John Walsh traces the evolution of the euro zone debt and banking crises and asks whether there is a solution on the horizon. One thing is certain however – doing nothing is not an option.
This magazine was going to print just as EU leaders were cobbling together a deal to prevent the debt crisis in the region from escalating. The stakes could not be higher. The fate of the single currency hinges on whether a package emerges that can convince the markets that a comprehensive solution is in sight. Moreover, spreads in the Euro interbank offered rate (Euribor) are approaching levels last seen in the aftermath of the collapse Lehman Brothers in the autumn of 2008.
Because of the level of interdependence in the banking system, if the credit market in Europe implodes, then the global economy could enter a deep and prolonged slump.
Deep divisions have emerged between France and Germany over how best to tackle the crisis. Indeed, deep divisions have opened up between the Franco-German axis and the European Commission as well as non-euro zone countries over the best way to succeed.
The only thing that can be said with any certainty is that the luxury of doing nothing is not an option. The three immediate priorities are recapitalising the European banking system; beefing up the European Financial Stability Facility (EFSF) and ringfencing Greece. All three are freighted with massive inherent risks.
The EU has stipulated that banks in the region must raise €108bn in fresh capital. This in turn poses a number of different dilemmas, not least, whether or not it is sufficient. Nick Bullam, managing partner of the consultancy firm Check Risk, believes that the figure is roughly €370bn. “The European Banking Authority (EBA) has completely underestimated the capital shortfall in European banks since this crisis began. The €108bn figure is nonsense.”
But there are major challenges in how that capital is raised. If banks try and reach the 9% tier-one equity capital ratio by deleveraging and selling assets, that will cause a massive credit squeeze and depress growth. The investment bank Morgan Stanley estimates that €2trn in credit will be removed from the European economy over the next three years if banks are forced to reach the 9% level.
It is highly unlikely that the private sector will stump up the capital needed, as there is a lack of clarity on the level of contingent liabilities sitting on the balance sheets of European banks.
If national governments are put on the hook for the pumping of money into the banking system, then sovereign credit ratings will take a hammering.
“The link between banks and sovereigns is the most dangerous spiral in the history of Europe,” says Bullman. “As long as governments bail out banks, they will get downgraded, which means that it will be more expensive to raise more capital. Until that spiral is broken, there will be no functioning credit mechanism in the EU and without that, there will be no growth.”
French president Nicolas Sarkozy has approached all negotiations with an unwavering commitment to preserving France’s AAA credit rating. “This is extremely important to France,” says John Mennis, London-based director of UK sales at the investment bank Evolution Securities. “Unlike the US and Japan, it cannot print its own money, so it will be doing its utmost to maintain that AAA rating,”
There is no argument that the firepower of the EFSF has to be greatly increased. But how that is increased has proved to be a huge sticking point. At the time of going to print, it is reported that there were two options on the table. One was setting up a special purpose vehicle that would seek outside investment – including potentially – from the IMF. The second option is a guarantee scheme.
Lorcan Roche Kelly, chief Europe strategist for the hedge fund Trend Macro, says that ultimately the most important test any new EFSF has to pass, is that it is effective.
“What needs to be done is to make the EFSF look like a great investment,” says Roche Kelly. “The bond market still has dreams of a risk-free investment. With an insurance programme, investors are not sure if it is risk-free or not. Then that begs the question whether or not it is going to be effective and that is exactly what we need now, so it isn’t about size, it is about being effective.”
Then of course, there is the not inconsiderable problem of Greece. The commission leaked a report on October 18, which estimated that the final tally for bailing out the country could reach €500bn. Haircuts of up to 50% are needed to make the debt level sustainable.
“The reason for private sector involvement of up to 50%, is that it gives EU authorities the excuse to say that Greek bondholders have taken the pain, so they can now pump in structural funds over the longer term without saying that it is a bailout. The long-term solution is that Greece will be a protectorate of the EU for the next number of years,” says Roche Kelly.
Recapitalising banks, beefing up the EFSF and ringfencing Greece are all only short-term fixes. The only durable solution to the euro zone crisis is stoking buoyant levels of growth. But there are concerns over whether this can ever be achieved.
The influential Financial Times columnist Martin Wolf argues that there will be no long-term solution to the euro zone debt crisis until the real cause of the problem is acknowledged. In his view, trade imbalances across the region made a financial crisis of this magnitude inevitable. The argument is that Germany engineered a competitive devaluation at the same time countries on the periphery were losing their competitiveness. This was, in no small part, enabled by German banks recycling German savings into Greece, Spain, Ireland and other peripheral countries, which fuelled a speculative bubble in these countries particularly in the real estate markets.
