EU Summit May Be Eurozone's Last Chance to Avoid Financial Disaster
Unless European leaders overcome their common-sense deficit, which is proving as intractable as any budget and trade deficit, this may not end well.
The last comprehensive and final plan – the fourth in the last 18 months – failed to mollify investors and markets. The crisis is now engulfing Italy, Spain and now re-infecting Ireland and Portugal. Stronger countries like France and Germany are increasingly vulnerable.
Standard & Poor's are reviewing the ratings of a number of 15 eurozone countries with with negative implications. This action was "prompted by … belief that systemic stresses in the eurozone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the eurozone as a whole." The rating agency highlighted tightening credit conditions across the eurozone, higher funding costs for many eurozone sovereigns, high levels of government and household indebtedness, the rising risk of a European recession and a lack of agreement among European policy makers on tackling problems.
The curious pas de deux between European banks and sovereigns has reached a critical stage. Needing to raise money and keep interest costs down, governments are pressuring banks to buy their bonds and use them as collateral to raise fund from individual central banks and the European Central Bank ("ECB"). At the same time, European banks exposed to the risk of large losses on holdings of sovereign bond, which would render them potentially insolvent need governments to support the banking system.
Time is running short. European sovereigns and banks need to find euro 1.9 trillion to refinance maturing debt in 2012. Italy alone requires euro 113 billion in the first quarter and around euro 300 billion over the full year. European banks need euro 500 billion in the first half of 2012 and euro 275 billion in the second half. This means they need to raise euro 230 billion per quarter in 2012 compared to euro 132 billion per quarter in 2011. Since June 2011, European banks have been only able to raise euro 17 billion compared to euro 120 billion for the same period in 2010.
There has to be acknowledgment that austerity -- draconian budget cuts and tax increases -- to bring budget deficits and public debt under control cannot deal with the problem: the deflation of the debt-fueled bubble. There also has to be acknowledgment that Europe doesn't have a "liquidity" problem which can be alleviated by substituting fleeing private sector lenders with official lenders such as the European Union ("EU"), ECB or the International Monetary Fund ("IMF").
European countries have a "solvency" problem – they have debt that they can never seriously expect to pay back. Stronger nations cannot save the peripheral nations without ultimately destroying their own credit and ability to raise funds.
There has to be realistic writedowns of the debt of countries like Greece, Portugal and Ireland and a preparedness to do the same for Italy and Spain quickly, if necessary. An aggressive program for recapitalization of European banks and the ECB is needed. Weaker countries may need assistance in recapitalizing banks.
The European Financial Stability Fund ("EFSF"), the European bailout fund, is now largely irrelevant, It lacks the resources to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from contagion. If it is to remain, then the fund needs to be restructured to support the financing requirements of Spain and Italy, which need around euro 1 trillion to meet their financing requirements over the next few years.
Schemes to increase the capacity of the EFSF -- borrowing to leverage the fund or partial guarantees or seeking Chinese funding – are simply farfetched or incomprehensible. The EFSF's attempt to raise money to meet existing commitments has run into problems, meeting lackluster support and a sharp increase in costs. In the event that the AAA guarantors are downgraded, the EFSF structure, as originally envisaged, becomes unworkable. Rating agencies have signaled that the EFSF's AAA rating is under threat. The risk that the cost of funding for the bailout fund is greater than the rate that it can charge is now increasingly evident.
Weaker nations should leave the euro. The devaluation of the new currency in conjunction with structural reforms will provide some chance of regaining competitiveness. Within the euro, the only option – internal devaluation entailing a sharp fall of incomes and living standards – cannot work on its own.
Fiscal union (greater integration of finances where Germany and the stronger economies subsidize the weaker economies combined with jointly and severally guaranteed eurozone bonds) or debt monetization (the ECB prints money and uses it to buy bonds) are unworkable.
Germany and France are unwilling or unable to increase the size of their commitments. Restricted by the German Constitutional Court's decision, for the moment, Germany cannot or will not go above euro 211 billion in guarantees for the bailout funds already committed – about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country's credit-worthiness. Chancellor Angela Merkel's spokesman Steffen Seibert put the matter plainly stating that Germany doesn't have "unlimited financial strength."
France is at the limit of its financial capacity and at risk of losing its AAA credit rating. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process. These constraints make full fiscal union difficult.
Stronger European countries have seen a sharp increase in the cost of their financing. Netherlands 10-year debt is trading around 0.40% above Germany, down from a November high of 0.68% but well above the 0.10% where it traded historically. Austria's 10-year rate relative to Germany fluctuated between 0.80% to 1.90% in November, up from an average of 0.23% over the last 10 years. Finland's 10-year spread to German bonds reached 0.79% in November, well above the low of 0.07% in January 2011 and an average of 0.35% over the last year. Finland's 10 year bonds are trading at around 1.00% over that of neighboring Sweden, down from a high of 1.37% but well above an average difference of 0.04% since the introduction of the euro in 1999.
The higher rates and increased volatility of rates has made it increasingly difficult for these countries to finance, despite relatively sound public finances. For Finland, where 75% of its debt is sold to foreign investors, this is increasingly problematic.
The ECB is not allowed and also unwilling to print money. Germany's Bundesbank opposes debt monetization. The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly breakup of the eurozone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetization.
Printing money may buy some time. But it does not deal with the level of debt, the problems related to bank holdings of sovereign bonds (a small fall in value may affect the solvency of many institutions), allowing countries to regain access to investors on a sustainable basis or economic competitiveness.
If fiscal union and debt monetization are unavailable, a "controlled" debt restructuring of some nations may be the only option available.
What happens in Europe will not stay in Europe. The shock will be rapidly transmitted through trade, investment and inter-relationships within the financial system to the rest of the world.
Early signs are not good. But no writedowns of debt or restructuring of the euro is contemplated.
The French President has pronounced that no European country will be allowed to default. Germany has placed its faith in more austerity without increasing her financial commitment, proposing a revised treaty between eurozone members to reinforce a commitment to fiscal discipline. Automatic, court-enforced sanctions on countries that exceed 3% of GDP on budget deficits and 60% of GDP on debt are laughable. The bulk of eurozone countries do not and cannot meet these limits now or in the foreseeable future. As for the proposed fine, they would have to borrow the money to pay them.
Plans to leverage the EFSF are to be tabled, although no one honestly knows whether any investor will support it with cash. The Chinese have said "nein, danke" and "non, merci."
The ECB will probably slash euro interest rates and lengthen the term of emergency funding of banks to say two years with easier collateral rules. European central banks may provide money to the IMF to provide money to beleaguered nations. Unless increased substantially, the IMF may be only able to muster euro 300-450 billion, which will be insufficient. IMF involvement will entangle all member countries forcing them to assume the risk of bailing out Europe.
European leaders seem content to discuss long term lifestyle changes with the near-death patient in ER.
To paraphrase Woody Allen, European leaders face two choices. One leads to a prolonged recession, privations and hardship. The other leads to economic and financial annihilation as well as hopelessness. May they choose well!
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