Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)
Michelangelo is credited with the saying: “The greatest danger for most of us is not that we aim too high and we miss it, but we aim too low and reach it.” In 13 emergency summits over 20 months, Europe has not only aimed low but failed consistently to reach even these modest targets.
In the course of the most recent summit, Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of action. This summit follows the 21 July 2011 declaration of a definitive “grand” plan to solve the problem. Like the ones before it, the 26 October meeting yielded a plan to have a plan to have a plan etc. There’s no reason to believe that this summit will be the last.
The actions needed to try to stabilise the European debt crisis are well recognised. Countries like Greece need to restructure its debt to reduce the amount owed – an euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilised by injecting new capital and ensuring access to funding to avoid insolvency. A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.
Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.
Greece has an unsustainable level of debt. The only way that the country’s solvency can be restored is by writing off a portion of this debt.
In July 2011, there was agreement with the banks to write-off around 21% of outstanding debt. The complexity of the deal meant that, in effect, the write-downs might have been as low as 5%. On 27 October 2011, the Institute of International Finance (“IIF”), on behalf of the banks and investors holding Greek bonds, agreed to a 50% haircut.
Greece has around Euro 350 billion in debt including Euro 70 billion in bailout loans and around Euro 80 billion in bonds held by the European Central Bank (“ECB”). A 50% haircut of the remaining Euro 200 billion equates to reduction of Euro 100 billion. This also ignores that around Euro 85 billion is held by Greek banks and pension funds, which further reduces the effect of the write-down.
At best, the reduction of Euro 100 billion is less than 30% of outstanding debt, as only private investors were covered. Greek bonds held by official institutions such as the ECB are excluded, to avoid embarrassingly large losses for the ECB, which would then require an injection of capital into the institution.
Banks and investors were “invited” to accept a 50% write down on the value of their Greek bond holdings under threat of an even larger losses if they did not agree. The write-down will come in the form of a voluntary bond exchange. Negotiations on the quantum of the haircuts were complicated by the requirement that the write-downs be voluntary to avoid triggering credit default swaps (“CDS”) contracts, a form of credit insurance. The banks argued that anything more than 40% was not “voluntary”. This increases the risk that some banks will refuse to participate in the restructuring and the triggering of widespread disruption to financial markets.
Without the write-down, a leaked assessment by the“Troika” (The European Union (“EU”), ECB and International Monetary Fund (“IMF”)) indicated that Greece would need Euro 252 billion in funding through 2020 with debt peaking at around 190% of gross domestic product (“GDP”) in 2013. According to the report, a 50% haircut reduces debt to 120% of GDP and funding requirements to Euro 114 billion through 2020. These forecasts are optimistic, assuming a return to growth by 2013. In the last 2 years, Greece’s economy has shrunk by around 15% with a further 3-5% expected in 2012.
While the write-downs were needed, it is unclear whether the quantum is sufficient and whether Greece’s residual debt burden is sustainable. A debt to GDP ratio of around 60-80% may be more realistic. This would require further write-downs. Based on history, a write-down of debt for distressed borrowers is frequently followed by others.
Much will depend on the growth trajectory of the Greek economy and the necessary structural reforms and asset sales. Greece has consistently failed to meet economic forecasts to date. One part of the new package was approval of a “new” facility of Euro 130 billion, an increase from the Euro 109 agreed in July 2011 reflecting a sharp deterioration in the outlook for Greece, since July 2011.
People like us…
The EU, to date, has carefully confined discussions about debt restructuring to Greece. The attention of financial markets will inevitably turn to Ireland and Portugal.
Ireland’s economy is improving with growth projections having been recently revised upwards. The country has implemented an aggressive austerity package, entailing tax and spending cuts equivalent to 20% of the country’s GDP (around Euro 30 billion) over a 7 year period. Government finances have improved with the budget deficit likely to shrink to a still very large 10% of GDP, from 32% in 2010, with a target of 3% by 2015. Government debt is now expected to peak at around 120-125% of GDP in 2013.
The improvements in the economy have come at a cost. Output has shrunk by nearly 20%, unemployment is 14% and house prices have fallen 43%. Bailouts of Irish banks have cost around Euro 85 billion to date.
