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Satyajit Das: Europe's Debt Crisis Will Return


Perhaps overly optimistic European governments and policy makers now proclaim a stabilization or lower rate of decline as an indication of the success of their policies.

Everyone had been waiting for the German elections. Now that they are over, attention will turn to key decisions on the European Debt problems. Hopes of any decisive actions are misplaced.

Taking the Waters

Over the last year, a combination of austerity programs, debt write-downs, the European Central Bank's (ECB) commitment to "do whatever it takes" to preserve the euro, the proposed banking union, and the finalization of the primary bailout fund (European Stability Mechanism (ESM)) helped restore relative financial stability. There were declines in the interest rates of peripheral countries and a rally in stock markets, although there was no meaningful recovery in the real economy.

In Spain, the cost of 10-year debt fell from more than 7.5% to 4.04%; Italy from 6.7% to 3.76%: Greece from 30% to about 10%; Portugal from 12% to 6.4%. The Spanish and Italian stock markets recorded a one-year gain of 31% and 24% respectively. The French and German stock markets rose by over 24%. In contrast, eurozone gross domestic product (GDP) fell 0.1% during Q3 2012, 0.6% during Q4, and 0.3% during Q1 2013, with sharper declines in the weaker economies.

Falling Off the Austerity Wagon

Austerity has failed to bring public finances and debt under control. Increases in taxes and cuts in government spending have led to sharp contractions in economic activity, reducing government revenues and increasing welfare and support payments as unemployment rates increase. Budget deficits, while smaller, persist and debt levels continue to rise.

Eurozone GDP is now 3% below its level in 2007/2008. Individual economies have fared even worse: in Greece, the economy has decreased by 23%; Ireland by 8%, Portugal by 8%, Spain by 8% and Italy by 9%. Eurozone unemployment is 12%. Despite emigration of skilled workers, some weaker nations have higher unemployment: Greece 28%, Ireland 14%, Portugal 17%, Spain 26%, and Italy 14%. Youth unemployment is significantly higher with 25-50% in some countries.

Governments have found it difficult to continue austerity programs in the face of weak economic activity and high levels of unemployment. Pleading exceptional circumstances and extraordinary conditions, many nations have sought and received exemptions. Deficit and debt reduction targets have been deferred, although even these new reduced or deferred thresholds are unlikely to be met.

Write Me Down, Write Me Up

Further write-downs in debt, as in Greece and Cyprus, to reduce debt to sustainable levels is difficult. Official lenders now, directly or indirectly, own large amounts of the relevant debt.

The ESM, the ECB and the International Monetary Fund (IMF) have direct loans to or have purchased bonds issued by Greece, Ireland, Portugal, Cyprus, Spain, and Italy. The ECB and national central banks have substantial loans to eurozone central banks and banks secured over the bonds of beleaguered countries. For example, the ESM, ECB, IMF, and European central banks now hold more than 90% of Greece's outstanding debt. Further debt write-downs, providing relief for the borrowing nations, would result in immediate losses to these official bodies, ultimately flowing through to the taxpayers in stronger countries such as Germany.

The Invisible Measure

The ECB Outright Monetary Transactions (OMT), which allows purchase of unlimited amounts of the debt of eurozone nations, has been hailed a success. President Mario Draghi has, self-effacingly, referred to it as the "most successful monetary policy measure undertaken in recent times."

Details of the yet to be used program remain opaque, especially on key issues such as the ECB's status as a preferred creditor on such purchases in the event of default or restructuring.

The OMT program is conditional, requiring the relevant government to formally request assistance and agree to comply with strict. It will be politically difficult for countries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits as in Cyprus. If they are forced to seek assistance, then it will be under such extreme conditions and market pressures, meaning that ECB intervention may be too late.

Germany and other eurozone members remain opposed to unlimited purchase of sovereign bonds under the OMT. Its legal basis remains uncertain. The result of a challenges being heard by the German constitutional court is unknown.

Diluting the Break

The banking union was intended to "to break the vicious circle between banks and sovereigns."

