This last bout of the euro crisis was to a large extent triggered by the debate on how to improve the EU institutions. It is paradoxical that the right conceptual issues can accelerate the crisis that originates from the euro fundamental institutional flaws, but it is what is happening. The Germans decided to openly discuss the possibility of default by a euro member, without the proper framing and explanation on whether it would or could affect current crisis countries. This is just a part of the right debate, at the wrong time in the wrong way. The institutional debate lacks to key components: the need for a regional fiscal authority that backs the currency, and the structural reforms each country has to pursue to all become more homogeneous in terms of economic efficiency and competitiveness. There is no serious debate about these very important flaws of the euro. In sum, this current incarnation of the crisis is the result of an incomplete and improperly managed (though still correct) effort to fix the euro, coupled with real fiscal and financial issues in the problem countries (Greece, Ireland, Portugal, and Spain, in order of appearance…). This follows our views from back in May when we wrote “Euro reform or German Spa?”, and back in February in “The euro is naked, how about the dollar?”. On the euro specifically, the evolution of our view was clearly stated back in July in “Short-term jitters have not changed the view”.

Given that Europe has already established the EFSF (European Financial Stability Facility, funded with EUR440 billion), which joins the EFSM (European Financial Stabilization Mechanism, funded with EUR60 billion), which together with the IMF (which can max out at EUR250 billion) and the ECB (secondary market purchases), make up the ESA (European Stabilization Actions). All these acronyms to say that the policy response is in place, and the first country has been “bailed out”, but the markets do not seem to believe it can work, as signaled by the prices of Greek debt, or Irish debt more recently, and gradually that of Portugal (which is followed by Spain).

What can Europe do now? Well, it can certainly provide packages to all four countries (hopefully it stops there, and let us assume those facilities can handle Spain and its corporate sector), and if the reforms and adjustment programs of each country are executed properly, and the economies gradually recover, most can recover and the Germans would gradually recover their money. Realism obliges to think that maybe Greece would still need to restructure its debt as it is the one with the most compromised debt dynamics (which apparently is being postponed to minimize its impact on the rest and the world).

The other possible scenario is that of facing the beast head on: restructure debt and banking systems earlier than planned. This is to some extent what the market fears and prices when it shows its lack of credibility on all the acronym facilities above.

Is it really about Ireland?

We think it is not about Ireland, nor about Portugal, but about Spain. That is the country with a size and relevance that can really put a dent on the euro and its institutions.

Though Ireland does have a fiscal problem (primary deficit of almost 12% of GDP expected for this year, excluding banks’ bailouts), it does also have a serious banking problem of a similar magnitude than those of Turkey in 2000 and Korea in 1997 (fiscal costs of about 30% of GDP, fairly front-loaded), still estimated to be about two-thirds that of Thailand in 1997. This has taken Ireland from a government debt/GDP ratio of 44% of GDP in 2008 to 95% at the end of this year, peaking just over 102% by 2013 in a moderately optimistic scenario (some analyses show it peaking just over 120%). The fiscal adjustment needed is larger than most precedents, with about 2.5% of GDP per year during the first 5 years, continuing thereafter. The EU facilities can easily take care of the government funding needs for the next 3 years, while the adjustment is implemented. If the adjustment is successful, the debt/GDP ratio would show a downward trend (assuming growth stays roughly above 2/2.5% consistently), and we should expect a gradual recovery of market access. Successful implementation, under difficult political and economic conditions is what makes these programs risky. The Irish banking system owes roughly $140 billion to Germany and the UK, each. Assuming an EU bailout prevents a more serious bank run, Ireland can be “saved” in the same fashion as Greece was (which could mean to postpone the problem, we should only know with time).

Portugal’s case is mostly fiscal, as was Greece, but with a better starting position in terms of stocks and flows, less of a competitive issue and other fundamental differences to its benefit. However, it is evolving as a as a self-fulfilling prophecy, in terms of market dynamics pushing Portuguese debt yields to levels that will trigger the need for a bailout.

Portugal’s debt dynamics would show solvency if they accomplish a primary fiscal adjustment of 9% of GDP over 5 years (1.8% per year, or 25% less than what Ireland needs). The forecasts for this year’s primary deficit are around 9% of GDP, which is a much better starting point than that of Greece or Ireland (especially if you add the banking upfront costs). The government debt/GDP ratio was 76% in 2009, is forecasted to be 83.5% at the end of this year, and if the government plans are executed, would not peak above 90%. All of its debt is in fixed rates and less than 20% is short-term. After “saving” Greece and Ireland, the size of the EU facilities can also deal with Portugal.

The key issue is whether market dynamics and adjustment progress leads us to a situation in which Spain needs to apply for a bailout. A lot will depend on how quickly Ireland approves a budget and starts implementing a package. However, Portuguese debt prices continue to price an increasing probability of a crisis there. The yield of its 10-year government bonds has gone from 4.5% in May to 7% today, while Ireland’s 10-year was at 8.7%, Greece’s at 11.7% (as of 11/24/2010, while Germany’s 10-year yields 2.7%, Spain’s 5%).

Spain is significantly bigger than its three predecessors, with its GDP being twice that of Greece, Ireland and Portugal combined. The EU package announced in May was coincidentally sized to cover the 4 countries main funding needs. In other words, with the known Greek and Ireland packages (latter, almost known), assuming Portugal would need 70 billion euros, the 750 billion euro package can also accommodate Spain’s gross government funding needs. However, Spain’s main problem is the corporate sector, which is leveraged to a large extent with its financial sector. Spanish banking system is already dealing with the residue of a real estate bubble. Corporate debt (non-financial) is about 120% of GDP. The picture on the fiscal side is less scary. Its 2009 primary deficit was 9.4% of GDP and is forecast to be 7.1% in 2010, falling to 3.4% in 2011, if the program continues to be executed as planned. Government debt/GDP was at 53% in 2009, and is forecast to be 63% in 2010, peaking below 70% in 2012/2013.

At this point in time it is almost impossible to predict how a funding crises would happen and evolve. It is clear that European policy makers work with this problem in mind: preventing Spain’s crisis.

In sum, the real risk here is a serious unraveling of a Spanish funding crisis (one that would include its corporate sector). This event would put a dent on the euro and its future. Greece, Portugal or Ireland have to continue implementing their adjustment programs, together with EU programs, with varied probabilities of success across time. Either or more than one of those three could fail and restructure, without a severe impact on the rest of the region or the world (especially if it is well managed and happens later on in this global economic recovery). This is only true as long as contagion is not stronger than adjustment and economic performance in Spain.

It is fairly clear to most in the markets that we will see a restructuring of the debt of at least one of those countries (most likely Greece), but that the EU is postponing the event for a moment in time in which the potential impact on the region and the world is significantly less of what it would have been earlier this year or now. Depending on the pace of the domino process (reaching Spain), that impact-minimization could be in jeopardy. This is the situation that needs to be monitored, and portfolios need to be designed with this in mind. We have worked to strike a balance between a fairly optimistic view of the world (especially the emerging markets) and this risk. We believe our portfolios have so far fared satisfactorily, especially due to our long-dated skepticism about the euro and its institutions, which had led to almost no exposure to the region and its currency since we started this company.