With domestic demand flat at best, Ireland is dependent on exports. The deteriorating global environment is a major risk, with the potential to reduce growth and making it harder to meet budget and debt targets prescribed by the bailout package. The need for further capital injections into the banks as the property market continues to weaken cannot be ruled out.
Portugal is in the midst of its deepest recession for 30 years, with the economy likely to contract by anywhere (up to) 5% this year. Unemployment is over 13%. Promised structural reforms are proving difficult to implement. A return to growth by 2013 looks ambitious.
Despite measures, such as a 27% cut to public sector pay, hidden debts of Euro 3.4 billion, including Euro 1.1 billion on the island of Madeira, have undermined efforts to regain control of public finances. The budget deficit this year will be around 7%. A reduction of Portugal’s credit rating to “junk” or non-investment grade has also increased its cost of funds.
The Greek write-downs may create speculation for Ireland and Portugal to follow suit, especially if economic condition deteriorate.
The EU plans calls for Euro 106 billion in recapitalisation of European banks, primarily to cover losses on holdings of sovereign debt such as Greece, by June 2012. The core idea is to revalue distressed sovereign bonds at current market prices and increase capital levels to 9% of risky assets to provide adequate solvency margins.
The amount is at the low end of what is required. The amount of recapitalisation focuses on losses from holding of Greek bonds. Taking into account possible losses on Irish, Portuguese, Spanish and Italians bonds, the required recapitalisation is around Euro 200-250 billion.
In total, global banks have exposures around $2.2 trillion to Portuguese, Irish, Italian, Greek and Spanish debt. The exposure of German and French banks to troubled European countries is around $1 trillion.
According to the European Banking Authority stress tests conducted in July 2011, the 90 largest European banks have exposure to Greece of Euro 90 billion. These European banks have larger exposures to Spain (Euro 287 billion) and Italy (Euro 326 billion) as well as to France (Euro 215 billion). The banks also have large exposures to private sector debt in these countries, which would be affected by problems of the sovereign. For example, French banks hold around Euro 400 billion of Italian private debt.
In addition, the recapitalisation does not take into account “second order” effects. The write-offs, covering the cost of recapitalisation and the general de-leveraging (reduction in debt) are likely to reduce economic growth resulting in increasing credit losses that must be covered. This may increase the required recapitalisation by another Euro 100 billion bringing the total to Euro 300-350 billion.
The recapitalisation is to be overseen by the European Banking Authority (“EBA”). A little more than 3 month ago the EBA calculated that only 8 out of the tested 90 European banks were in danger in a stressed scenario and needed a mere Euro 2.5 billion in additional capital. The EBA also passed the Franco-Belgium financial institution Dexia, which subsequently had to taken over by the governments of Belgium and France requiring the assumption of Euro 90 billion in debt.
It is not clear where the additional capital is coming from. Banks must try to raise the capital privately through equity raisings or restructuring and conversion of existing instruments into equity. Banks should also reduce dividends and bonus payments to improve their capital position. If this is insufficient or unsuccessful, national governments are required to provide support. Recapitalisation funded via a loan from the European Financial Stability Fund (“EFSF”), the European bailout fund, is the last resort.
Given concerns about asset quality, earnings, dividends and (in some cases) the health of the sovereign, banks are likely to face difficulties in raising private capital. There will be increased pressure on nations, like France and Germany, to inject capital into their banks, affecting their own financial position. As banks within the weakest economies, Greece, Portugal, Ireland, Spain and Italy, hold large exposures to sovereign bonds, they will, in all probability, have to seek support from the EFSF. Greek, Italian and Spanish banks account for about two-thirds of the Euro 106 billion of capital that will have to be raised.
Reluctant to dilute existing shareholders, some large banks have stated that they may choose to sell assets and stop new lending to meet capital targets. The EU and national regulators will prevent excessive “deleveraging” to ensure adequate flow of credit flow to the real economy to avoid slowing down growth. As much as $2 trillion of assets may be sold as part of the program to reach the new capital levels with an unknown effect of economic activity.
Recent history, in Japan in 1998 and the US in 2008, suggests that recapitalisation programs accelerate the process of banks reducing assets. The conflicting objectives – recapitalisation and reducing leverage to improve capital levels and maintaining flow of credit to provide for economic growth – may not be able to be simultaneously accommodated.
