LUIFS JOURNAL

Issue 1, December 2 2011

Kimon Mikroulis, Halvor Berg Sand, Aleksandar Hristov

Lancaster University Investment & Finance Society Journal

November 2011

Contents
Publication team ............................................................................................................................. 1 Our Sponsors ................................................................................................................................... 1 The European Sovereign Debt Crisis ............................................................................................... 2 About the Author ........................................................................................................................ 2 References ................................................................................................................................... 9 It is all about trust.......................................................................................................................... 12 About the author ....................................................................................................................... 12 References ................................................................................................................................. 14 Market Overview of 28 November- December 2 .......................................................................... 15 About the author ....................................................................................................................... 15

Publication team
Editor In Chief: Kimon Mikroulis Design: Kimon Mikroulis Editors: Kimon Mikroulis, Halvor Berg Sand and Aleksandar Hristov

Our Sponsors

Ernst & Young is a global leader in assurance, tax, transaction and advisory services. We aim to have a positive impact on businesses and markets, as well as on society as a whole.

Lancaster University Investment & Finance Society Journal

December 2011

The European Sovereign Debt Crisis

by Kimon Mikroulis

About the Author

I have 4 years experience trading spot foreign exchange and metals using systematic algorithmic and discretionary trading. I have coded EMA crossover strategies with MACD, RSI and Stochastic filters to trade Yen crosses. My method is walk forward strategy optimization on Sharpe ratios to determine Kimon Mikroulis optimal timeframes and currency pairs for different market BSc Finance and Economics conditions. In addition, I follow the economic calendar and use automated trade management to enter around specific market moving events to exploit arbitrage opportunities. My research interests include foreign exchange and commodities markets, intermarket analysis, asset class correlations and market efficiency theory. Europe will be forged in crises. Those were the words of Jean Monnet, one of the European Unions chief architects and founding fathers. The truth of this adage is currently being tested as the saga of the European sovereign debt crisis continues and the mettle of the European Monetary Union (EMU) is being tried by capital markets. This essay attempts to explain how this crisis came about, examine its impacts and propose measures that could be taken to amend the situation. Even prior to the introduction of the Euro in 1999, there had been much skepticism about its vaunted advantages to European economies. However, the fears were quickly dispelled by the euphoria induced with the Euros introduction. Occurring shortly after the burst of the dot com bubble in North America, the elation spurred investors to flock to European equity markets providing huge liquidity for the nascent currency and monetary union (Currie, 1999). In addition, the adverse environment towards the dollar and concerns about another US crisis led European and Asian central banks to diversify their currency reserves into the Euro. The capital inflows in turn led to euros appreciation and were interpreted by American economist Michael Hudson as the

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harbinger of a possible conversion of Europe into a safe haven destination for capital flight during risk aversion. The emulation of Switzerlands model portended trade problems and engendered jitters about the euros exchange rate levitation (Hudson, 2003).

Figure 1 Euro-US Dollar exchange rate 1999-2011

Years before the crisis, in a perspicacious paper by Arestis and Sawyer (2001), the two authors predicted that the divergence in employment and standards of living amongst EMU members, the internal trade imbalances, and the multipronged institutional setting of the Stability and Growth Pact (SGP) would increase the financial fragility of the Eurozone and exacerbate tendencies towards financial crisis.

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Figure 2 Current account imbalances within the EMU in 2009

Congruently with their observations, the SGP was ratified in 1997 with the explicit intent to enforce fiscal discipline, but it was hardly ever implemented. The disregard of the SGP adds support to the view that it was only a shrewd political tactic by the German government to overcome the German publics reticence of giving up the Deutsche Mark in favour of the euro. This constituted a strategic choice of Germanising the Euro (Hoekstra et al., 2008) with the actual provisions to be left inert after enactment. The SGPs idiosyncrasy was further reinforced when the excessive deficit procedure (EDP) of the SGP was suspended in November 2003 and the European government bond yields barely moved to reflect the laxer rules and increased risk. The bond markets apathy hinted at an implicit economic pact between European governments and sovereign bond holders. As long as the economic rationale of fiscal sustainability remained intact, investors would leave ample wiggle room to member states to pursue growth without imposing extra costs to their debt issuance. The hiatus of market discipline would prove disastrous in the long run as the fiduciary trust was breached and exploited by national governments. Leblond (2006) cogently predicted that if member states did not

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consolidate their finances during the boom years, the interest rates on their long-term debts would soar during the bust. The bust was precipitated in 2008 by the US credit crunch and subprime lending crisis.

