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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."

The scale of the problems, the inadequacy of financial resources available and political difficulties means that decisive actions to resolve the European debt crisis are unlikely. A slide into a deeper economic malaise, both for at risk countries but also stronger eurozone members, is the most likely course of events.

The real economy, already in recession, is likely to remain weak, with low growth and high and rising unemployment.

Eurozone members remain committed to avoiding the unknown risks of a default and departure of countries from the euro. This means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain.

Peripheral countries will be forced to rely on the ESM and ECB to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly and indirectly. Central banks in stronger countries will continue to use the TARGET2 ("Trans-European Automated Real-time Gross Settlement Express Transfer System"), a payment system to settle cross border funds flows within the eurozone, to finance peripheral countries without access to money markets to fund trade deficits and capital flight.

Over time, financing will become concentrated in official Euro-Zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the eurozone, especially Germany and France.

The ESM relies primarily on the support of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Market analyst Grant Williams prosaically described the other countries backing the ESM as Greece, irrelevant, doesn't matter, don't bother, makes no difference, who cares, somewhere near Poland, pointless, up the top, former something-or-the-other, tax shelter, pretty much a non-country and somewhere with mountains. If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase.

Germany provides an indication of the magnitude of the task. German guarantees supporting the EFSF are Euro 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany's liability could be as high as Euro 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims.

The size of these exposures (potential losses of Euro 1 trillion or more) is large, both in relation to Germany's GDP of around Euro 2.5 trillion and German private household assets which are estimated at Euro 4.7 trillion. Germany also has substantial levels of its own debt (around 81% of GDP). The increase in commitments or debt levels will absorb German savings, crippling the economy. Germany demographics, with an aging population, compound its problems.

Over time, the shift of risk will mean de facto debt mutualization and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid.

Stealth integration will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession.

Living standards will be reduced by internal devaluation. In the period since the introduction of the euro, German unit-labor costs rose by 7-8%, compared to 30% in Italy, 35% in Spain and 42% in Greece. These rises have to be reversed to increase competitiveness. Employment conditions, pension benefits, and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income.

In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker eurozone members. Europe will find itself locked in a period of subdued economic activity and high unemployment. Unemployment rates, which in some countries approach 30% and 50% for people under 25 years, will feed increasing social and political instability.

While de facto integration is the likely outcome, a smooth transition is not guaranteed. Outflows of actual cash to beleaguered nations, the first claims on the German budget, significant rating downgrades for core eurozone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalized structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults, or a breakdown of the euro and the eurozone. Whatever the outcome, ordinary Germans will discover the reality of an old proverb: "If you stay the beast will eat you, if you run the beast will catch you."
No positions in stocks mentioned.

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