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European End Games

The indecisive results in the Italian elections, the corruption scandal surrounding the Spanish government, Portugal, Ireland and Greece’s efforts to ease the ligatures of the bailout conditions and reluctance of countries like Germany to bail out Cyprus point to many twists and turns in the European debt crisis.

While the probable endgame of Europe’s debt crisis is known – de facto mutualisation of European debt and greater integration – the precise events leading up to it are unknown. The story is being told backward.

European Problems
 

Europe’s problems are well documented. Many European nations have high and, in some cases, unsustainable levels of debt, compounded by a cluster of maturities and ratings pressures.

Public finances are weak. European bank have either significant exposures to the weak property sector or sovereign debt. Euro-Zone bank claims on the public sector range from 13% to 38%.

Sluggish even before the crisis, Europe’s growth rates are too low to sustain current debt levels. Many European countries have uncompetitive cost structures in global terms.

Following revelations of Greece’s problems in 2009, investor scrutiny of Europe’s position has increased. A number of nations have lost access to commercial sources of finance. Their cost of borrowing has increased to uneconomic levels.

Greece, Ireland and Portugal have required bailouts. Spain is to receive financing to support its banking system. The European Central Bank (ECB) has been forced to finance nations and banks, to avoid the risk of defaults.

The crisis has exposed Europe’s social compact based on government spending and welfare services that is unsustainable at current rates of growth and taxes. As German Chancellor Angela Merkel stated in December 2012, ‘Europe has 7% of the world’s population…but is financing 50% of global social spending.’

It has highlighted the inflexibility of single interest rate and common currency, which limits policy options. It has revealed the complex inter-relationships which allow the rapid transmission of financial pressures. It has exposed the absence of institutional arrangements to deal with a crisis, because the entire framework assumed that it could not occur.

European Solutions

 


The required policy responses have remained largely unchanged since the commencement of the crisis – reduction of debt, temporary financing for entities that have lost market access and recapitalisation of affected banks. Almost two years into the crisis, European policymakers have begun to address each of these areas.

Reduction of debt can be achieved by austerity (directing revenues to the repayment of debt) or debt restructuring (voluntary write offs or default). Austerity measures are enshrined in the Fiscal Stability and Growth Pact which requires Euro-Zone members to reduce budget deficits to less than 3% in any one year and a debt to Gross Domestic Product (GDP) ratio no larger than 60%.

The European Union (EU) has undertaken a debt restructuring for Greece, euphemistically known as PSI (Private Sector Involvement), writing off €100 billion of debt.

The EU, ECB and IMF have collaborated to provide liquidity support and lower borrowing rates for weaker countries.

Facilities include the bailout funds – the EFSF (European Financial Stability facility) which is to be replaced by the ESM (European Stability Mechanism). The ECB has the ELA (Emergency Liquidity Arrangement), LTRO (Long Term Refinancing Operations), the SMP (Securities Market Program) and its new OMT (Outright Monetary Transactions) facility. The EU has agreed the concept of a banking ‘union’.

European bureaucrats seem afflicted by acronomania – the belief that a suitable sequence of letters can solve any problem. Unfortunately, the response is inadequate.

Austerity is self-defeating. Cuts in spending and increases in taxes lead to contracting economic activity, increasing the budget deficit and debt. Additional austerity merely exacerbates a vicious negative feedback loop as the economy becomes mired in a deep recession with rising unemployment.

Writing off the debt results in large losses to banks and investors. This requires government support to maintain the integrity of the payment and financial system, increasing budget deficits and debt.

The policies also fail to address growth and improving competitiveness. Without the option of currency devaluation, affected countries must force down costs, which exacerbates the reduction in activity.

Not Enough
 

The EU Commission 2012 State Aid Scoreboard calculated that between October 2008 and December 2011, all 27 EU states provided banks alone with €1.6 trillion in assistance (around 13% of EU GDP) for liquidity support, capital and removing impaired assets from balance sheets.

Since 2011, further assistance has been provided to banks. There was additional assistance provided by the ECB and IMF to banks and nations. If these are included, then the total amount of assistance to date approaches €3.5 trillion (30% of EU GDP), around €7,000 for every EU citizen.

But the financial resources remaining to deal with the crisis may be insufficient.

The ESM has total lending capacity of around €500 billion. Financial assistance agreed for Greece, Ireland and Portugal in the form of loans and guarantees is around €294 billion.