However, in the period since the announcement of the banking union, bank exposure to sovereign debt has increased, as national banks have purchased the sovereign's debt, which is used as collateral to obtain financing from the national central bank or ECB.

Eurozone bank claims on the public sector range between 10-40% of national GDP. European banks own around Euro 700 billion of Spanish government bonds and Euro 800 billion of Italian government bonds. They also have significant exposure to Greece, Ireland, and Portugal.
The key elements of any banking union are deposit insurance and a centralized recapitalization fund.

German opposition forced the ECB president to personally assure the Bundestag that a eurozone-wide deposit insurance scheme would not be part of the arrangements. There are no specific additional financial resources for recapitalization, which remains reliant on the inadequate ESM. Germany insists that the banking union cannot be responsible for "legacy" risk, that is, problems originating from events before the finalization of the banking union.

The banking union has become an inadequate single supervisory mechanism for a small number of eurozone banks, maintaining pretense of action and progress, allowing all governments to save face. The European Union has clarified that the goal is now to only "dilute" the link.

Same Again

The identified weaknesses of key policies will increasingly be tested by markets.

Firstly, the weakness of the real economy will increase financial pressure on European countries. During the second quarter 2013, European economies recorded slow growth, technically ending the recession. However, the levels of economic activity excluding Germany and France remained low. The turnaround may prove fragile, given deteriorating conditions in emerging markets which have been major buyers of European exports.

Ever optimistic European governments and policy makers now proclaim a stabilization or lower rate of decline as an indication of the success of their policies. But those forecasts of recovery may prove overly rosy.

Secondly, banking sector problems will continue. European banks may have as much as Euro 1 trillion in non-performing loans. Italian banks may have as much as Euro 250 billion of these.

Increasingly, European governments are resorting to tricks to resolve problems of the banking system, including inadequate stress tests, overly optimistic growth and asset price forecasts, and accounting stratagems. For example, Spain is seeking to convert Euro 51 billion in deferred tax assets resulting from loan losses into core capital to meet minimum requirements. If successful, then these would represent around 30% of Spanish bank core capital.

Without urgent and resolute action, bad debts and weak capital positions will create zombie banks that are unable or unwilling to supply credit to the economy, restricting any recovery.

Thirdly, crucial structural reform of labor markets and entitlements will be slow, reflecting weak economic activity and also the unpopularity of many measures. In addition, the relative stability of the last 12 months has lulled governments into a false sense of security, reducing the urgency of pursuing economic restructuring.

Fourthly, political tensions, both national and within the eurozone, are likely to increase. As evident in Greece, Portugal, Spain, and Italy, weak economic conditions have increased pressure on the government, highlighting political differences and destabilizing fragile ruling coalitions. All these countries also have domestic issues that contribute to political instability; for example, the bribery scandal involving the ruling PP in Spain and the continued legal difficulties of former Italian Prime Minister Silvio Berlusconi.

Across the eurozone, Germany's repeated rejection of any steps amounting to a mutualization of debt or hidden transfer payments as well as reluctance to increase German commitments, increasingly supported by Northern European nations, will complicate crisis management. Little is expected to change under the new German government.

The new phase of the crisis will follow a familiar narrative. Weaker countries may require extensions of existing loans, additional assistance, or debt write-downs.

Credit ratings will come under pressure. Italy's current credit rating (BBB with a negative outlook) is perilously close to non-investment grade. Stronger countries will also face rating pressure from larger financial burdens of supporting peripheral countries and European and global economic weakness.

Borrowing costs of weak European countries will remain high or increase, reflecting different factors including the following: economic weakness of the borrowers, political stresses, and also the potential reduction of the US quantitative easing program. Doubts about the OMT program and decreasing flexibility to use national banks and state pension funds to purchase government debt will accelerate the pressure on rates.

In 2012, Europe's policy makers were able to calm markets. This time around, with their options increasingly constrained, it will be interesting to see their response, and whether or not it works again.
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