There are already signs of resistance to or efforts to dilute the recapitalisation measures. German and Spanish banks are seeking to have the definition of capital altered to accommodate instruments other than share capital, as mandated.
European banks, especially banks in weaker countries, have faced significant difficulties in raising long term money from financial markets to fund their activities. Funding costs have increased. The ECB has provided around Euro 500 billion to European banks to fund the system.
The EU proposal wants banks to reduce reliance on short-term funds but offers no concrete proposals, at this stage, for actions to improve the ability of banks to raise term money. If the states provide guarantees to support the banks, then this would affect the credit quality of the sovereign and increase its potential financial obligations.
An enhanced EFSF is the cornerstone of efforts to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis.
Following an expansion of its powers in mid 2011, the EFSF can:
1. Issue bonds or other debt instruments on the market to raise the funds needed to provide loans to countries in financial difficulties.
2. Intervene in the primary or secondary debt markets.
3. Act on the basis of a precautionary program, presumably by providing credit lines.
4. Finance recapitalisation of financial institutions through loans to governments.
The EFSF will provide loans to or purchase bonds in order to support market access for Euro-Zone Member States faced with market pressures and to ensure that their cost of borrowing does not rise to levels that threatens solvency.
The original capacity of the bailout fund was Euro 750 billion – Euro 440 from the EFSF with the remainder being provided by the International Monetary Fund (“IMF”) and European Union (“EU”). The structure and the condition of the EFSF’s AAA rating meant that its capacity was limited to around Euro 250 billion. This issue was subsequently addressed with changes to the structure that were finalised and ratified by member states only recently. In effect, the EFSF’s capacity is still the same as it was when it was originally announced in mid 2010. There has been no commitment of new funds for the bailout by Euro-Zone members.
The EFSF does not have adequate resources to perform its functions.
After accounting for existing commitments to Greece, Ireland and Portugal, the fund’s available capacity is around Euro 200-250 billion. If it has to finance recapitalisation of banks in member states, then this capacity is further reduced.
The amount available can be compared to the financing requirements of beleaguered European countries. In the period to the end of 2013, Ireland, Portugal, Spain, Italy and Belgium will need to raise about Euro 700 billion to finance their deficits and refinance maturing debt. In 2012, Spain faces maturing debt of around Euro 120 billion. Italy has debt maturities in 2012 of Euro 260 billion and another Euro 150 billion in 2013. Crucially, Italy faced debt maturities of around Euro 40 billion in February 2012. Over the next 3 years, Spain and Italy will need to find around Euro 1 trillion to meet their financing requirements.
Italy’s total debt is Euro 1.9 trillion (118% of GDP), the fourth-largest debt in the world after the United States, Japan and Germany. Spain’s total debt is above Euro 600 billion (61% of GDP).
Amusingly the French President’s brother Olivier Sarkozy, head of the financial services group at Carlyle, in an opinion piece published in the Financial Times, estimated the total required for European banks alone to be Euro 1.4 trillion.
In order to enhance the capacity of the EFSF, the EU proposes to leverage the fund. In the period leading up to the 27 October 2011 announcement, the authorities looked at a variety of options. These included: conversion of the EFSF into a bank, the EFSF borrowing money from the ECB, the EFSF providing credit insurance on member state bonds (either in the form of insurance or via derivative instruments such as CDS) or providing a partial first loss guarantee on sovereign debt.
The EU proposes provision of credit enhancement to new debt issued by member states to reduce its funding costs. This will entail, apparently, the EFSF guaranteeing a certain percentage of the first losses on new bonds. Promoted by German insurer Allianz, the plan would entail investors in say Ireland, Portugal, Italy and Spain being protected against losses on bond holdings, up to an unconfirmed amount of around 20%.
The plan raises several issues:
1. The bondholders would still look to the issuer and assess its solvency and ability to meet its obligations.
2. If losses turn out to be above the insured first loss amount then the investor would be at risk. Losses on sovereign bonds are variable and difficult to predict.
3. Technical details such as the trigger of the payment, the loss determination and payment mechanisms are complex.
4. The insurance would apply to new issues and may create a two-tier market – one for existing bonds and another for the new insured securities.
5. This risk insurance would be offered to private investors as an option when buying bonds in the primary market for a price. There are uncertainties about the price. It is also not clear that it would be preferable to alternatives already commercially available such as CDS.