Figure 3 Bond yields barely moved until 2008

Furthermore, the softening of the dissuasive enforcement arm of the SGP on March 20, 2005 institutionalized moral hazard (Fourans & Warin, 2007). The ensuing infraction of the rules by fiscally delinquent states without suffering the consequences created a dangerous path whereby countries were less inclined to abide by the SGP and imprudent national governments further ignored the foregoing implicit pact with investors. Another flaw in the design of the EMU can be identified in the informal working methods of the Eurogroup, the meeting of euro area finance ministers. The absence of a central authority at the supranational level to coordinate national economic policies should have informed the Eurogroup so as to make its Recommendations legally binding for member states. Instead the emphasis was put on consensus building and was

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followed by overreliance on the voluntary commitment of individual member states to commonly agreed policy objectives (Puetter, 2004). As a result, asymmetries in the economic behavior of member states persist even today. Mayes & Virn back in 2004 examined these asymmetries and reached the conclusion that in the long run they could lead to the creation of unsustainable debt to GDP ratios. What could have mitigated this effect was the corresponding asymmetry of the enforcement rules of the EDP. Alas, by 2005, EDP was already defunct. The aforementioned misplaced faith of the markets in the efficacy of the SGP as a defacto risk pooling mechanism amongst member states was reflected in the minimal spreads between peripheral countries ten-year sovereign bond yields and the benchmark German Bunds rate. The perceived minimal risk was underscored by the credit rating agencies willingness to weigh the risk of these bonds to zero. The devastating effect was that banks were incautiously encouraged to invest in sovereign bonds and bounteously lend European governments money. Consequently, the banking sector became inextricably intertwined with regional governments and banks balance sheets were loaded with paper previously deemed of highrisk, now ostensibly assigned to zero risk rating. The banks real risk exposure foreboded a banking crisis when credit rating disparities would recrudesce and expectations of sovereign default risk would rise (Risk, 2010). With national economic policies still misaligned and the absence of a central authority reviewing and controlling spending policies, it is no wonder that eventually the ECB was forced to enact a bond-buying program in the form of temporary lending facilities in order to ensure the solvency of the banks in the EU (Walker et al., 2010). This course of action was buttressed by the previous experience of the Icelandic financial crisis where the governments ineffectiveness in bailing out its major commercial banks led to their eventual demise, which had the domino effect of a currency crisis and a still ongoing sovereign debt crisis (Olivares-Caminal, 2010).

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Unfortunately, the EU bank stress test exercise that was carried out in July of 2010 did not take into account realistic write-downs on the bonds of debt-laden countries like Greece or Ireland. Consequently, the credibility of its positive outcome was undermined and its calming effect on the markets short-lived (Krause, 2010). World-renowned international financier George Soros in a 2010 op-ed in the Financial Times highlighted the importance of bank recapitalization before any haircuts on sovereign debts are administered in order for those to be smoothly absorbed (Soros, 2010). The impact of the Euro crisis has been multitudinous. Some experts fear that it could rival the 2008 credit crisis that erupted after the bankruptcy of Lehman Brothers on September 15, 2008 (American Banker, 2010). By reducing economic activity in Europe, U.S exports to Europe will be hurt (Rick, 2010). This could force U.S companies to keep their payrolls low in fear of another recession. The static job market and enduring high unemployment levels could bode ill for the U.S recovery and create a Euro contagion (Hudgins, 2010). An inkling of this was hinted when the German government declined to bail out the Opel division of General Motors in Europe after guaranteeing a loan package to Greece, thus spelling trouble for the US car manufacturers turnaround efforts (Cremer et al., 2010). Moreover, an after-effect of the euro crisis is that countries in Central and Eastern Europe (CEE) have grown hesitant to the prospect of euro adoption after the sobering realization that it is not a panacea for economic security and prosperity (Kandell, 2010). The CEE countries wavering was exemplified by Poland which announced on May 6, 2010 its intention to defer plans of joining the euro to a later date than originally scheduled. This on the other hand can be correlated with Polands growing fiscal deficit and the contrasting need for tougher fiscal rules for new members to follow in order to gain admission, especially after the painful experience with Greeces accession to the EMU (Emerging Markets Monitor, 2010). On the investor side, the increased volatility the euro crisis has spawned in the credit markets has offered speculators the opportunity to make substantial profits by utilizing derivative instruments like foreign exchange options (Cofnas, 2010). In addition, the

