Economics and politics of trading zone drives events

What an interesting week this past one has been!

Filled with portents of disaster and the promise of rejuvenation. Lucas Papademos takes charge as the new Greek Prime Minister, knowing very well that the path ahead is not just perilous for his country, but for the Eurozone itself. Silvio Berlusconi who resigned as the Italian Prime Minister, leaves behind a disastrous legacy as a modern day Nero who fiddled (or, to wit, fondled) while Rome burdened itself with new debt issuances and paid higher interest rates. Pakistan, meanwhile, granted India the most favoured nation status, thus allowing the possibility of increased trade and economic integration in the decades ahead. In similar ways these are three variations on the same theme: the economics and politics of a trading zone.

By July 2011, outstanding Greek debt in nominal terms was ¤366 billion. Domestic Greek institutions, like banks and asset managers, hold €104 billion of these debts. Any reduction in value of these bonds held by them would mean that these asset managers (such as pension funds) would need to be recapitalised in order to provide for regular citizens.

The ensuing chaos is unchartered waters that no politician wants to sail in. Supranational entities like the IMF, ECB and others hold another €118 billion of debt. As Papademos has clarified, it is "inconceivable" that Greece will default on such obligations since the ramifications extend well beyond Greece's credit worthiness and will effect the public finances of the rest Europe. So, this remainder is €144 billion held by foreign non-sovereign institutions.

The Merkel-Sarkozy plan had offered a plan that involves: a haircut on private debt (around 21 per cent of notional) and additional support by the European Financial Stability Facility (EFSF). Others want private lenders to be penalised for their spurious practices. Papademos, however, has argued that should the haircut on the private bond holders increase from 20 to 50 per cent, this would only reduce the outstanding debt by 4-6 per cent while the consequences on other European sovereign and corporate debt would be all too large. So, he advocates that the Merkel-Sarkozy plan be implemented as is.

Haircut on bonds

Ironically, European Council has come out and questioned the extent of the haircut on bonds expected of private players. This seems to have been interpreted as a possible unwillingness by the creditors in the Eurozone to bailout any sovereign state. In the hall of mirrors where these negotiations take place, a clear perspective is hard to come by. Predictably, the bond yields and CDS spreads on European debt has spiked. As of writing yesterday, the Italian CDS premium briefly crossed the 600 basis point.

A CDS spread is like an insurance premium paid to protect against losses on bond notionals. In April-May 2011, Italian CDS premium traded at 126 basis point of notional insured. (i.e., in April, to insure 10 million of bond cost €126,000; now it costs €600,000.) The perceived risk of these bonds has virtually tripled. Similarly, again, the yields on 2 year bonds issued by France and Belgium have spiked by 16 per cent, the Austrian bonds by 24 per cent, the Dutch bond by 44 per cent etc., A capital flight into German bonds seems inexorable. The Greeks today face a unique quandary: the solutions to their problem lie beyond their hands.

So, now what?

To save the Eurozone, some have openly advocated the creation of a Eurobond market. This would mean that an agency like EFSF would become a bond buying agency from the rest of European sovereigns.

Its ability to purchase would be financed by the European Central Bank which would "print" money. Per this view, the solution to the Eurozone crisis involves greater centralisation, a visible commitment to a fiscal union (with uncertain spending rules) that is morphologically and legally equivalent to one large country. Yet, the question remains, will politics allow for individual countries to subsume their historic fiscal freedoms? Will they subsidise others? Therein lies the hardest of all questions. After all, who can blame if one wants to tango with only those who dance as well as themselves.

Meanwhile the Pakistan-India MFN deal is rightly hailed as a step in the right direction. Lowered transaction costs and increased competition is likely to spur productivity growth between the two countries. But, the consequences of increased trade go well beyond what meets the eye. Trade creates losers and winners in any society. The question, always, is how do societies channel the energies and protect the losers from trade?

Further, should trade levels increase manifold over a decade, how long will it be before one country exports inflation to the other? This will inevitably bring out into the open, questions regarding the harmonisation of monetary policy and currency substitutability.

In two decades, ceteris paribus, it should not come as a surprise if India and Pakistan end up closer to each other thanks to commerce and trade than all the peace talks and confidence building measures have managed. The hurdle here too, is the nature of the political discourse.

So, while Europe seems to stand at a crossroads between a collapse of the Eurozone and increased centralisation; India and Pakistan like estranged cousins have gingerly begun a process of rapprochement, with far-reaching consequences.

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.