Euro crisis getting worse than one could ever imagine

Will Asia find a scapegoat when the terror strikes?

Here’s from David Carbon, analyst at DBS Research Group:

Europe is back on the front burner. Why? Because the trillion euros of LTRO loans from the ECB wrapped vulnerable banks with a veneer of protection but it didn’t change the real economy pain being felt in Europe one iota. And the issue now is not ringfencing vulnerable assets and finding a bigger pile of money to throw at the problem. The issue now is whether countries like Greece will throw in the towel and walk out on the euro anyway.

Of course that would be chaotic. Contracts would have to be rewritten in ‘new’ drachma. Capital flight would ensue. Banks would go bust inside the country and nervous investors would ask ‘who’s next’ outside the country. Interest rates would rise, the euro would fall. It wouldn’t be pretty.

But juxtaposed against that rock is a place just as hard. At the end of the day, Europe’s problems are balance of payments / competitiveness problems. Capital inflows into peripheral countries pushed up wages and prices while they created asset bubbles and unsustainable debt loads. Competitiveness differentials need to be restored or existing debts will never be paid back. If debts were forgiven, they would only return. Prices in the periphery need to fall and/or prices in core countries, like Germany, need to go up.

There’s another word for falling wages and prices: depression. Incomes fall, unemployment rises. Eventually competitiveness is restored but it’s a long, painful process. Greek GDP has already fallen by 15% over the past three years and most reckon it will fall another 6% over the next two. It could be 3-4 more years before any income growth is seen.

So the hard place isn’t much better than the rock. It may be worse. Hence the risks of a Greek withdrawal continue to rise, as do the risks of contagion to other economies and markets. The mud could hit the fan next week, or next month, or next year. Or never, though that possibility seems less and less likely. It all depends on where the limits of real economy pain lie. And psychologists are probably better placed to gauge that than economists or market strategists.

Still, chaos doesn’t have to mean disaster. The biggest reason why a Greek exit doesn’t have to bring another Lehman ‘moment’ is simply that people have had two years to think about it and prepare for it. When Lehman Brothers collapsed, it literally happened in a moment – over a weekend. People came to work Monday morning and had no idea who they could trade with. Because they had no idea who was holding Lehman’s rotten apples. Everything froze.

Markets have had since May 2010 to research and discover who’s holding the bad apples this time. And most have known for quite a while who it is. It’s some French banks, and some German banks, and some US banks with exposure to them. Markets have also had two years to reduce their exposure if they’re uncomfortable with it. A sudden freeze up seems much less likely accordingly.

And Asia: what does all this mean for us? How does trouble in Europe spell trouble out here?

Europe hits Asia via two routes: the real economy and the financial sector. The real economy impact is straightforward and, frankly, it’s not a big worry to us. If Europe contracts by 1% this year, as seems likely, it wouldn’t be good for Asia’s exporters. But as we’ve shown many times here, Europe has run pretty much sideways for the past two years anyway. It didn’t contribute much to Asia’s growth between 2009-2011 so taking it out the equation doesn’t change much. Subtract zero from a number and most of it remains.

The US didn’t contribute much either. It wasn’t until 3Q11 that the US finally recovered precrisis (2Q08) levels of output and demand.

But while the US and Europe were flat on their backs, the problem in Asia was that growth was too fast and inflation too high. In 2010 and 2011, Asia’s central banks raised interest rates 48 times in order to cool things down. China raised its RRR by 300bps in each year for a total rise of 600bps. What was the Fed doing in this time? Giving the world QE2 and Operation Twist. Asia has slowed partly because exports to Europe are weak. But mostly because Asia’s central banks worked hard for two years to make it happen. That’s easy to forget with Europe dominating the headlines every day.

The second route by which trouble in Europe enters Asia is via financial markets. A freeze in bank lending is what hurt Asia most in 4Q08 and it – not weak demand from abroad – is what would hurt Asia the most this time too.

That said, the risk of a credit crunch remains far lower than in 2008. The biggest reason was already mentioned above: markets have had two years to think about this and prepare for it. If arks haven’t been built yet, Noah’s in the wrong line of work.

There are other reasons why a credit crunch is less likely this time too. In 2008, the crisis was about dollars, this time, it’s (mainly) about euros. Dollars are a lot more important to Asia’s trade finance than euros are. The risk for Asia should be lower accordingly.

Another reason is transparency. The bad apples that everyone tried to avoid in 2008 were derivatives. They were hard to see and hard to count, because they were all off the balance sheet. Today’s bad apples are mostly sovereign bonds – on the balance sheet, easy to see, easy to count. Most people are less afraid of things they can actually see. Transparency matters.

Finally, central banks have been providing nearly unlimited liquidity for some time. Back in 2008, they were always behind the curve, reacting to events after the fact. It may be the same song today but it’s the second verse. That’s always easier to sing.

The bottom line is a Greek exit doesn’t have to be another ‘Lehman moment’ for Europe and it’s very unlikely to be one for Asia. That’s our story and we’re stickin’ to it.