Author: Satyajit Das
In his novella Chronicle of a Death Foretold (Crónica de Una Muerte Anunciada in the original Spanish), Gabriel Garcia Marquez commences at the end of the story gradually revealing the events leading up to a murder. The non-linear telling creates an unusual tension. With the conclusion known, only the precise steps leading to the tragedy remain unclear.
The probable endgame of Europe’s debt crisis is already known – de facto mutualisation of European debt and greater integration. But the precise events leading up to it are unknown. The story is being told backward.
European Problems ….
Europe’s problems are well documented. Many European nations have high and, in some cases, unsustainable levels of debt, compounded by a cluster of maturities and ratings pressures.
Public finances are weak. European bank have either significant exposures to the weak property sector or sovereign debt. Euro-Zone bank claims on the public sector range from 13% to 38%.
Sluggish even before the crisis, Europe’s growth rates are too low to sustain current debt levels. Many European countries have uncompetitive cost structures in global terms.
Following revelations of Greece’s problems in 2009, investor scrutiny of Europe’s position has increased. A number of nations have lost access to commercial sources of finance. Their cost of borrowing has increased to uneconomic levels.
Greece, Ireland and Portugal have required bailouts. Spain is to receive financing to support its banking system. The European Central Bank (“ECB”) has been forced to finance nations and banks, to avoid the risk of defaults.
The crisis has exposed Europe’s social compact based on government spending and welfare services that is unsustainable at current rates of growth and taxes. It has highlighted the inflexibility of single interest rate and common currency which limits policy options. It has revealed the complex inter-relationships which allow the rapid transmission of financial pressures. It has exposed the absence of institutional arrangements to deal with a crisis, because the entire framework assumed that it could not occur.
The required policy responses have remained largely unchanged since the commencement of the crisis – reduction of debt, temporary financing for entities that have lost market access and recapitalisation of affected banks. Almost two years into the crisis, European policymakers have begun to address each of these areas.
Reduction of debt can be achieved by austerity (directing revenues to the repayment of debt) or debt restructuring (voluntary write offs or default). Austerity measures are enshrined in the Fiscal Stability and Growth Pact which requires Euro-Zone members to reduce budget deficits to less than 3% in any one year and a debt to Gross Domestic Product (“GDP”) ratio no larger than 60%.
The European Union (“EU”) has undertaken a debt restructuring for Greece, euphemistically known as PSI (Private Sector Involvement), writing off Euro 100 billion of debt.
In November 2012, the EU was reluctant to allow further write downs to provide additional debt relief to Greece. With 60-70% of Greek debt now held by official agencies (governments, the ECB, European bailout funds and the International Monetary Fund (“IMF”)), recognition of losses was politically difficult. Instead, a debt buyback (that handed hedge funds a large profit) and lower coupons and longer maturities on existing debt was used to reduce debt.
The fiction of zero coupon perpetual Greek debt allowed Chancellor Angela Merkel to honour her promise that Germans would not suffer any losses from the bailout. There is resistance to similar debt relief for other countries, as Greece is different.
The EU, ECB and IMF have collaborated to provide liquidity support and lower borrowing rates for weaker countries.
Facilities include the bailout funds – the EFSF (European Financial Stability facility) which is to be replaced by the ESM (European Stability Mechanism). The ECB has the ELA (Emergency Liquidity Arrangement), LTRO (Long Term Refinancing Operations), the SMP (Securities Market Program) and its new OMT (Outright Monetary Transactions) facility. The EU has agreed the concept of a banking “union”.
European bureaucrats seem afflicted by acronomania – the belief that a suitable sequence of letters can solve any problem. Unfortunately, the response is inadequate.
Austerity debt is self-defeating. Cuts in spending and increases in taxes lead to contracting economic activity, increasing the budget deficit and debt. Additional austerity merely exacerbates a vicious negative feedback loop as the economy becomes mired in a deep recession with rising unemployment.
Writing off the debt results in large losses to banks and investors. This requires government support to maintain the integrity of the payment and financial system, increasing budget deficits and debt.