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distressed debt instruments of countries like Greece have aroused the interest of fund managers due to their hefty rates of return and were oversubscribed, but the auctions had to come to a halt because Greece could not withstand the onerously high interest rates (Total Securitization & Credit Investment, 2010). The solution to the crisis may at the end lie within its origins. What created the crisis was a sustained loss of competitiveness brought about by bloated states that were profligate in creating welfare dependencies (Sanders, 2010). In response, sweeping structural reforms are needed such as reducing red tape, eliminating industry subsidies and lowering barriers to entry in professions such as law (Coy et al., 2010). A greater integration in the euro zone should also exert a grip on national governments that spend beyond their means and jeopardize economic sustainability. These behaviours can be attributed to the statist philosophy that seems to permeate Europe and puts emphasis on the state whilst denigrating free markets. By contrast in the US, belief in the general efficacy of free markets has promoted growth and prevented economic stagnation (Stephens, 2010).

Figure 4 Unit labour costs above Germany's after Euros introduction

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The yawning trade imbalances within the Eurozone should also be moderated. Germany has been accused of benefiting from these discrepancies by relying on an export model that used peripheral countries as buyers, while boosting its industrial productivity and controlling spending (Neuger, 2010). Of course this is not a zero-sum game and the solution for weaker countries is not for Germany to abandon fiscal rigour and limit its output, but for them to boost their productivity and curb unit labour costs. This can only happen by implementing much-needed liberalization reforms. Another issue is the obscurantism concerning public finances in certain countries like Greece. This should be brought to bear by increased transparency and inspection from third parties (Economist, 2010). What Europe might ultimately need is a populist movement that instead of more debt and more entitlements demands smaller and less-intrusive government. In conclusion, the Euro crisis may indeed prove to be a seminal moment for Europe. A proper response could have such reverberating effects to the structure of European societies that could reestablish their modern social contracts and ground them on healthier foundations. Economic liberalization could curb public spending and dependence on state largess, while fiscal conservatism could shatter the tyranny of thought that afflicts the current beneficiaries who form the political majority in these counties - from retirees to government workers to university students. Maybe then we would have governments in Europe that advocate fiscal accountability and private enterprise for sustainable growth and real unlevered economic prosperity.

References
American Banker (2010) Euro Crisis Could Rival Credit Crunch. American Banker, 175 (F319), p.15. Arestis, P. & Sawyer, M. (2001) Will the Euro Bring Economic Crisis to Europe? In: What global economic crisis? New York, Palgrave Macmillan, pp.78-103. Cofnas, A. (2010) Euro crises, options opportunity. Futures: News, Analysis & Strategies

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for Futures, Options & Derivatives Traders, 39 (4), p.28. Coy, P., Brady, D., Layne, R., Petrakis, M., Pressley, J. & Reiter, C. (2010) Come Together. Bloomberg Businessweek, (4180), pp.5-7. Cremer, A., Reiter, C. & Welch, D. (2010) GM's Fast Turnaround Slams into the Euro Crisis. Bloomberg Businessweek, (4182), pp.19-20. Currie, A. (1999) Issue now -- before the next crisis. Euromoney, (358), pp.98-100. Economist (2010) Euro follies: The European Unions plans to repair its single currency risk missing the main point. Economist, 396 (8701), pp.20-22. Emerging Markets Monitor (2010) Poland: Greek Crisis Further Delays Euro Adoption. Emerging Markets Monitor, 16 (7), p.16. Fourans, A. & Warin, T. (2007) Stability and Growth Pact II: Incentives and Moral Hazard. Journal of Economic Policy Reform, 10 (1), pp.51-62. Hoekstra, R., Horstmann, C., Knabl, J., Kruse, D. & Wiedemann, S. (2008) The Stability and Growth Pact--Germanising the Euro. International Journal of Public Policy, 3 (1-2), pp.100-117. Hudgins, M. (2010) Euro contagion, weak employment threaten recovery. National Real Estate Investor, 52 (5), p.21. Hudson, M. (2003) Will Europe Suffer The Swiss Syndrome? International Economy, 17 (4), p.50. Kandell, J. (2010) Paradise Postponed. Institutional Investor-International Edition, 35 (4), pp.42-48. Krause, R. (2010) Euro Crisis Spreads To Spain, Portugal, Italy As Yields Swell. Investors Business Daily, December 1 2010, p.A01. Leblond, P. (2006) The Political Stability and Growth Pact Is Dead: Long Live the Economic Stability and Growth Pact. Journal of Common Market Studies, 44 (5), pp.969-990. Mayes, D. & Virn, M. (2004) Pressures on the Stability and Growth Pact from asymmetry in policy. Journal of European Public Policy, 11 (5), pp.781-797. Neuger, J. (2010) The Perils of Pragmatism. Bloomberg Businessweek, (4198), pp.67-68.

