Rebalancing Euro

Given the mountain of literature on Greece & European debt crisis, I think another article may just add to the litter than light some hope.

Hence, instead of going through the crisis and the reasons that led to it, I will instead focus on the risk management and steps to resuscitate the situation.

Firstly, if EU wishes to remain as a single unit then it must instill discipline among the disparate economies. It needs to manage the interests of the stronger members, while putting competitive framework for weaker economies. If the unity of countries wishes to enjoy a common currency, then must adhere to certain economic framework. The architecture which brought the countries together may need some review periodically, to assess the situation of the partners to continue their existence in the zone. There will be political & economic issues unique to each country, with various degrees of debt issuances, trading surplus/deficit, unemployment and need for monetary flexibility. A Germany or, France may present a very different set of economic data, than Portugal or, Ireland over extended periods and hence, rebalancing the EU’s economic framework is essential to ensure its continuity.

ECB would need to create a risk management framework that sounds the alarm bells before the economic performance tapers off from benchmarks. Much like the classification framework that banks use to identify portfolios or obligors with various degrees of credit or, market risk, EU may need to define such layers and specific action steps to remediate the affected countries. This calls for Euro A, B, C countries depending on their risk scores or, economic data.

The layering through risk scores or economic parameters, will lead to differentiated market on European debt, with various CDS spread equivalent to the country’s risk and better price the risk, calling upon the respective Governments to manage their revenue deficits, taxation and stimulus packages with an economic rationale. Since, the countries do not have the flexibility to intervene on the currency exchange rate, the remaining variables would need more efficient management.

The bailout packages that are being discussed through a European Financial Stability Facility (EFSF) are designed to singularly address the countries that have a risk of falling off the edge and, not towards developing competitive long-term strengths. The presence of bailout packages are like safety-nets, which may abet risk taking than risk containment. With classification, the bailout packages can be designed to offer objective supply of credit and not, short-term liquidity or, short-term crisis management pills. If a specific country does not meet basic threshold for interim supply of credit, then it may unilaterally default. Given the risk tiering, the collateral damage will be limited. Investors subscribing to the debt, would be better informed due to risk classification and hence, structure their positions with the risk view. The debt downgrade through layering and the bailout packages can cushion the market efficiently than, leaving the discussions open for last minute bailouts and hence, market gyrations.

To just implement the suggested point, EU may have to draft policies that present risk structures. If Greece situation merits a default, then EU may guide Greece to drop to a level C, which would contain the risk. In case, bailout if needed, be limited to a first loss default guarantee to certain portions. In the event a EU member country defaults, then it may be kept outside through a development package. The country be made flexible to take some unilateral economic measures and reviewed on specified benchmarks. The EFSF be geared to infuse liquidity into banks, with a mandate to issue credit and provisioning for losses due to poor credit in future. The EFSF, through ECB can monitor credit growth or, work with the respective country on avenues to invest in competitive industries and create employment. The results may not be immediate and can stretch across years. The result of such productive investments can help improve competitiveness, capital creation and hopefully a Greece Debt on GDP figure not look 120%, even after a decade.

The EU club cannot be just a coterie of maverick countries that have come together to create an economic block, but do not bring consistent and tangible competitiveness to the block. If they wish to share a common currency, they may have to sign up and deliver on a common purpose.