6. The legal impact of such insurance on legal provisions of existing bonds, such as the negative pledge and pari passu clause which prevents the borrower from pledging its assets to prefer a particular group of creditors or change the ranking of investors.
To address some of these problems, the EU has proposed the issue of detachable insurance certificates that can be freely traded which would be available with new bonds. The price of this insurance would be reflected in the lower interest rates on such bonds. Following a default event, the certificate would entitle the holder to claim their entitlement for the loss suffered not in cash but in EFSF bonds. In the absence of full details, it is difficult to assess the complex arrangements.
The structure introduces unnecessary problems. If the certificates are regarded as derivative contracts then many investors may not be able to purchase them. The accounting treatment of these certificates, vital to ensuring protection against losses in financial statements, is uncertain. The structure also introduces exposure to the credit standing of the EFSF itself as the insurer.
It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries like Spain and Italy.
The enhanced EFSF plan does not address fundamental problems of its structure. The EFSF in severally guaranteed by Euro-Zone member states (up to a stated amount). Major guarantors are Germany 29.07%, France 21.83%, Italy 19.18%, Spain 12.75%, Netherlands 6.12% and Belgium 3.75%. Given that Italy and Spain as well as others may need to avail themselves of the assistance of the EFSF, the circular nature of the scheme remains an issue with weakened nations undertaking to rescue themselves and their banks.
In the event that Italy and Spain need assistance, then they could not guarantee the EFSF, increasing the burden on larger and more creditworthy nations, such as Germany and France. In a recent research piece, analysts at UK bank RBS estimated that containing the crisis could require a bailout facility of over Euro 3.0 trillion, providing an effective lending capacity of around Euro 2 trillion. The size of the facility is dictated by the fact that maximum lending capacity is limited by the guarantee commitments of the AAA countries.
If the guarantees were treated as debt, a facility of this size would add Euro 727 billion to Germany’s existing Euro 211 billion of guarantees (bringing its debt to GDP ratio to around 110%). France’s guarantee commitments would increase to Euro 705 billion from Euro 159 billion (bringing its debt to GDP to around 112%). The Netherlands’ guarantee commitments would increase to Euro 198 billion from Euro 45 billion (bringing its debt to GDP to around 89%). This would place significant pressure on the ratings of these countries, especially France. Any downgrade to these AAA rated guarantors would undermine the effectiveness of the EFSF as provider of the bailout funds.
To date, the EFSF has issued only Euro 13 billion of bonds, around 20% of which were purchased by Japanese investors. The bonds have underperformed other AAA securities in secondary market trading suggesting concerns about its structure and raising doubts as to its future ability to raise funds at low costs.
What’s Chinese for Begging Bowl…
A second option proposed is to enhance the EFSF using resources from private and public financial institutions and investors through Special Purpose Vehicles (“SPV”). Few details are available currently.
The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the fund’s capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralised debt obligations (“CDOs”) and Structured Investment Vehicles (“SIVs”).
Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.
China has considerable “skin in this game”. Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in Euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.
The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. Officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are
seeking to limit their exposure.
China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.
But China seems desperate to be seen as a “global power”. Ego might seduce them into committing more money.
Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around Euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of Euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.
Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.
The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.
The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.
Without Wings, Sans Prayers…
Time will determine whether the plan creates “confidence” or is just a “con”. Promoters of the first loss guarantee scheme seem to believe that just providing it will solve the crisis and the commitment will not be drawn upon. When the EFSF was originally instituted, EU policymakers also thought it would never be needed to be activated.
The initial market response to the EU proposal was positive, with major stock markets and bank shares rising sharply. Financial markets focused on the tweet – European leaders conclude deal- agreement on 50% Greek debt write-down bank recapitalisation and boosting the bailout fund to Euro 1 trillion. 140 characters can not do justice to the issues and complexity. The market response ignored the lack of detail. They cheered the fact that an agreement had been reached, thanking the prevailing saint of the impossible.
Unlike equity markets, debt traders were cautious. On Friday 29 October, an Italian debt auction met with lack lustre demand falling short of the full amount offered for sale. The debt markets registered their doubts by pushing up 10 year interest rates on the bonds of both Italy (up 0.14% per annum to 6.01% per annum) and Spain (up 0.18% per cent to 5.49%). Greek rates remained high at 22.35% for 10 years while comparable Portuguese rates were 11.48% and Irish rates were 7.98%.