Debt relief is complicated by the fact that the claims are cross border. A large proportion of peripheral sovereign debt is held by banks and investors in Germany, France, Netherlands, Finland and Luxembourg. These nations are resisting write-offs, fearing destabilising their financial systems.
The policies also fail to address growth and improving competitiveness. Without the option of currency devaluation, affected countries must force down costs, which exacerbates the reduction in activity.
The EU Commission 2012 State Aid Scoreboard calculated that between October 2008 and December 2011, all 27 EU states provided banks alone with Euro 1.6 trillion in assistance (around 13% of EU GDP) for liquidity support, capital and removing impaired assets from balance sheets. Since 2011, further assistance has been provided to banks. There was additional assistance provided by the ECB and IMF to banks and nations. If these are included, then the total amount of assistance to date approaches Euro 3.5 trillion (30% of EU GDP), around Euro 7,000 for every EU citizen.
But the financial resources remaining to deal with the crisis may be insufficient. The amounts available have not changed for almost two years, with little appetite for increasing commitments.
The ESM has total lending capacity of around Euro 500 billion. Financial assistance agreed for Greece, Ireland and Portugal in the form of loans and guarantees is around Euro 294 billion. With around Euro 102 billion coming from the EU budget or bilateral aid to Greece, Euro 192 billion was provided by the EFSF, which will be subsumed into the ESM. Euro 100 billion has been committed to Spain for the recapitalisation of its banking sector. This leaves the ESM with available lending capacity of around Euro 208 billion.
There are increasing constraints on IMF participation, augmenting the ESM.
Greece, Ireland or Portugal may need further assistance, as their economies remain weak and market funding is unavailable or expensive, they may need additional funding to meet maturing debt and also finance budget deficits.
Spain and Italy may need assistance programs. Spain has debt of Euro 800 billion (74% of GDP). Italy has debt of Euro 1.9 trillion (121% of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of Euro 160 billion in 2013 and Euro 120 billion in 2014. The Spanish government has announced a financing program of around Euro 260 billion for 2013. Italy has principal and interest repayment obligations of Euro 350 billion in 2013 and Euro 220 billion in 2014.
Capital flight from peripheral European countries is a problem. Banks in peripheral countries have lost between 10% and 20% of their deposits, reflecting concern about solvency and the risk of currency redenomination. Additional resources may be needed to finance a deposit insurance scheme to halt capital flight.
Europe has total bank deposits of around Euro 8 trillion, including around Euro 6 trillion in retail deposits. Around Euro 1.5-2 trillion of these deposits are in banks in peripheral countries. An effective deposit scheme would need to cover around Euro 1-1.5 trillion of deposits, placing a large claim on available funds.
Europe may need bailout facilities of at least Euro 3 trillion to be credible. Potential requirements exceed available resources.
Europe’s Big Bazooka…
The only other potential source of financial support is the ECB. It has already provided over Euro 1 trillion in term financing to banks through the LTRO program alone. These programs mature in late 2014 and early 2015. They may need to be increased or extended to finance the weak banking system.
The ECB has purchased around Euro 210 billion in sovereign bonds under the SMP. In July 2012, the ECB announced the OMT program allowing purchase of unlimited quantities of sovereign bonds. President Mario Draghi announced that: “within our mandate, the ECB is ready to do whatever it takes to preserve the Euro”. Markets and investors have assumed that this is the “big bazooka” -an European version of quantitative easing (“QE”) and debt monetisation precedents of the US, Japan and UK. The ECB’s announcement underpinned relative stability in Europe in the second half of 2012.
But the OMT program is conditional. ECB action is contingent on the relevant government formally requesting assistance and agreeing to comply with the conditions applicable to assistance from the ESM/ EFSF. Instead of avoiding market pressures, the triggering mechanism requires that financing problems of “at-risk” countries get worse before the ECB will act.
ECB purchases will be confined to short or intermediate maturities. This condition is designed to make intervention similar to traditional monetary policy. It is also designed to reduce the cost of bank loans which is driven by shorter-term interest rates.