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Olivares-Caminal, R. (2010) Sovereign debt defaults: Paradigms and challenges. Journal of Banking Regulation, 11 (2), pp.91-94. Puetter, U. (2004) Governing informally: the role of the Eurogroup in EMU and the Stability and Growth Pact. Journal of European Public Policy, 11 (5), pp.854-870. Rick, S. (2010) What Happens in Europe Doesn't Stay in Europe. Credit Union Magazine, 76 (7), p.74. Risk, H. (2010) Banks can't dodge the EU sovereign debt crisis. Euromoney, 41 (491), pp.91-95. Sanders, S. (2010) The EU factor in the euro crisis. Washington Times, March 1 2010, p.4. Soros, G. (2010) Europe should rescue banks before states. Financial Times. [online] December 15 2010. Available from: < http://www.ft.com/cms/s/0/76f69cd8077a-11e0-8d80-00144feabdc0.html> Stephens, B. (2010) Europe's Crisis of Ideas. Wall Street Journal - Eastern Edition, 255 (43), p.A17. Total Securitization & Credit Investment (2010) Sovereign Debt Crisis Spurs Interest In Distressed Investments. Total Securitization & Credit Investment, July 2 2010, p.23. Walker, M., Forelle, C., Blackstone, B. & Gauthier-Villars, D. (2010) Currency Union Teetering, 'Mr. Euro' Is Forced to Act. Wall Street Journal - Eastern Edition, 256 (74), pp.A1-A16.

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It is all about trust

by Halvor Berg Sand

About the author

I have managed around 10,000 the last two years, investing in the Norwegian Stock Market. My focus is long term value investing and current holdings include the biggest insurance company in Norway, a gasoline station chain and a specialised EPC (engineering, procurement and construction) company. As of today, my biggest position is cash. Research interests include long term investments, hedge fund strategy and managers, risk adjusted return and the Norwegian Government Pension Fund (the largest pension fund in Europe and the US).

Halvor Berg Sand BSc Business Studies

This Wednesday, November 30 2011, we saw a coordinated action from major central banks to improve dollar liquidity support in the markets. The European Central Bank, the Federal Reserve, the Bank of England, the Bank of Japan, the Swiss National Bank and The Bank of Canada jointly announced lowering the minimum bid rate of existing temporary U.S. dollar liquidity swap arrangements by 50 basis points. Four of the banks, the Swiss, the English, Japanese and the ECB also declared that they will continue to offer three-month tenders until further notice (Appelbaum, 2011). As a result, banks will be able to borrow at a lower cost, since the cost decreased to the overnight index swap (OIS) rate plus 50 basis points. Fun fact, the central banks of Norway, Denmark, Sweden, Korea and Mexico have already had a premium of 50 basis points plus either OIS, LIBOR or TAF for many years, at least since 2008. Australia charges no premium on minimum bid rate (Goldberg et al., 2011) Except Mexico, these are all countries with a strong economy. Equity markets adjusted quickly by rallying sharply in response to this new information. The following overview was taken on 2011-12-01 at 01.15am, after closing time for most stock exchanges involved, except Japan.

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What is the logic behind this outcome? This intervention could only be seen as a pain killer or a tie break, because it definitely did not solve the underlying problem. However, the Central Banks did quell short-term dollar liquidity fears and the market finds the probability of a Lehman Brothers dj vu less likely after this announcement. To understand the importance of a liquid USD market in Europe, we can have a look at the change in European banks balance sheets over the last decade. USD exposures accounted for half of the growth in the banks foreign exposures over the 2000-07 period and the amount carried forward by banks in the Eurozone, Switzerland and the UK was more than 8 trillion USD in 2008, of which up to 16% was short term financing (McGuire & von Peter, 2009). All of the banks involved in the liquidity improvement are seen as Strong members of the Bank of International Settlements (BIS). The BIS is the central bank for central banks and a prerequisite for being a BIS member is that the central bank must operate free of political constraints. Many people, myself included, find it worrying that those central banks must take the initiative to change the direction the global economy is heading now. In my dream world strong political principals lead bureaucrats, not weak political principals being saved by proactive bureaucrats. You could always argue that the governors in the different central banks are just doing their job, but lack of political leadership is one of the main raison d'tre for the current crisis.

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References
Appelbaum, B., 6 Central Banks Act to Buy Time in Europe Crisis NY Times Online http://www.nytimes.com/2011/12/01/business/central-banks-move-together-to-easedebt-crisis.html?_r=1 Goldberg, L., Kennedy, C. and Miu J. May 2011 Central Bank Dollar SwapLines and Overseas Dollar Funding Costs Federal Bank of New York Economic Policy Review McGuire, P., and G. von Peter. 2009a. The U.S. Dollar Shortage in Global Banking. Bank for International Settlements Quarterly Review, March: 47-63.

