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What (Little) We Know For Sure After the Eurozone Summit
July 10, 2012 01:23 PM
THE GLOBAL ECONOMY
Initially the eurozone leaders’ summit was viewed by many participants as “encouraging.” Subsequently, the European Central Bank (“ECB”) cut rates by 0.25%. But for financial markets, the anaesthetic is wearing off as Spanish bond yields rise and old problems resurface.
In truth, the results of the summit were always unclear. The proposals were vague and lacked vital details.
The summit supported a single regulatory body for all European banks. But this is impossible without resources to recapitalize European banks or progress on a Europe-wide deposit insurance scheme which would limit capital flight from peripheral countries.
Meanwhile, the previously agreed upon euro 100 billion capital injection for Spanish banks was ratified and on July 9, eurozone finance ministers authorized an initial payment of euro 30 billion.
What's different this time is that payments will be made directly by the European Financial Stability Fund (“EFSF”) and its successor, the European Stability Mechanism (“ESM”), to the banks rather than as loans to the relevant country. Notably, such loans will not have priority of repayment over commercial lenders.
As before, capital injections are subject to unspecified “economy wide” conditions. As investors in Greek bonds discovered, the EU can, if they wish, retrospectively change the terms to subordinate commercial creditors.
Furthermore, the EFSF/ ESM will take whatever actions are “necessary to ensure the financial stability of the euro area... in a flexible and efficient manner.” This was taken by the market to mean that they will purchase bonds of beleaguered countries like Spain and Italy to keep bond rates down.
Legal Rate Manipulation, Hurdles to Implementation
The potential for EFSF/ ESM purchases of Spanish and Italian bonds to provide funding -- and manipulate interest rates -- was actually agreed upon last year. It requires a member state to request assistance and execute a Memorandum of Understanding, which involves less onerous conditions than a full bailout. The June 29 statement confirmed that any such assistance would be conditional.
The ECB already has the ability to intervene by purchasing bonds under its Securities Markets Programme. Bond purchases by the ESM may reduce buying by the ECB, which may mean less -- not more -- support.
The European Union (“EU”) will also provide euro 120-130 billion of financing for investment to boost growth. The growth initiative amounts to only 1% of eurozone gross domestic product (“GDP”). As it was a repackaging of existing unspent funds, it is unlikely to be operational quickly.
After the meeting, German Chancellor Dr. Angela Merkel told the Bundestag that that “differing communications” from various eurozone leaders about the exact agreement had “led to a whole number of misunderstandings.” Spain and Italy’s gleeful boasts of unconditional aid does not square with Dutch and Finnish insistence that any money would require compliance with strict conditions. Finland is insisting that any aid have priority over commercial lenders.
To legally implement some initiatives may require complex and time consuming changes in European treaties.The German Constitutional Court must also rule on some aspects of the current proposal.
Given issues of national control and sovereignty, the risk of delays and failure of agreement are significant. In essence, implementation risks remain.
Where’s the Cash and Is There Enough?
Importantly, there was no commitment of new money of any kind. Since mid-2011, Germany has resisted any increase in the size of existing bailout facilities.
The ability of the EU to support the peripheral nations on an ongoing basis is questionable.
The euro 440 billion of the EFSF is largely committed to the Greek, Irish, and Portuguese bailouts plus euro 100 billion required for Spanish banks. When the new ESM is fully operational, there will be euro 500 billion available.
Potential requirements include a third bailout for Greece and further assistance for Ireland and Portugal. Additional money for recapitalizing European banks, especially Spanish banks, may be needed. Spain and Italy have financing requirements of approximately euro 600 billion in the period from now until 2014, mainly to pay maturing debt.
This also assumes that the EFSF (which is backed by guarantees from eurozone members including Spain and Italy) and the ESM (which will require capital contributions totaling euro 80 billion from all eurozone members) can issue any required debt to finance its activities.
Support from the International Monetary Fund (“IMF”) is uncertain. The lack of conditions and supervision of loans may complicate IMF participation. Domestic politics within the US in a presidential election year may also limit flexibility.
The monetary arithmetic of European debt problems remains unsustainable.
The EU may simply not have enough funds to carry out their programs unless the bailout fund are increased in some way or the ECB follows the US, UK, and Japan into full-scale quantitative easing to monetize European sovereign debt.
Where’s the Love?
The June Summit also highlighted deep fissures within the eurozone itself.
Germany, which is expected to pay substantially to solve the European debt problems, finds itself increasingly vilified and isolated. At the same time, the German Chancellor faces increasing domestic criticism for providing assistance without extracting an agreement to suitably tough conditions from the recipients.
The cost of support for the peripheral nations is rising. The ECB has provided over euro 2 trillion in the form of bond purchases and funding for European banks. Eurozone members are directly and indirectly supporting the two European bailout funds -- the EFSF and ESM -- for around euro 1 trillion. National central banks in Germany, Netherlands, Finland, and Luxembourg have provided more than euro 700 billion in financing for weaker nations.
Even without agreement on eurozone bonds, mutualization of debt is already a fact as stronger countries, especially Germany and France, effectively underwrite support for weaker members of the eurozone. As more financing for weaker nations moves to official institutions, the commitment will increase. Germany faces potential losses of between 800 and 1.4 trillion euros (up to 40% of its GDP). France also faces large losses.
Germany’s willingness to continue to finance the existence of the eurozone cannot be taken for granted.
Chancellor Merkel has increasingly emphasized that Germany’s financial strength is not infinite. Facing complex domestic political pressures, Finland and Netherlands remain equivocal.
Europe’s Chronic Condition: Denial
Despite progress, European leaders refuse to acknowledge that a portion of the debt of the peripheral nations is unrecoverable. None of the steps announced improve the sustainability of the debt levels of the affected countries, their access to markets, or the cost of borrowing in the medium to long term.
Ultimately, it is not possible to solve the problem of excessive indebtedness with more debt or by simply changing the lender.
Austerity dooms Europe to a prolonged contained depression as the debt burden is worked off.
The alternative, a debt write-off, would result in significant loss of wealth for the mainly European lenders and investors, thus triggering an economic contraction and a prolonged period of economic stagnation.
The eurozone has managed to avoid a life threatening emergency, converting its condition to that of a chronic disease requiring constant medical management. Treatment options available are now limited. The strategy is palliative care, hoping for the miracle of growth in Europe and the global economy.
It would be wise to remember American writer Edgar Howe’s observation: “There is nothing so well known as that we should not expect something for nothing -- but we all do and call it hope.”
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