The ECB can also nominate a cap on yield or the size of its purchases in advance of any intervention. There is uncertainty as to whether the ECB will relinquish its status as a preferred creditor on such purchases in the event of default or restructuring.
The OMT program revealed significant divisions within the ECB. Jens Weidmann, the head of the German Bundesbank and a former advisor to the Chancellor, opposed the measure. Other Euro-Zone members are also known to be uncomfortable.
The legal basis of the OMT program remains uncertain. Article 123 of the Lisbon Treaty prohibits the ECB from directly buying national governments’ debt. Future legal challenges cannot be ruled out. Overcoming legal issues would require time consuming treaty changes, support for which is not assured.
The OMT has not been activated to date. In 2008, US Treasury Secretary Hank Paulson’s argued that if everyone knows that you have a bazooka in your pocket it may not be unnecessary to use it. The ECB has gambled that the announcement that it is prepared to intervene will restore market access of peripheral borrowers and reduce the interest rate demanded by the market. The borrowing cost of weaker countries remains above sustainable levels. The true access to market remains unclear because of the activity of banks purchasing sovereign debt which can be financed with the ECB at a profit.
The ECB President’s statements have been dominated by two words: “may” and “adequate”. Market analyst Carl Weinberg neatly summarised this as: “A promise to do something unspecified at some yet-to-be-determined time involving yet-to-be-invented programs and institutions, in a yet-to-be-decided way”.
Dr. Draghi, anointed as the Financial Times’ 2013 Person of the Year, operatically stated that the OMT program would: “And believe me, it will be enough”. Markets will undoubtedly test the ECB’s resolve. As Yogi Berra knew: “In theory there is no difference between theory and practice. In practice there is.”
The scale of the problems, the inadequacy of financial resources available and political difficulties means that decisive actions to resolve the European debt crisis are unlikely. A slide into a deeper economic malaise, both for at risk countries but also stronger Euro-Zone members, is the most likely course of events.
The real economy, already in recession, is likely to remain weak, with low growth and high and rising unemployment. The key influences will be austerity programs and weak global environment, including slowdowns in emerging economies. Other factors will be the continued restriction of credit as European banks restructure and shed assets.
The low levels of economic activity will be particularly pronounced in the peripheral economies. The weakness will be transmitted to stronger economies, through weaker exports. Given that their largest markets are within Europe and in recession, Germany and France will also experience slowdowns. Increased financial strains from the need to support the weaker countries will also contribute to the contraction.
Governments in the at-risk economies will not meet budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels. Further funding assistance may be required.
Euro-Zone members remain committed to avoiding the unknown risks of a default and departure of countries from the Euro. This means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain.
Peripheral countries will be forced to rely on the ESM and ECB to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly and indirectly. In the indirect case, the ECB will provide cheap funds to banks to purchase government bonds which will be used as collateral for the central bank financing.
The TARGET2 (“Trans-European Automated Real-time Gross Settlement Express Transfer System”) is a payment system to settle cross border funds flows between Euro-Zone countries. Before 2008, deficits of individual nations were financed by banks and investors. Since the commencement of the crisis, the absence of commercial financing has meant that central banks in stronger countries have used the TARGET2 to finance peripheral countries without access to money markets to fund trade deficits and capital flight. This process will continue.
Over time, financing will become concentrated in official Euro-Zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the Euro-Zone, especially Germany and France. This reflects the reality that the stronger countries stand behind each of the support mechanisms.
The ESM relies primarily on the support of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Market analyst Grant Williams prosaically described the other countries backing the ESM as Greece, irrelevant, doesn’t matter, don’t bother, makes no difference, who cares, somewhere near Poland, pointless, up the top, former something-or-the-other, tax shelter, pretty much a non-country and somewhere with mountains. If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase. A similar process operates in respect of the ECB.
