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April 2010 Market Commentary Amit Chokshi

Addressing the PIIGS Crisis

Much has been made in recent months of the sovereign crisis facing a number of European countries, collectively referred
to as the PIIGS (Portugal, Ireland, Italy, Greece, and Spain, respectively). These countries share similar financial
characteristics in that they maintain significant budget deficits as a percentage of GDP, high debt to GDP, and generally
high unemployment relative to the broader EU27. In addition, the PIIGS, due in part to structural problems with their
economies that have been ignored, have suffered severe declines in GDP from peak to trough. Another component
related to the PIIGS' structural employment issues is that these countries also have high labor costs relative to EU27
behemoths such as Germany, which makes it very difficult for these countries to aggressively turn their economies
around.

Greece has captured the majority of headlines due to the refinancing hurdles it faces in May, when roughly €10B comes
due. Greece also has the most severe budget deficit of its PIIGS compatriots, with its 2009 budget deficit coming in at
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nearly 13% . These issues have led investors to spurn Greek bonds, resulting in 10-year Greek bonds trading over 400
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basis points relative to 10-year German bonds . As the chart below demonstrates, Greece is the headline act right now
but other PIIGS as well as the UK, could be poised to experience an uptick in yields.

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On April 23, 2010 Greece went to the EU and IMF hat in hand, asking for a bailout. The efforts to craft a bail out has led
this week, according to the Financial Times' Wolfgang Munchau, to be "the most important week in the 11-year history of
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Europe's monetary union" . Unfortunately, the IMF has a poor track record with regards to structuring successful
economic policies and the current suggested bailout package size (€45B), lack of expressed future support, and
imposition of strict austerity measures would only further cripple Greece's efforts to bounce back and simply delay the
crisis. As Center for Economic & Policy Research ("CEPR") co-Director Dean Baker reminds us, the IMF was known as
the "Typhoid Mary" of emerging markets in the 1990s as many of its suggested policies led to sharp economic declines in
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each country the IMF advised . Now, the IMF may bring similar results to the PIIGS, starting with Greece.

The first problem with the proposed EU and IMF package is that it's too small. At €45B, Greece would have just enough
to hold it over for a year. This is not enough time for Greece to put its financial house in order and many economists
believe an aid package twice the suggested amount is needed. An aid package of €90B, which would basically cover
Greece's funding gap over the next few years, seems unlikely given the stance of the EU and IMF. In addition, neither
institution has expressed any willingness to have an "all out" commitment to Greece beyond this package. As capital
market participants have observed over the past several years, confidence is an important factor in assuaging markets
and the size of the proposed package and lack of commitment by the EU and IMF does not inspire confidence. In
addition, the EU and IMF are pushing severe austerity measures on Greece that could send the country into a depression.

Part of the problem stems from German and French posturing. Germany in particular, views itself as a modicum of fiscal
responsibility, maintaining a healthy current account surplus due to its position as the second largest exporter in the world.
Germany has been less than willing to support its Club Med neighbors unless a strict austerity program is implemented.
In addition, Germany faces political pressures as its most populous state holds elections on May 9, where a number of
voters are against support packages for Greece. Consequently, Chancellor Merkel has been pressured to draw a hard
line on the terms Germany would require from Greece or potentially risk losing her party's majority in the Bundesrat.

The EU and IMF suggest that a successful aid package to Greece could curtail the likelihood of the sovereign crisis
spreading throughout the PIIGS. While a bailout could result in calming the bond markets of the PIIGS, this would likely
be just a brief respite given the significant level of debt coming due in each of the PIIGS throughout 2010. The chart
above, courtesy of Der Spiegel, illustrates a cascade of PIIGS debt that must be rolled over each month. These are high
levels and while some of the PIIGS, notably Italy, are in better shape than others, it's clear that alleviating Greece's
problems for one year may not be a solution that does much to address the financial and structural problems of the PIIGS.
More so, half hearted efforts that still utilize substantial levels of capital like the current €45B proposal may ultimately just
burn this capital up while providing no real benefit. It's akin to having an expensive drug that can cure an ailment but
utilizing too low a dose such that the ailment still persists despite drawing down on an expensive treatment.

In addition, the Germans and French feel little need to bailout Greece and will place pressure on their elected officials to
limit any aid. The lack of interest to aid Greece and its compatriots may be misguided and ignores basic economics.
Germany wishes to be a global exporting powerhouse and its current account surpluses must by balanced by current
account deficits which its neighbors run. This is a basic accounting identity. By pushing for hard austerity measures
attached to a bailout, Germany would have its neighbors, who are purchasers of German goods, to sharply reduce their
expenditures which in turn would adversely impact German industry. There's a misguided fetish with deficits in a world
with unacceptably high levels of unemployment. These deficits in many cases are only one half of the problem as the
current account surpluses of countries such as Germany have also been large contributors to these imbalances.

