|Europe's Road to Nowhere, Part 2|
By Satyajit Das JAN 18, 2012 9:00 AM
Over the next few months, the eurozone faces a number of challenges, including the implementation of the new arrangements, possible further downgrading of nations, refinancing maturing debt, and meeting required economic targets.
Editor's note: Click here to read Part 1.
Over the next few months, the eurozone faces a number of challenges, including the implementation of the new arrangements, possible further downgrading of a number of nations, refinancing maturing debt, and meeting required economic targets.
No to Implementation
Implementation of the new fiscal compact may not be a fait accompli. Delays and changes cannot be ruled out.
At least four governments have indicated that agreement to the changes is contingent on the precise legal text. One key area of concern is the precise form and extent of powers granted to the EU to police national budgets. Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions. Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.
In the background, negotiations on the Greek package of July 2011 have also stalled. There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a write-down of 50% of private debt.
Following a review, S&P has downgraded France and Austria from AAA to AA+. The rating agencies may follow. The risk of further downgrades exists. The European bailout fund is under threat of being downgraded, as the number of AAA rate guarantors backing it has fallen from 451 billion euros to 271 billion euros (a fall on 40%). This weakens its already compromised ability to raise funds to meet existing commitments to Greece, Ireland, and Portugal and to support the funding of other countries.
Wall of Debt
A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.
European sovereigns and banks need to find 1.9 trillion euros to refinance maturing debt in 2012. Italy requires 113 billion euros in the first quarter and around 300 billion euros over the full year.
European banks, whose fates are intertwined with the sovereigns, need 500 billion euros in the first half of 2012 and 275 billion euros in the second half. They need to raise 230 billion euros per quarter in 2012 compared to 132 billion euros per quarter in 2011. Since June 2011, European banks have been only able to raise 17 billion euros compared to 120 billion euros for the same period in 2010.
Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain. The bailout fund and the IMF with around 200 billion to 250 billion euros each cannot absorb this issuance.
Europe will be forced to resort to “Sarko-nomics” to finance itself -- European banks purchase sovereign debt, which is then pledged as collateral to borrow unlimited funds from the ECB or national central banks.
This perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government. It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy’s interest costs will rise by about 30 billion euros over the next two years, from 4.2% of GDP in 2011 to 5.1% currently and 5.6% in 2013.
Debt reduction through restructuring remains off the agenda. The adverse market reaction to the announcement of the 50% Greek write-down forced the EU to assure investors that it was a one-off and did not constitute a precedent. Despite this, investors remain sceptical, limiting purchases of European sovereign debt.
The prospects for the real economy in Europe are uncertain.
For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit, and debt level targets have been missed.
Greece has an 14.4 billion euro bond maturing in March 2012. Prime Minister Lucas Papademos must meet existing targets and agree to the second Greek bailout worth 130 billion euros by the end of the month, before scheduled elections, to allow official funding to be available to refinance this debt.
Ireland, the much-lauded poster child of bailout austerity, has experienced problems. The country’s third-quarter GDP fell 1.9%. Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015. Despite spending cuts and tax increases, Ireland is spending 57 billion euros, including 10 billion euros o support its five nationalized banks, against 34 billion euros in tax revenue.
Spain’s economic outlook is poor and deteriorating. Spain’s budget deficit is above forecast (at 8% of GDP, it is a full 2% above the target agreed with the EU), and the need for support of the Spanish banking system may strain public finances further. Unemployment increased to over 21% (nearly 5 million people).
Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilize debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures. Structural reforms to promote growth are still under consideration, and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.
If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilize its public finances. The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.
In the third quarter of 2011, Italy's economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic. Confindustria, the Italian business federation, forecasts the economy will contract by 1.6% in 2012.
Stronger countries within the eurozone are also affected. German export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and Spain total around 9% to 10% in 2010), higher than to either the US (6% to 7%) or China (4% to 5%). Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.
The risks of political and social instability remain elevated.
Greece faces elections in April 2012. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties. An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package. Failure could result in a disorderly default and Greece leaving the euro.
The French presidential elections, scheduled for May 2012, also create uncertain. The principal opponents to incumbent Nicolas Sarkozy either oppose the euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed eurozone bonds (the Socialists led by Francois Holland).
The European debt crisis is also creating political problems in Germany, the Netherlands, and Finland, especially among governing coalitions. The risk of unexpected political instability is not insignificant.
A downgrade of Germany’s cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts. Germany’s commitment to date is 211 billion euros in guarantees, 45 billion euros in advances to the IMF, and 500 billion euros owed to the Bundesbank by other national central banks – around 25% of GDP.
The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the “Group of Death” with the Netherlands, Portugal, and Denmark.
Road to Nowhere
In the short term, Europe needs to restructure the debt of number of countries, recapitalize its banks, and refinance maturing debt at acceptable financing costs. In the long term, it needs to bring public finances and debt under control. It also needs to work out a way to improve growth, probably by restructuring the euro to increase the competitiveness of weaker nations other through internal deflation.
Such a program is difficult and not assured of success, but would provide some confidence. At the moment, Europe does not have any credible policy or workable solution in place.
One persistent meme is that Europe has enough money to solve its problems. This is based on the eurozone members’ aggregate debt-to-GDP ratio of around 75%. There are several problems with this analysis.
The debt is concentrated in countries where growth, productivity, and cost competitiveness is low, which is what caused the problems in the first place. The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbors. A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.
The total debt of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) plus Belgium is more than 4 trillion euros. A write-down of around 1 trillion euros in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP). In the absence of structural reforms and a return to growth, the write-downs required are significantly larger. This compares to the GDP of Germany and France, respectively, of 3 trillion and 2.2 trillion euros.
In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries' budget and trade deficits. This does not appear economically or politically feasible.
Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive. A full and complete recovery is unlikely on the present medical plan. Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises. The risk of a sudden failure of vital organs is uncomfortably high.
In their song “Road to Nowhere,” David Byrne and the Talking Heads sang about “a ride to nowhere.” Byrne sang about “where time is on our side.” Europe’s time has just about run out. A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere. It is journey that the global economy will be forced to share, at least in part.