Has Europe Risen To The Challenge?

By Stephen D. Simpson, CFA | May 12, 2010 AAA
Has Europe Risen To The Challenge?

After seeing punishing increases in interest rates, declines in the euro and chaos in the equity markets in response to slow and unsteady action on Greece, the ministers of the European Union decided to try to get ahead of the next round of worry and launch a massive liquidity measure for its members. The announced package immediately sent the euro higher along with equities of all stripes, but especially those exposed to the financial chaos in Europe. (To learn more, check out EU Economics? It's All Greek To Me!)

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What Happened
Early on Monday morning, the finance ministers of the EU announced an enormous liquidity package designed to restore faith in the euro and the solvency of its members. The three-part program is worth almost $1 trillion and it consists of 60 billion euros in loans, 440 billion euros in future loan guarantees and as much as 250 billion euros in funding from the IMF.

Although not specifically earmarked at this point, it is widely assumed that this package is a preemptive measure to ensure that Spain, Portugal, Ireland and Italy do not find themselves in the same position as Greece. (For more, see Greece: By The Numbers)

In addition to the liquidity package, the European Central Bank will buy bonds in the open market as needed to maintain liquidity. So as to not to increase the overall money supply, these purchases will be "sterilized" with offsetting transactions.

What It Means
At the risk of oversimplification, the meaning of the European package is this - the countries of the European Union are committed to the viability of the euro (and the current composition of the eurozone), and are willing to back that commitment with a large amount of capital. Also explicit in this announcement is that the ECB and the member countries are going to step in and provide liquidity as needed to keep the markets moving. Rather than be criticized for dawdling while a situation spirals out of control, the ECB can now move with relative speed to help a member country that needs assistance.

While these moves are arguably necessary to maintain the smooth functioning of the markets, there is always a longer-term price to pay. While there is a possibility that the lenders in this plan will profit, there is the risk that it will misallocate capital for years to come, and in so doing will depress growth and impose unfair burdens upon the citizens of countries that have kept their houses in good order.

What Happens Next
This liquidity package is by no means the end of the story, and it does not alter the fact that far-reaching changes are still to come. Specifically, it seems a given that Spain and Portugal are going to have to launch austerity measures to control their deficits. Likewise, it is safe to assume that the markets will expect Italy and Ireland to come forward with plans to improve themselves as well. Longer term, the ECB will eventually have to revert back to a much stricter posture should it wish to maintain the notion that it is independent and conservative.

What Can Still Go Wrong
It is important for investors to realize that things can still go wrong. Germany is going to bear the largest share of the financing of these bailouts and, given Germany's historic emphasis on very sound fiscal policy, there are unhappy grimaces all over that country. That suggests a limit on just how much further some of the eurozone members will go to support their peers.

Another significant risk is that certain governments may exploit the package and use it as a means of stalling difficult decisions and unpopular cutbacks in their countries. There have been rumblings from Spain and Portugal that the questions about their economies were part of some far-reaching plot to discredit them and run them out of the euro, while even the ECB has made oblique references to speculators being at fault. If governments do not face up to their problems (overspending with cheap debt) and address them, the ECB does not have the resources to delay the day of reckoning forever. (For more, see Greece: The Worst-Case Scenario.)

What It Means For Investors
As Monday's rise in the U.S. stock markets in the wake of the deal suggests, we are all in this together - to a certain extent. All equity investors will benefit if this calms the market and reduces volatility.

Investors holding shares in European companies, especially the banks, can rest a bit easier. The package should keep credit flowing throughout Western Europe, and that will be beneficial for business in general. For the banks, the finance ministers have basically chosen to socialize their mistakes. This should put a limit on the losses experienced by the banks and eliminate the fears that further extensive capital-raising will be necessary. Much as we have seen in the United States, this bailout should be a boon to banks that either avoided trouble to begin with or move quickly to clean up their balance sheets and position themselves for the new reality.

Bottom Line
Assuming that Spain and Portugal move ahead with austerity measures and no new surprises crop up, investors can most likely look ahead to hearing about the next worrisome spot in the global financial system. Whether it is rising rates in Brazil or an overheated property market in China, there is always something to worry about. In the meantime, investors should simply inform themselves as best they can, stay diversified and pick the best investment ideas they can.

Feeling uninformed? Check out the financial news highlights in Water Cooler Finance: Greece Is Burning And Buffett's Under Fire.

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