The German government, perhaps unsurprisingly, rejects this narrative. Finance Minister Wolfgang Schäuble claims that fiscal deficits were the cause of this crisis and that imbalances only played a marginal role.
Bart von Creyest, senior economist at Belgian bank Petercam, says the euro was designed with a serious structural flaw, in that there was no attempt to put any mechanism in place that would be able to smooth over imbalances. “As long as that is not fixed, even if there is a solution to this crisis, we will just trot along until the next crisis.
“We have monetary union without political or fiscal union, which means a euro that is always going to be vulnerable to divergent pressures. So we will always be at risk until we move to political and fiscal integration.”
The Euro Plus Pact was announced earlier this year and is designed to introduce much greater economic surveillance and coordination among euro zone member states. The commission will play a central role in the preparation of national budgets. Moreover, there will be tough sanctions for countries that persistently flout the terms of the growth and stability pact.
Von Creyest says that there is nothing in the Euro Plus Pact that will stop countries from breaking the rules. “When countries like France and Germany come under pressure, they will postpone their obligations under the pact. As long as fiscal and economic policy are done along national lines, then it will not work. There has to be a move towards fiscal union, with some sort of centralised fiscal authority. Not all national fiscal sovereignty has to be given up, but some of it does.”
Even though the Irish Government is implacably opposed to another EU referendum, there is an emerging consensus that there will have to be a change to existing treaties if the euro zone is to ever function in an effective manner.
No default please
At a joint press conference in Brussels between German Chancellor Angela Merkel and French president Nicolas Sarkozy on October 23, the latter cited Ireland as a country that was on the verge of bankruptcy in 2008, but was now on the cusp of emerging from the crisis.
But whether Ireland can manage to get through the next few years without defaulting has divided experts.
“Ireland is by far the best performing of the countries that are in the bailout programme.
“It has stayed well within the terms of the troika’s plan. On a standalone basis then, the numbers look sustainable for Ireland,” says Bullman. “But whether that is enough in the event of a Greek default is not clear. Portugal would probably default following a Greek default, which would mean massive headwinds for Ireland and huge pressure to default,” says Bullman.
The problem is the level of debt in the euro zone system, adds Bullman. He says leveraging up the EFSF is missing the point. “You don’t cure an alcoholic by bringing him on a pub crawl. Europe is addicted to debt and that is the problem. This is an issue of solvency, not liquidity.
“What needs to happen is a bit of creative destruction. A number of banks should be a allowed collapse and there has to be a series of sovereign defaults. Otherwise Europe is looking at a lost couple of decades similar to what has happened in Japan. But it is highly unlikely the political courage is there to bring about such policies.”
Ban on short-selling: A cure for market excesses?
On October 19th, it was announced that the EU was putting a ban on naked short selling of sovereign credit default swap (CDS). It wasn’t a surprise move: the commission had been threatening to introduce this legislation for a while. Moreover, the ban received very little media attention. But what does it ultimately achieve? Was it as some market analysts claim a stroke more about political optics than having any rationale? Or was it necessary to take some of the froth out of market volatility?
Naked short-selling enables an investor to take out insurance in the event of a default without actually owning the underlying asset. Supporters of the product claim it provides much needed liquidity in what is a very important market. Opponents say it leads to volatile and costly speculation. The German government in particular has been a very vocal opponent of speculators since the crisis escalated. The view is that hedge funds have been behind untrue and destabilising market rumours which have added billions to the cost of the crisis rescue.
But John Mennis, London-based head of UK Sales at Evolution Securities, says the policy is misguided and part of a broader agenda. “The UK and other governments put a ban on short-selling of bank stocks in the autumn of 2008. But some of the biggest falls in the market took place after the ban. The fact is, if Greece was a private company, then it would be bust. The markets’ fears about Irish banks were completely justified. If rumours are not true, then the investors who follow them will get hammered.”Lorcan Roche Kelly, chief Europe strategist with the hedge fund, Trend Macro, says that all this move achieves is to remove a functioning part of the market. “I can see politically why they did it, but if they are trying to curb market excesses, then it will not make any difference.
“Anyway, I am not sure how a CDS would be triggered outside a chaotic default. The private sector involvement in the Greek debt writedown is not triggering a default, according the International Swaps and Derivatives Association (ISDA). In fact, ISDA is not sure, under its own rules, how a default would be triggered.”
Moreover, Mennis says that nobody at a governmental level complains when speculators pile into sovereign debt. “Look at Irish bond yields. They have come down dramatically over the past few months and that is because hedge funds now believe that the Irish debt position is sustainable. But you don’t hear the Irish Government complain about that.”