Equity markets held their gains but investors increasingly sought more information about the details of the proposal.
Implementation of the plan faces significant risks. Many elements of the plan are works in progress and are yet to be agreed with affected parties.
The decision by the Greek Prime Minister to seek support for the arrangements in a referendum to be held early in 2012 casts doubt on even whether Greece will ultimately accept the plan.
It is not certain that the IIF will be able to obtain the agreement of the banks to the 50% write-down. In the earlier agreement for a 21% haircut, the IIF anticipated a 90% participation rate. Subsequently, officials decided they could live with 80%, but the acceptance rate came in at roughly 75%. With higher losses, a deteriorating overall economic position and lack of agreement on aspects of the plan, agreement cannot be assumed. Funding for the bank recapitalisation and the ability of the EFSF to leverage or attract third party investment also remain uncertain.
The deal may yet flounder on the highly technical point of whether future Greek bonds will be governed by international law or Greek law, which governs 90% of existing Greek bonds. Aimed at preventing Greece from changing its laws to disadvantage creditors, such a change would be unprecedented for an EU country.
The players also seemed to have left the summit with different song sheets. ECB council member and head of the German Bundesbank Jens Weidmann expressed doubt about proposals to increase the capacity of the EFSF through leverage: “The leverage instruments that have been tabled are similar in their design to those that helped to cause the crisis.” He also observed that: “it [is] very important that all aid extended to member states under threat should only be in the form of loans.” Portugal asked Mexico to tell fellow G20 members at an upcoming meeting that the United States should offer “financial help”.
Germany’s Finance Minister Wolfgang Schäuble and retiring ECB President Jean-Claude Trichet pointedly cautioned that the crisis was far from over.
At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s deep seated structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency.
A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for action by these two members at some length. There is considerable doubt as to whether this will occur.
Spain’s economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain’s growth has slowed with an increase in the unemployment rate to 21% and youth unemployment above 40%.
Spain is seeking to reduce its budget deficit, enacting a balanced budget amendment to the constitution. But Spanish debt levels are still rising. Regional finances are even worse.
Spain’s banking sector is heavily exposed to construction, which was affected when the real estate bubble burst. The building sector alone owes Spanish banks around Euro 300 billion. The banks own more than 1.5 million dwellings, which are probably worth less than the value in their books. There are substantial levels of uncompleted buildings. The Bank of Spain asked lenders to write down the value of their property related assets by 20% but further writeoffs may be necessary. Spanish banks are also exposed to European sovereign debt, especially neighbouring Portugal. Given the high unemployment rates, the risk of further mortgage related losses are present.
Banks could have to write down property related loans by around Euro 100 billion. The need for Spain to provide capital for the banks would place a strain on public finances.
Any recapitalisation is also difficult because of the structure of Spanish banking. Around 50% of mortgages are owned by local savings institutions called Cajas, essentially semi-public institutions with no shareholders which reinvest around half of their annual profits in local social projects. Local politicians control how these funds are used as mechanism for political influence making reform difficult.
Outstanding debt of Spanish banks is around 45% of the country’s GDP. In addition, Spain’s total private debt stands at around 180% of GDP.
Implementation of structural reforms of product and labour markets has been slow. Unions and the population at large are highly resistant to the austerity measures planned.
Italy also faces difficulty in reforming its economy. Italy has a relatively low annual budget deficit but its total debt to GDP is the second highest in the Euro-Zone after Greece. In an emotional letter to the EU, Italian Prime Minister Silvio Berlusconi described hoped-for measures to improve the economy. A commitment to increase the retirement age in Italy from 65 to 67 by the year 2026 highlighted the lack of urgency and intent of the reforms.
The Northern League, a coalition partner of the government, is resisting many of the reforms. In a letter to the newspaper Il Foglio, Prime Minister Berlusconi supported growth and development but rejected austerity measures declaring that the word “isn’t in my vocabulary”. This conflicts with Italian commitments to the EU for large cuts in government spending.
It is difficult to see Italy, weakened by internal political strife, making rapid progress to making required structural changes to its economy and cutting public debt.
The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem – the deflation of the debt-fuelled bubble.
