April will be an interesting month for the European Union. The chips are on the table, but a large wave of events threaten to wash away the few chips the EU has left. This may be a potentially disastrous chain of events involving the large amount of European bonds due for Greece, Spain and Italy in the period between February and April, more downgrades driving up borrowing costs, and the French election in April.
The first piece of the domino is for certain: we know European bonds are going overdue en masse for Greece, Spain and Italy between February and April. Downgrades and increases in borrowing costs would logically follow (though not for certain) as not only nations in debt scramble to balance their books, but other EU nations struggling to find solutions as well due to the threat posed towards their monetary union. Borrowing costs would increase, further scarring manufacturing industries that are just slowly recovering.
The most uncertain piece of the puzzle, is the French presidential election race. We know that Sarkozy, while consistently applying pressure to Greece for more significant fiscal changes, stands by a unified Europe. Here is the looming storm cloud for France though: the recent closing of the gap by Sarkozy to 8 percentage points up from up to 20% late last year. Will this sudden rally change the political landscape, and instill political uncertainty around the central player France? Let’s dissect the candidate’s positions first.
Francois Hollande, contrary to his motto “now is the time for change,” seems to seek similar solutions to Sarkozy in terms of preserving the union. His main mechanism would be a French-German inner circle dictating common policies for the European Union, though he is proposing no means of enforcement. He defends the euro-bonds as a potential instrument (in contrast with Sarkozy’s anti-eurobond stance), but promotes a strong ECB much like his competitor. At the end of the day, I don’t think we will see anything radically different in terms of dealing with the PIGS.
Here’s the good news for those afraid of uncertainty: though Sarkozy is catching up in terms of percentage points, his campaign is still slumping. With high unemployment and borrowing costs working against him, his rival has a definite edge that his recent rally in popularity likely couldn’t overcome. And even if Sarkozy does pull a miracle win, their ways of dealing with the EU seem to be similar enough that investors shouldn’t expect a radical change.
Things could get desperate, though, as investors are already preempting the eventual downgrade by forcing up bond yields. With borrowing costs set to skyrocket, the EU financial situation set for turbulence, the guy ahead or the guy behind just may do something really stupid.
Democracy is powerful: with angry voters and a candidate resorting to demagoguery, crazy policies such as cutting out Greece and extreme austerity measures will create a lot of uncertainty in the French political scene. This political uncertainty would unfortunately overlap with a period where the European Union needs strong leadership, and may just crumble the monetary union…
Over-pessimism (which I love, as you can tell) aside, let’s take a look at what might happen if Hollande gets elected as predicted. To stop the spiral of debt, we need the PIGS to cut away from their welfare state. But such a cut is easy to draw up, hard to implement. Without a strong enforcement mechanism, Hollande may be stuck back where Sarkozy is right now: negotiating as hard as he can, but still seeing Italy and Spain bleed away billions to their welfare state. Will Hollande take decisive action if elected? Will he negotiate better? We will just have to wait and see. One thing is for sure though: the systematic risk is still present. We shouldn’t let impressive numbers from the American stock market cloud our view of Europe.
with help from SW