New treaty please: Without more federalism the euro project will not survive
It is highly unlikely that the euro zone will survive without a substantial treaty change. There is a growing consensus that some sort of fiscal union is needed, possibly complemented by banking federalism and much closer political co-operation. The Taoiseach Enda Kenny and Minister for Finance Michael Noonan have both insisted over recent weeks that no new treaty is needed and that there was enough wriggle room in the Lisbon Treaty to enable greater institutional flexibility among euro zone institutions.
“I don’t think we need another treaty similar to Maastricht, which was brought in over 1992/93 in three pillars to the EU. It moved it beyond what had been European economic cooperation and spread it out into foreign policy and security and justice and home affairs. Maastricht was an institutional revolution and we will not see something on that scale again,” says UCD law lecturer Gavin Barrett.
“The Government’s reluctance to see treaty change is referendum-driven. I think it is wishful thinking that we can get the reforms needed through the existing treaties. They are running scared and probably rightly so in view of how unpredictable treaties have become.”
As discussed in the main body of this text, one of the primary causes of the euro zone debt crisis has been trade imbalances across the region. Even if there a solution that is put in place on this occasion that is amenable to the markets, unless deep structural flaws in the architecture of monetary union are rectified, then there will be another crisis in the future.
But to put in place the institutional framework that would be able to iron out these imbalances is not possible within the scope of existing treaties, says Barrett.
There is enhanced cooperation which means that a vanguard of member states can enter into a system of closer integration and co-operation on certain issues. But there are limits to what this option can achieve. “Enhanced cooperation cannot overstep the bounds of existing treaties. For example a Eurobond would not be compatible with existing treaties,” says Barrett. “Moreover, the other member states will want a more comprehensive view of existing treaties with a view to setting up a more permanent kind of arrangement. The idea of relying on existing treaties is unlikely to be acceptable from a legal or political point of view.”
Just as there has been enormous and still unresolved wrangling over how the fiscal and economic tensions can be resolved, a political fault line has emerged between the main powerbrokers that has the potential to be equally destabilising in the longer term. The European Commission traditionally shaped the policy agenda. But since the crisis erupted in 2008, the commission has been supplanted by the European Council and in particular a Franco-German axis which has inevitably rankled with senior commission officials and smaller member states.
German Chancellor Angela Merkel and French president Nicolas Sarkozy, both favour an inter-governmental approval to further integration. The president of the commission José Manuel Barroso favours a move to much closer integration. In a recent speech to the parliament he said, “what is needed is more Europe.” The growing consensus is that without more federalism, the euro project will not survive.
In the event there is an agreement between the political leaders that requires treaty change, then that would set in train a chain of events that could have many unintended consequences. Article 48 of the existing treaty framework states that a convention between the various political leaders would have to be held. This would take place most probably in the second half of 2012. Similar to the negotiation of previous treaties, there would be a high level of brinkmanship and political horsetrading. But upon the conclusion of talks, it would have to be ratified by every national parliament within two years. In view of the growing level of Euroscepticism across the region, the passage of any new treaty is likely to face stiff opposition in a number member states.
Consequently, many governments may decide to proceed for ratification through their national parliaments rather than putting it to a referendum.
There was widespread and almost unconditional support for Ireland’s membership of the EU until relatively recently. The Nice referendum in 2001 and Lisbon in 2008 may have both been voted down, but Eurobarometer polls show that the electorate rejected both of these plebiscites because they didn’t understand what was contained in either treaty. They were both subsequently passed. But the EU has become a bogeyman in this country, particularly since the Government was forced to accept an EU/IMF bailout in November 2010.
Recent opinion polls suggest that if there was another EU referendum in this country in the near-to-medium term, then it would be rejected. “Let’s assume that there is a referendum and it is rejected,” says Dr Barrett. “What would happen? In theory, all states are equal, so if one country votes No then that kills the proposal. In reality, a country of 5mn people is not going to tell a region of 500mn people how to organise itself. If Ireland votes No, then it will determine the position of Ireland rather than the others because they will find a way of moving ahead. What they could do is have some sort of inter-governmental agreement which is a treaty outside a treaty which will be used by willing member states.” One of the inherent problems with referendums is that the electorate often vote for reasons other than what is being proposed. So there is every chance that even if it is in this country’s interests to vote in favour of a future treaty, it could very well be rejected.
But does the Government have any choice other than putting it before the people? “The test is laid down by the Crotty case which asks ‘has the scope of the existing treaties been altered,’ says Barrett. “The test is as long as a piece of string in the sense that it is utterly vague. So far, the Government has played it safe by having a referendum. But this is no longer a safe option, so the temptation might be there to run it through the Oireachtas without having a referendum. But if the Government tries to put it through the Oireachtas without having a referendum, then it may come unstuck and they might end up holding a referendum. It seems to me reasonably likely that we will end up having a referendum in the next two years.”