrifices in terms of lost options for governments are more obvious. He is unsure this is fully recognised by the candidate eastern Europeans but thinks eurozone entry by 2015 is now less likely.