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Market Overview of 28 November- December 2

by Aleksandar Hristov

About the author

I am currently studying MSc Finance. I have developed an interest in equities and more specifically value investing and identifying mispriced stocks. Further topics include general behavioral finance and investing strategies. Outside finance, I am a passionate free skier and currently trying to progress (not very successfully though) in wakeboarding.

Aleksandar Hristov MSc Finance

The past few months were a wild rollercoaster for financial markets around the world. The driving force behind the market sentiment has been the Sovereign Debt Crisis in the euro zone. The uncertainties around the future of the heavily indebted Greece, and the more recent fears that Italy will follow suit (its last 10-year bond auction hit a record yield of 7.56% on Tuesday), have led the outflow of capital from Europes equity markets to other (presumably) safer investments. The tension between EU leaders concerning the path that the union has to go was an additional factor for the day-to-day stock market movements. The signs that Germany, in particular, is unwilling to bail out the troubled union members has on many occasions caused panic among investors, leading to equity sell offs. Last week was a little different. The week started with optimism, caused by hopes that EU leaders are going to finally cooperate to resolve the debt crisis and reach an agreement on its bail out facility. Surprisingly, as the week progressed, global equities rallied, finishing the week in the blue and posting the highest weekly gains in nearly 3 years. On Monday, Nov 28, the FTSE 100 closed the trading session with gains, after having reached a 7-week low the previous week. In the beginning of the day the market was fuelled by rumors that Italy is negotiating a loan from the IMF, which were later dismissed. Similarly, Wall Street ended its losing streak mostly due to the record Black Friday sales profits. Tuesday followed without any major news on the fundamental side.

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On Wednesday, Nov 30, markets gained confidence after six of the worlds richest central banks announced a coordinated move in an attempt to inject liquidity in the financial system. Their collective decision was to cut the cost of dollar swap lines (effectively targeting the shortage of USD in Euro zone banks). This action alleviated the fears from a credit crunch in EU countries. Just a few hours before that, the Peoples Bank of China announced it is lowering the reserve requirements for Chinese banks by half a percent. The wave of announcements triggered a rally in the stock markets across the world. On the day FTSE 100 closed at 5,505 (+3.16%, the biggest rise for eight weeks) while S&P 500 realised best gains since August (+4.33%), Dow and NASDAQ both rose by 4.2%. Markets on Thursday were uncertain and no notable events occurd. Better-than-expected economic news helped markets in the US gain more than one percent on Friday. The unemployment rate dropped from 9 percent to the two and a half year low of 8.6 percent. Financials were the top gainers of the S&P 500, with JPMorgan Chase in the lead with 8 percent increase. Similarly, the beaten down banking stocks in the UK bounced back to be the top performing sector with Barclays in the lead (+7.6%). Hopes on an agreement between euro zone leaders next week also boosted gains. In summary, all major stock market indexes posted their best performance in 3 years, with FTSE 100 up 7.5%, S&P 500 rose more than 8%, and the FTSE All Share gained 8.75%. Technical analysis

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From the technical perspective, the FTSE 100 has gained a strong momentum during last week. However, it is currently close to resistance at 5650 and faces additional an psychological test as it is approaching the 200 day Moving Average. If the FTSE loses momentum it is likely to plunge as deep as the last support level at 5100 (with next strong support level being 4810 from May 2010).

The S&P 500 is facing a similar configuration as the FTSE 100. Both patterns are facing too many uncertainties to make solid conclusions. What to expect from next week? The proactive announcements from the German Chancellor Angela Merkel and the French President Nicola Sarkozy showing their support for a fiscal union have given bullish investors a reason to hold their positions. The scheduled meeting on Monday, where both parties will outline proposals for the EU summit on the 9 December, will determine whether we will see more optimism before Friday or if the bearish sentiment will take over. Another must-watch event next week is the IPO of Zynga, the Facebook game maker (Farmville anyone?). The company plans to float 11.1% of its shares on the stock market, hoping to raise as much as $1 billion. If successful, this would be the highest valued initial public offering of a US Internet company since Google became public in 2004. The IPO prices put a value on the company of between $7.7bn and $9bn, making it one of the largest publicly traded game companies in the United States. We will see next week

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whether it will be as successful as the debut of the business social network LinkedIn, or as doubtful as the performance of Groupon, both from earlier this year.

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