Europe's Road to Nowhere, Part 1

By Satyajit Das  JAN 17, 2012 8:50 AM

Financially futile, economically erroneous, politically puzzling, and socially irresponsible, the December 2011 European summit was a failure.


Financially futile, economically erroneous, politically puzzling, and socially irresponsible, the December 2011 European summit was a failure.

Only the attending leaders and their acolytes believe otherwise. German Chancellor Angela Merkel’s post-summit homilies about the “long run,” “running a marathon,” and “more Europe” rang hollow.

Fiscal Bondage

The centerpiece of the new plan was a commitment to a new legally enforceable “fiscal compact” requiring government budgets to be balanced or in surplus, with the annual structural deficit not to exceed 0.5% of nominal gross domestic product. 
The fiscal compact did not countenance any write-downs in existing debt. It also did not commit any new funding to support the beleaguered European periphery. Germany specifically ruled out the prospect of jointly and severally guaranteed eurozone bonds. Instead, there were vague platitudes about working toward further fiscal integration.

Whatever the long-term merit of greater budget discipline, the compact recycles previous treaties, which have been honored in the breach rather than the observance. Since 1999 or from the time of their entry, eurozone member countries have recorded nearly 70 breaches of the existing Stability and Growth Pact, including nearly 30 occasions when budget deficits exceeding 3% of GDP were allowed because of recessions. Germany and France have been in breach on at least six occasions each.
Just as former British Prime Minister Margaret Thatcher favored “sado monetarism” (a term coined by Denis Healey), the German plan for Europe is “fiscal B&D” (bondage and discipline).
The plan may result in a further slowdown in growth in Europe, worsening public finances, and increasing pressure on credit ratings. This would make the existing debt burden even harder to sustain. The rigidity of the rules also limits government policy flexibility, risking making economic downturns worse.
Fiscal controls may not prevent future problems. Until 2008, Ireland, Spain, and Italy boasted a better fiscal position and lower debt than Germany and France. The weak economic fundamentals of these countries were exposed by the global financial crisis, leading to a rapid deterioration in public finances.
Irrespective of the treaty’s provisions, enforcement will be difficult. The Excessive Deficit Procedure call for “automatic consequences unless a qualified majority of euro area Member States is opposed.” The provision defines how any breach and automatic sanction can be waived rather than the consequences of failure to comply. It is difficult to see France and Germany voting to levy sanctions on each other. In 2003, there was an ignominious episode where France and Germany each breached the deficit ceiling but voted against condemning each other.
Recalling John Maynard Keynes’ observation about the Treaty of Versailles, if actually implemented and strictly followed, the compact will skin Europe, especially those in the weaker economies, alive year by year.
Rebranding Bailouts
Instead of dealing with the financial problems of the central bailout mechanism (the European Financial Stability Facility), European leaders chose the re-branding option.
The EFSF will remain active until mid-2013 and then be subsumed into the permanent European Stability Mechanism, or ESM. The ESM will be implemented by July 2012 once 90% of member countries have ratified it -- “rapid deployment” in European terms.
Crucially, the overall ceiling of the EFSF/ESM remains at 500 billion euros, but will be reviewed in March 2012.
Given the indifference toward various leveraging proposals, especially from emerging nations like China, the ability to reach the target of at least 1 billion euros in capacity remains in doubt.
Long-standing problems of the original EFSF structure remain unaddressed. The creditworthiness of Italy and Spain (which make up around 30% of the EFSF’s supporting guarantees) remains questionable. The European bailout fund is under threat of being downgraded.
Currently, the EFSF is only issuing short-term bills to finance its commitments (under the bailout packages agreed for Greece, Ireland, and Portugal). Its long-term funding costs are nearing the rate it is permitted to charge borrowers. The EFSF was even forced to deny reports that it would need to include a health warning about the risk of a rating downgrade and also the breakup of the euro in documentation for any new fund-raising.
Given the problems of the EFSF, especially the ratings threat, the acceleration of the ESM initiative is an attempt to reduce the reliance on the member nation guarantees. The ESM will have paid-in capital (80 billion euros) that member countries can contribute.
Like its predecessor -- the EFSF – it is leveraged: 80 billion euros supporting 500 billion euros, equivalent to six times leverage. Continuing the circularity, nations like Italy and Spain will borrow to contribute capital to the ESM to allow the ESM to buy Italian and Spanish bonds. The ability of the ESM, like the EFSF, to raise the additional 420 billion euros is also uncertain.

Calling in the Cavalry

Eurozone nations and other EU members were asked to provide (up to) 200 billion euros to the International Monetary Fund to be lent, in turn, back to eurozone countries. As with the ESM, it is unclear how some countries will finance their contributions and the wisdom of countries de facto lending to themselves. The curious arrangement was necessary to avoid breaching existing European treaties.
The arrangement, most likely, will be an IMF-administered account, with the full risk being taken solely by the providers of funding. In the unlikely event that the IMF used its general resources, all members would have to bear the risk.
Full involvement of the IMF is difficult. A loan on the required scale represents a serious concentration risk for the fund. In addition, the funding would be released in tranches subject to meeting IMF conditions. IMF loans also have seniority over other obligations. So IMF involvement may reduce the relevant country’s access to commercial funding.
To date, European countries have only committed 150 billion euros. Britain is a notable absentee, having rejected the treaty changes, refusing the invitation to join the Europeans on the maiden voyage of the Titanic. The IMF (Influential Monied Friends) have proved reluctant, with the US and others unwilling to get involved. Only Russia has indicated a willingness to contribute (20 billion euros).
Bundesbank President Jens Weidmann observed that Germany would only release its contribution (45 billion euros) if “there is a fair distribution of the burden amongst the IMF members. If these conditions are not fulfilled, then we can’t agree to a loan to the IMF.” He noted that, “If large members, for example the USA, were to say ‘we’re not taking part,’ then from our point of view it is problematic."

Don’t Bank On It

Parallel to the Summit, The European Banking Authority (or EBA) updated its stress tests, increasing the amount of capital that European banks need to raise to 115 billion euros. The increase was necessary to cover a fall in the value of sovereign bonds held by the banks. As the data used was dated, further deterioration of the value of holdings may mean that more capital will ultimately be needed.
Italian, Spanish, and Greek banks have the largest capital requirements. Italian banks need to raise 15 billion euros. UniCredit, which holds around 40 billion euros in Italian government bonds, needs to raise 8 billion euros. Spanish banks need 26 billion euros, with Banco Santander (STD) needing 15 billion euros. German banks also need capital, with Commerzbank (CRZBY.PK) the country’s second-largest bank, needing 5.3 billion euros.
With share prices down significantly (40% to 60% for the year) and the likelihood of weak profits driven by write-offs and lack of balance sheet growth, European banks face difficulties in raising capital.  The most likely source is national governments providing the capital, adding to their debt problems. Germany has already reactivated its bank bailout fund for this purpose.
Banks can also lift their capital levels by reducing the size of their balance sheets. Asset sales by European banks to improve capital are acceptable to the EU as long as they “do not lead to a reduced flow of lending to the EU’s real economy.” Withdrawal from foreign markets is already having a noticeable impact in Eastern Europe and Asia. A slowdown in these economies will indirectly affect Europe, reducing demand for European exports.
Europe is now firmly on the road to nowhere, with doubts whether there is enough money or political will to retrieve the position.

Editor's Note: This is Part 1 of a two-part series. Stay tuned for the second tomorrow!
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.