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By Jeremy Glaser | 08-09-2012 01:00 PM

Only a Haircut Will Do in Europe

While liquidity may provide temporary relief, only debt reduction--and a creditor haircut--will put Europe back on the road to growth, says TCW's Komal Sri-Kumar.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm pleased to be joined today by Komal Sri-Kumar. He's the chief global strategist and group managing director of TCW. He's also the chair of the asset allocation committee.

We're going to talk about the future of the European sovereign debt crisis, and if the United States is headed for another recession.

Sri, thanks for joining me, today.

Sri-Kumar: Good to be here, Jeremy.

Glaser: So, let's start in Europe. Certainly that's an area of interest on a lot of investors' minds. Recently there's been some excitement--as excited as anyone gets about Europe nowadays--about the European Central Bank buying bonds, trying to keep Spanish yields down.

Do you think this is a viable strategy? Can the ECB really act here to keep the crisis contained?

Sri-Kumar: Jeremy, I think it is viable only in the very short term. This is not the first rescue operation the Europeans have gone through, and even in the part of the ECB, we saw that they did two repurchase agreements, known as the LTRO, last December and again in February, totaling about €1 trillion, and you got the benefit of it in terms of lower interest rates on the bond market for two months, and then the rates went up again.

I think the same thing is going to happen again, and the basic reason is, Europe, many parts of Europe, have a solvency problem; it's not a liquidity issue. So providing them with additional liquidity is not going to get rid of the main problem, which is that they have an excess level of debt, which has to be reduced.

Glaser: So is there anything that policymakers can do, then, at this point to try to stem the crisis, or is this already so out of control that the euro is kind of doomed, and we need to just start preparing for that fallout?

Sri-Kumar: Absolutely timely question. I think what comes out of the Latin American experience in the 1980s, where I started my career, is that we had something called a Brady Plan in 1989, named after U.S. Treasury Secretary Nicholas Brady at that time. This involved a reduction in the level of debt of countries like Mexico and Brazil and Argentina. We allowed for debt-to-equity conversions. So, overall, we brought down the level of debt to a level that the countries could service, and that's what made Latin America start to grow again.

What we need to do, Jeremy, is to have the eurozone countries grow again, rather than have a more and more severe recession, and that won't happen until the debt level is reduced.

Instead of that, what we are doing is adding to the level of debt. Can you believe that? They can't pay the existing level of debt, and we are providing them more debt in the form of bailouts, so the situation gets worse, surprising only to the European powers, not to us investors.

Glaser: But is there any appetite for that debt reduction? Is it something that's politically feasible, or will it never actually happen?

Sri-Kumar: The debt reduction is never voluntarily done. It gets eventually forced on the governments. Even in the 1980s with Latin America, we tried many, many, many bailouts between 1982 and 1988, before we gave up and said they need debt reduction.

The problem with debt reduction is, somebody needs to take a haircut on the other side--they are going to be the creditors, the lenders who lent all the billions, trillions of dollars of money to the different countries, which is why they resisted. And eventually, I think that has to happen, and that's when the situation starts to improve. So that's your answer to what needs to be done. What can be done to turn the situation around.

Glaser: So if we're looking at the euro, then, can it survive this? With these debt reductions, will it survive? Or will it fall before these debt reductions are forced?

Sri-Kumar: I think if the debt reduction is done fairly soon, meaning within the next two to three months, and then you eject one country, say perhaps Greece, and then put a firewall around the remaining 16 members so that they are protected from further deterioration in the situation, you can save the euro.

But if they decide to postpone it, as they have done in the last three years, and don't deal with the problem until well into 2013, then the whole euro concept is going to be in jeopardy. And then you have to ask, not just will Greece or Portugal will leave the eurozone, but whether Germany will be better off leaving the eurozone and forming a strong currency union with a few other countries.

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