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Europe Most Likely to Unleash ‘Shock’ to Unravel Global Economy

Wednesday, 31 August 2011 06:30 AM Current | Bio | Archive

Investors in the United States and elsewhere already know that the financial institutions of the eurozone continue to pose an extremely serious risk of causing the “shock” that has the potential of destabilizing the extreme fragile global recovery.

Christine Lagarde, managing director of the International Monetary Fund, has warned that “banks (European) need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth … we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis … The most efficient solution would be mandatory substantial recapitalization.”

I thought it could also be helpful to take note of what she said, among other things, about the United States.

“In the United States, policymakers must strike the right balance between reducing public debt and sustaining the recovery — especially by making a serious dent in long-term unemployment.”

But first, let’s come back to Europe for a moment because it’s there, at least in the short term, I think the risk of causing havoc in the markets is the greatest.

The International Accounting Standards Board (IASB) made public the letter it sent to the European Securities and Markets Authority earlier this month wherein it states: “There have been indications in the market that some European companies are applying the accounting requirements for fair value measurement and impairment losses in a way that seems to differ from the objective of IAS 39 Financial Instruments: Recognition and Measurement. This is evident particularly in their accounting for distressed sovereign debt, including Greek government bonds. Those indications have now been confirmed by recently published financial reports, which show inconsistent application of IAS 39 across Europe. This is a matter of great concern to us.”

To better understand the situation, I thought it would helpful to demonstrate some facts the IASB is referring to, notwithstanding it didn’t single out anyone in particular. The problem we face is that it has now become clear that some European financial institutions should have taken bigger losses on their Greek government bond holdings in their recent results announcements.

For example, the French bank BNP Paribas and the French insurer CNP Assurances both applied 21 percent write downs on the Greek exposures while the Royal Bank of Scotland (RBS) accepted a 51 percent cut on the value of their Greek government bond portfolio. I think investors should do well to remember these huge valuation divergences these European financial institutions apply. It’s clear that the 51 percent cut of the RBS is much closer to reality than these “delusional” 21 percent cuts of the aforementioned French institutions. Unfortunately, it seems the European “smoke and mirrors” game continues unabated …

So, who and what should you trust in the eurozone? Unfortunately, that number continuous to shrink … No wonder we see growing political but also on main street unrest within Germany about being perceived as the ultimate guarantor for the rest of Europe’s debts. Honestly, who shouldn’t? As said here before, investors shouldn’t expect any real, and therefore trustworthy, “good” surprise coming out of Europe, in the short term at least.

Coming back to the United States, in my opinion the main problem remains employment. To me at least, it’s obvious we face an extremely serious problem for which there is no quick fix at hand. Back in the 1930s, we faced a structural transformation from agricultural to manufacturing. In this “Great Recession,” we face a structural transformation from manufacturing to services. Today’s manufacturing productivity growth is well in excess of growth in demand for U.S. produced goods.

By the day, it becomes clearer that U.S. labor growth is getting “trapped” in a more and more declining manufacturing sector, which consequently should cause declining income that will not allow growth of healthy spending on U.S. produced products.

All this makes me cautious on how quickly the United States comes back on sound footing to its average (3 percent) or above average growth. I still believe strongly the United States has the potential and can do it, but it will take much more time than most are willing to accept for now.

As uncertainty remains at extremely high levels, especially caused by the European situation in the short term, my preference remains fully “risk off.”

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Investors in the United States and elsewhere already know that the financial institutions of the eurozone continue to pose an extremely serious risk of causing the shock that has the potential of destabilizing the extreme fragile global recovery. Christine Lagarde,...
Wednesday, 31 August 2011 06:30 AM
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