With around €102 billion coming from the EU budget or bilateral aid to Greece, €192 billion was provided by the EFSF, which will be subsumed into the ESM. €100 billion has been committed to Spain for the recapitalisation of its banking sector. This leaves the ESM with available lending capacity of around €208 billion.

There are increasing constraints on 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 €800 billion (74% of GDP). Italy has debt of €1.9 trillion (121% of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of €160 billion in 2013 and €120 billion in 2014.

The Spanish government has announced a financing program of around €260 billion for 2013. Italy has principal and interest repayment obligations of €350 billion in 2013 and €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 €8 trillion, including around €6 trillion in retail deposits. Around €1.5-2 trillion of these deposits are in banks in peripheral countries. An effective deposit scheme would need to cover around €1-1.5 trillion of deposits, placing a large claim on available funds.

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

Europe’s Big Bazooka
 

The only other potential source of financial support is the ECB. It has already provided over €1 trillion in term financing to banks through the LTRO program alone.

The ECB has purchased around €210 billion in sovereign bonds under the SMP. In July 2012, the ECB announced the 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’. 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 Euro-Zone 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 summarised 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. 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.

The borrowing cost of weaker countries remains above sustainable levels. But the true access to market remains unclear because of the activity of banks purchasing sovereign debt which can be financed with the ECB at a profit.

Dr. Draghi, anointed as the Financial Times’ 2013 Person of the Year, operatically stated that of the OMT program, ‘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.’

Stealth Integration
 

The scale of the problems, the inadequacy of financial resources available and political difficulties mean 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 Euro-Zone 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. The key influences will be austerity programs and weak global environment, including slowdowns in emerging economies. Other factors will be the continued restriction of credit as European banks restructure and shed assets.

The low levels of economic activity will be particularly pronounced in the peripheral economies. The weakness will be transmitted to stronger economies, through weaker exports.

Given that their largest markets are within Europe and in recession, Germany and France will also experience slowdowns. Increased financial strains from the need to support the weaker countries will also contribute to the contraction.

Governments in the at-risk economies will not meet budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels. Further funding assistance may be required.

Euro-Zone 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. 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 Euro-Zone, especially Germany and France. This reflects the reality that the stronger countries stand behind each of the support mechanisms.

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. A similar process operates in respect of the ECB.

Germany is by far the largest creditor in TARGET2. The Netherlands, Finland and Luxembourg are the other creditors with all other Euro-Zone countries being net debtors within the system. The Bundesbank has current exposure of over €750 billion to other central banks in the Euro-Zone.

The TARGET2 net claims are not a true measure of the risk of the Bundesbank. The net balance would only be lost in the case of a breakup of the Euro-Zone and if sovereign central banks refuse to honour their debts. This risk is difficult to quantify. But there is a clear transfer of financing risk to the stronger core countries. This ultimately weakens their financial position materially.

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

The size of these exposures is large, both in relation to Germany’s GDP of around €2.5 trillion and German private household assets which are estimated at €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 transfer of risk will mean de facto debt mutualisation and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid.

World of Pain
 

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-labour 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 Euro-Zone members. As integration becomes a reality, 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.’

Europe will find itself locked in a period of subdued economic activity and high unemployment. The core Euro-Zone countries, especially Germany and France, are increasingly affected by the problems of the rest of Europe.

In early 2013, Joerg Asmussen, a German ECB board member, was quoted as predicting Germany could become the ‘Sick Man of Europe’ if the problems continued.

The dry economic language masks a world of human pain as life will turn into a grim struggle for survival. Social unrest and conflict is likely. Militant opposition to austerity and declines in living standards will increase.

European Magic Realism
 

European political leaders are increasingly optimistic in their language- the Euro-Zone crisis is ‘behind us'; the problems are ‘resolved’. Only German Chancellor Angela Merkel has sounded cautious, arguing that the crisis is likely to continue for many years.

It may be tacit acknowledgement of the cost of the crisis to Germany. It may also a strategy to prepare Germans for the harsh reality of the likely endgame.

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 Euro-Zone 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 institutionalised 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 Euro-Zone.

Regards,

Satyajit Das
for The Daily Reckoning Australia

© 2013 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money and Traders Guns & Money

The author would like to thank Oliver Marc Hartwich, Executive Director of the NZ Initiative, for his helpful comments on an earlier draft of this paper.

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