Germany is by far the largest creditor in TARGET2. The Netherlands, Finland and Luxembourg are the other creditors with all other Euro-Zone countries being net debtors within the system. The Bundesbank has current exposure of over Euro 750 billion to other central banks in the Euro-Zone.
The TARGET2 net claims are not a true measure of the risk of the Bundesbank. The net balance would only be lost in the case of a breakup of the Euro-Zone and if sovereign central banks refuse to honour their debts. This risk is difficult to quantify. But there is a clear transfer of financing risk to the stronger core countries. This ultimately weakens their financial position materially.
Germany provides an indication of the magnitude of the task. German guarantees supporting the EFSF are Euro 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany’s liability could be as high as Euro 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims.
The size of these exposures is large, both in relation to Germany’s GDP of around Euro 2.5 trillion and German private household assets which are estimated at Euro 4.7 trillion. Germany also has substantial levels of its own debt (around 81% of GDP). The increase in commitments or debt levels will absorb German savings, crippling the economy. Germany demographics, with an aging population, compound its problems.
Over time, the transfer of risk will mean de facto debt mutualisation and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid.
World of Pain…
De facto integration may help make European debt problems more manageable.
As a single unit, the Euro-Zone’s current account is nearly balanced, its trade account has a small surplus, the overall fiscal deficit is modest and the aggregate level of public debt while high is more manageable. Around 75% of its trade is within member nations, aided by removal of trade barriers and the common currency. Germany, the EU’s largest economy and one of the world’s largest exporters, sells over 60% of its products within the common market, much of it to other Euro-Zone members.
But significant disparities between individual Euro-Zone members of income levels, public finances, external balances and debt levels will necessitate a net wealth transfer from richer nations to weaker members. Stronger more creditworthy members will also have to underwrite the borrowings of weaker nations. Despite opposition to such joint and several liabilities from net lenders such as Germany, Finland and Netherlands, this process is now the most likely outcome.
Stealth integration will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession.
Living standards will be reduced by internal devaluation. In the period since the introduction of the Euro, German unit-labour costs rose by 7-8%, compared to 30% in Italy, 35% in Spain and 42% in Greece. These rises have to be reversed to increase competitiveness. Employment conditions, pension benefits and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income.
In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker Euro-Zone members. As integration becomes a reality, ordinary Germans will discover the reality of an old proverb: “if you stay the beast will eat you, if you run the beast will catch you”.
Europe will find itself locked in a period of subdued economic activity and high unemployment. The core Euro-Zone countries, especially Germany and France, are increasingly affected by the problems of the rest of Europe. In early 2013, Joerg Asmussen, a German ECB board member, was quoted as predicting Germany could become the “Sick Man of Europe” if the problems continued.
The dry economic language masks a world of human pain as life will turn into a grim struggle for survival. Unemployment rates, which in some countries approach 30% and 50% for people under 25 years, will feed increasing instability. Social unrest and conflict is likely. Militant opposition to austerity and declines in living standards will increase.
Major political parties in many countries now poll less than 50% of the total vote, requiring unstable coalitions which make decision making difficult. As Jean-Claude Juncker, the Luxembourg Prime Minister noted: “We all know what to do, we just don’t know how to get re-elected after we have done it.”
The political environment favours political parties which favour more radical actions, such as abandonment of the Euro or default on outstanding debts. Opposition to immigration and cultural minorities, often taking the form of violent action, is growing. It is these realities rather than the economics that may determine the future of Europe.
European political leaders are increasingly optimistic in their language- the Euro-Zone crisis is “behind us”; the problems are “resolved”. Only German Chancellor Angela Merkel has sounded cautious, arguing that the crisis is likely to continue for many years. It may be tactic acknowledgement of the cost of the crisis to Germany. It may also a strategy to prepare Germans for the harsh reality of the likely endgame.
While de facto integration is the likely outcome, a smooth transition is not guaranteed. Outflows of actual cash to beleaguered nations, the first claims on the German budget, significant rating downgrades for core Euro-Zone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalised structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults or a breakdown of the Euro and the Euro-Zone.