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Satyajit Das: The European Debt Crisis Is Not Over


Despite statements by European leaders and policy makers, here's why it's premature to claim victory in the European debt wars.

European equity and bond markets performed well in the second half of 2012. The rally reflected a growing belief that the eurozone and the European Central Bank (ECB) was, at last, taking the correct policy actions. But despite statements by European leaders and policy makers, it is premature to claim victory in the European debt wars.

The financial resources remaining to deal with the crisis may be insufficient. The amounts available have not changed for almost two years, with little appetite for increasing commitments.

The major bailout facility -- the European Stability Mechanism (ESM) -- has total lending capacity of around Euro 500 billion. Financial assistance agreed for Greece, Ireland, and Portugal in the form of loans and guarantees is around Euro 294 billion. With around Euro 102 billion coming from the EU budget or bilateral aid to Greece, Euro 192 billion was provided by the European Financial Stabillity Facility (EFSF), which will be subsumed into the ESM. Euro 100 billion has been committed to Spain for the recapitalization of its banking sector. This leaves the ESM with available lending capacity of around Euro 208 billion. There are increasing constraints on further IMF participation, augmenting the ESM.

Greece, Ireland, or Portugal may need further assistance, as their economies remain weak and market funding is unavailable or expensive, they may need additional funding to meet maturing debt and also finance budget deficits.

Spain and Italy may need assistance programs. Spain has debt of Euro 800 billion (74% of GDP). Italy has debt of Euro 1.9 trillion (121% of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of Euro 160 billion in 2013 and Euro 120 billion in 2014. The Spanish government has announced a financing program of around Euro 260 billion for 2013. Italy has principal and interest repayment obligations of Euro 350 billion in 2013 and Euro 220 billion in 2014.

Capital flight from peripheral European countries is a problem. Banks in peripheral countries have lost between 10% and 20% of their deposits, reflecting concern about solvency and the risk of currency redenomination. Additional resources may be needed to finance a deposit insurance scheme to halt capital flight.

Europe has total bank deposits of around Euro 8 trillion, including around Euro 6 trillion in retail deposits. Around Euro 1.5-2 trillion of these deposits are in banks in peripheral countries. An effective deposit scheme would need to cover around Euro 1-1.5 trillion of deposits, placing a large claim on available funds.

Europe may need bailout facilities of at least Euro 3 trillion to be credible. Potential requirements exceed available resources.

The only other potential source of financial support is the ECB. It has already provided over Euro 1 trillion in term financing to banks through the Long Term Refinancing Operation (LTRO) program alone. These programs mature in late 2014 and early 2015. They may need to be increased or extended to finance the weak banking system.

The ECB has purchased around Euro 210 billion in sovereign bonds under the Securities Markets Program (SMP). In July 2012, the ECB announced the Outright Monetary Transactions (OMT) program allowing purchase of unlimited quantities of sovereign bonds. President Mario Draghi announced that: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro." Markets and investors have assumed that this is the "big bazooka" -- a European version of quantitative easing (QE) and debt monetization precedents of the US, Japan, and UK. The ECB's announcement underpinned relative stability in Europe in the second half of 2012.

But the OMT program is conditional. ECB action is contingent on the relevant government formally requesting assistance and agreeing to comply with the conditions applicable to assistance from the ESM/ EFSF. Instead of avoiding market pressures, the triggering mechanism requires that financing problems of "at-risk" countries get worse before the ECB will act.

ECB purchases will be confined to short or intermediate maturities. This condition is designed to make intervention similar to traditional monetary policy. It is also designed to reduce the cost of bank loans which is driven by shorter-term interest rates.

The ECB can also nominate a cap on yield or the size of its purchases in advance of any intervention. There is uncertainty as to whether the ECB will relinquish its status as a preferred creditor on such purchases in the event of default or restructuring.

The OMT program revealed significant divisions within the ECB. Jens Weidmann, the head of the German Bundesbank and a former advisor to the Chancellor, opposed the measure. Other eurozone members are also known to be uncomfortable.

The legal basis of the OMT program remains uncertain. Article 123 of the Lisbon Treaty prohibits the ECB from directly buying national governments' debt. Future legal challenges cannot be ruled out. Overcoming legal issues would require time consuming treaty changes, support for which is not assured.

The ECB president's statements have been dominated by two words: "may" and "adequate." Market analyst Carl Weinberg neatly summarized this as: "A promise to do something unspecified at some yet-to-be-determined time involving yet-to-be-invented programs and institutions, in a yet-to-be-decided way."

The OMT has not been activated to date. In 2008, US Treasury Secretary Hank Paulson's argued that if everyone knows that you have a bazooka in your pocket it may not be unnecessary to use it. The ECB has gambled that the announcement that it is prepared to intervene will restore market access of peripheral borrowers and reduce the interest rate demanded by the market. After an initial sharp fall, the borrowing cost of weaker countries increased and remains above sustainable levels.

Dr. Draghi, anointed as the Financial Times'' 2012 Person of the Year, operatically stated that the OMT program would: "And believe me, it will be enough." Markets will undoubtedly test the ECB's resolve. As Yogi Berra knew: "In theory there is no difference between theory and practice. In practice there is."
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