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By ignoring Greece, Germany and France are also risking their banking and financial services sector as a weak Greece
will punish German and French banks which carry, in some instances, substantial levels of Greek bonds. By ignoring
Greece, Germans and French may simply be electing to sacrifice Greece only to eventually bailout or recapitalize some of
their own banks which have large holdings of Greek bonds.

And this is really the crux of the problem for financial markets and why it matters to the broader investment community.
While the recession for much of the world has likely ended or is ending from purely data-based (resumption of growth)
measures, the global economy is still in the doldrums and financial institutions are slowly recapitalizing and healing
themselves but still face a number of credit challenges such as commercial real estate and consumer credit. According to
the Bank of International Settlements, foreign bank exposures to Greece, Portugal, and Spain total €1.2T with the majority
held by continental European banks. Significant impairments to these holdings could cripple banks, once again spurring a
liquidity crisis which could derail a weak recovery.

Greece has the largest external sovereign debt/GDP ratio in the world despite its rank as 28th in terms of GDP. A number
of European banks such as those in France and Germany have exposure to Greek sovereign debt. Challenges in Greek
bonds have a direct impact on those financial institutions, which on the whole are still recovering from the financial crisis
of 2008. However, due to Greece's size, the distribution of its government debt worldwide is manageable and likely would
not be a knock out blow to the recovering financial sector. The same could be said for Portugal and Ireland bonds.

Italy may also be less of an immediate issue because much of its debt is domestically financed. In addition, its budget
deficit stands at just over 5% which is below the average of the EU27 and much lower than its PIIGS peers. Further, its
unemployment rate is roughly 8%, also below the EU27 composite levels.

Spain, however, could be a very serious issue and preventing contagion to this country should be the EU and IMF's top
priority. Spain is the world's ninth largest economy according to the IMF compared to Ireland (#38), Portugal (#37), Italy
(#7), and Greece (#28). Spain has a budget deficit of roughly 12% while unemployment is nearly 20%. Spain's high
unemployment is structural in nature due the country's heavy reliance on the housing sector so shifting workers that were
reliant on labor-intensive applications will be a long and painful road ahead. While the US and UK experienced significant
busts in home prices, Spain experienced an even larger bubble based on the house prices/rents ratio. Even after a
painful housing implosion, this ratio currently suggests that home values in Spain are still 50% above fair value. One
saving grace of Spain is that its Debt/GDP ratio stands at roughly 50%, which considering a very anemic economy is not
bad at all.

Given the potential for Spain to become a much larger problem down the road, policy makers should not treat Greece in
isolation as they currently seem intent on doing. As RAB Capital’s Marshall Auerback recently put it, Greece is Europe’s
version of Bear Stearns. With Bear Stearns, US policy makers implemented a band aid solution that made policymakers
believe that the problems were solved, rather than look ahead and be proactive to the larger systemic problems on the
horizon which ultimately led to the failure of Lehman Brothers and financial crisis.

The EU and IMF unfortunately seem intent on following these policies, by developing insufficient aid packages and
attaching harsh austerity measures for Greece that pressure the entire Euro-zone. If the EU and IMF wish to provide
meaningful support to Greece, they should provide aid that can sustain Greece through the entirety of its funding shortfall.
In addition, while Greece must restructure its bloated public sector and improve its tax collections, the EU and IMF should
not make the strings attached to an aid package similar to that of a noose. Imposing strict fiscal discipline in the face of a
massive shortfall in private consumption and high unemployment will only heighten the likelihood of major economic
retrenchment for not only Greece but much of Europe.

An alternative to providing a bailout package would be to allow Greece, Portugal, and Ireland to formally restructure,
essentially defaulting and dropping out of the Euro-zone for a set period of time, perhaps two years, during which time
these countries can devalue their currencies, address their problems without the meddling of the IMF, and then re-enter
the Euro-zone. The IMF and EU can then provide a full backstop for Spain, guaranteeing its sovereign debt which is more
broadly distributed.

There is a high degree of aversion to sovereign default but history suggests that defaulters can get second chances. The
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April 3 , 2010 issue of The Economist presented findings from an IMF study by Eduardo Borensztein and Ugo Panizza
covering sovereign defaults. The study found that in recent years, defaulters have been able to re-enter capital markets
once restructuring is complete albeit at higher spreads. However, the effects on spreads are short lived illustrating the
short memory capital markets have. Nonetheless, the article noted that the current global economy in conjunction with
weak global financial institutions could result in a much more deleterious impact in the event of a Greek default.

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Unfortunately, if the IMF and EU attempt to bailout Greece with a half hearted attempt, then a restructuring/default for the
PIIGS may be ultimately unavoidable.

1
http://www.economist.com/world/europe/displaystory.cfm?story_id=15838029
2
http://www.frbatlanta.org/documents/research/highlights/finhighlights/FH_040710.pdf
3
http://www.ft.com/cms/s/0/47b429f4-5091-11df-bc86-00144feab49a.html
4
http://www.cepr.net/index.php/blogs/beat-the-press/the-imf-has-qa-long-history-of-stabilizing-economies-and-solving-
global-financial-problemsq/

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