The plan calls for members states to comply with the rarely adhered to rules for membership of the Euro. The stability and growth pact requires a deficit no larger than 3% in any one year and a debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.
Strict enforcement of this rule about deficits would prevent counter cyclical spending by Governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.
The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the Euro makes dealing with this problem difficult.
For many of the weaker countries, the best option would be to devalue their currency in the same way that the US and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.
An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.
German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which drove economic activity and growth. Germany also gained export competitiveness from a weaker Euro. An exchange rate of Euro 1 = US$ 2.00 would be a realistic exchange rate if the Euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.
In chess, endgames require utilising the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.
The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.
The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.
The key element of the 27 October Plan was the unwillingness or inability of Germany and France to increase the size of their commitments. The communique explicitly states: “[the increase in the EFSF’s capacity will be] without extending the guarantees underpinning the facility [Paragraph 18].” In other words, any further increase in the bailout facility will be difficult.
Germany is increasingly unwilling to increase its commitments. It is restricted by the German Constitutional Court’s decision, which makes it difficult to increase support for bailouts without a new constitution. On 28 October 2011, the German Federal Constitutional Court issued a temporary injunction requiring the government to stop relying on a selected group of lawmakers (effectively the Bundenstag Finance Committee) to fast-track approval of Euro-Zone bailout funds. If the decision is upheld, then the German government’s flexibility to act quickly will be restricted as it will need full parliamentary approval for each decision.
For the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness. Germany’s GDP is around $3.2 trillion and its debt to GDP ratio is around 75%. Supporting the financial needs of weaker countries would stretch its financial abilities.
France is at the limit of its financial capacity. France’s GDP is around US$2 trillion and its debt to GDP around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.
Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process.
These constraints make fiscal union difficult.
The ECB is not allowed to print money. Theoretically, it would need a change in European Treaties although the ECB has stretched its operational limits. Under new President Mario Draghi they may be willing to monetise debt as a response to the special circumstances.
Germany’s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.
Unless restructuring of the Euro, fiscal union and debt monetisation is removed from the verboten list, sovereign defaults may be the only option available.
Slip Sliding Away…
There is an increasingly social and political dimension to the debt problem. In Greece, Spain, Portugal and Italy, there is growing social unrest resulting from the hardships inflicted upon the general population under the mandated austerity program. There is also deep resentment at what is seen as external interference in sovereignty. Given European history, the fact that this intervention is seen to be driven by Germany and France is unhelpful.
In the “donor’ nations, there is increasing resentment at bailing out “lazy” Club Med members. The argument, whilst simplistic and incorrect, plays well electorally, appealing to nationalism, racism and xenophobia. In Europe generally there are deep differences between a political class (preserving political careers using taxpayers money and funds that simply don’t exist) and ordinary men and women (whose futures are being mortgaged in the process).
The atmospherics were not aided by the pre-summit discussions where German Chancellor Merkel, French President Nicolas Sarkozy read Italy’s Prime Minister Silvio Berlusconi the riot act. The discussion was framed by an earlier phone conversation recorded in a wiretap and widely disseminated on the Internet in which the Italian described Ms Merkel’s physical appearance in extremely vulgar terms. At a press conference following the meeting, there was derisive laughter when Ms. Merkel and Mr. Sarkozy both revealed sarcastic grins in response to a question about Italy’s commitment to implementing the necessary measure. Italians took this as an affront to the nation’s leader and a slur on the country’s character. Even opposition politicians rallied to Mr. Berlusconi’s defence.
The coming months will provide numerous tests to the new plan. Details will have to be provided and agreement reached with the relevant parties. Greece, Ireland and Portugal will need to meet test specified under their bailout plans to qualify for release of funds. Spain, Italy as well as other Euro-Zone members will need to issue debt. Economic releases will provide information on the state of Europe’s economies.
Any slippage on any of these fronts could quickly and fatally de-rail the process.
Europe’s signature anthem to date has been Led Zeppelin’s “The Song Remains The Same”. But Robert Plant’s lusty wailing about “I have a dream” may soon have to give way to Carole’s King more plaintive voice. The song will be “It’s To Late”.
“And it’s too late, baby, now it’s too late though we really did try to make it something inside has died and I can’t hide And I just can’t fake it”.
Europe’s Plan To End the Debt Crisis
By Satyajit Das
October 27, 2011