Deflation - not inflation - to provide the answer to Europe's debt crisis?



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Tobias S. Blattner, Economic Research
Daiwa Capital Markets Europe Limited
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24 November 2011

This week’s events have served as a reminder that the endgame to Europe’s debt crisis is rapidly approaching. Germany, the euro area’s paymaster, faced a massive shortfall in bids at its most recent 10Y Bund auction, forcing the Bundesbank to act as a lender of last resort, taking 35% of the issue, with the resulting market moves pushing German yields nearly 30bps higher in just two days.

While it is too early to say if the euro area’s last bastion has fallen and Germany has joined the club of nations whose debt is being shunned, the auction’s failure has certainly reinforced the fear among investors that the euro’s future is dangling by a thread.

With the entire currency union now on fire, liquidity drying up rapidly and spreads close to record levels for all member states, markets appear to be increasingly losing hope of a happy end to the crisis. Certainly, the current inadequate patchwork of policy responses cannot stop the crisis from spreading further.

Unlimited ECB purchases of euro area government bonds are increasingly viewed as the (only?) solution to the crisis. But in isolation, that would merely delay the death of the euro – it would not prevent it. Without deep and far-reaching changes to the euro area’s fiscal framework, including the option for independent fiscal policy to be removed from member states that breach the rules, the ECB would become everything the Germans always feared – the financiers of government deficits – without fostering market confidence in the ability of the periphery to repay its debt in the future.

In fact, sovereigns would fall victim to the same trap as peripheral banks in the euro area. When the ECB began to provide unlimited liquidity to banks, they became addicted to the ECB’s refinancing operations without being able to regain access to market funding as the underlying problem – impaired balance sheets – was not tackled.

So, while more aggressive ECB interventions would calm markets for a while, they can only serve as a bridge. Market confidence has to be restored through a mixture of effective austerity measures and Treaty changes delivering closer fiscal integration, almost certainly including the issuance of common Eurobonds to deliver lasting financial stability and guaranteeing the survival of the euro. For this to happen, both Germany and the ECB have to shift from their current positions.

In this process, unsurprisingly, Italy will play a key role. With the Italian yield curve trading as though a default is imminent and debt standing at 1.2 times its annual GDP, Italy next year will require a primary budget surplus (i.e. the deficit excluding interest rate payments) of at least 6% of GDP in order to stabilise its ballooning debt stock, assuming yields stay where they are. Of course, with the country likely facing a pronounced recession next year, the budget will be nowhere close to these levels, even if Monti, the new interim Prime Minister, is able to deliver further austerity measures in the coming months. 

More pressingly, with more than €50bn of bonds maturing in February and further downgrades of Italy’s credit rating seemingly imminent, the chances are high that Italy will soon have to ask its European partners and the IMF for financial assistance, sending new shockwaves through financial markets.

Is Italy too big to be saved? Not necessarily. Under the IMF’s new Precautionary and Liquidity Line (PLL), approved just this week, Italy could receive as much as €333bn of financial assistance for two years (absorbing 64% of the IMF’s available resources in the process). This is enough to cover around 72% of Italy’s financing needs of €461bn for 2012 and 2013 (excluding short-term bills and notes). The remaining share (€128bn) could then potentially be financed by the EFSF (although doubts about the EFSF’s ability to raise such vast amounts of cash persist).

But this would only leave around €170bn in the EFSF’s armoury for Spain and Belgium, both of which seem to be careering towards needing their own bailouts. That would not be enough to cover their combined financing needs of around €230bn for 2012 and 2013. So, in poker terminology, an Italian bailout is an “all-in” that could eventually result in the default of the third (Italy) or fourth (Spain) largest economy in the euro area, given the lack of resources to save both.

At this point, the ECB has to shift from its current position if it is serious about its price stability mandate. Faced with the risk of a large sovereign default, and the grim consequences that this would have on the global financial system and economy, the euro area would be staring at a protracted period of deflation. With interest rates already close to the lower bound (we expect the ECB to cut rates to 1%, or possibly below, in December), the ECB, faced with the probability of an imminent default of a large member state unless it were to step in and increase its bond purchase programme, would have no choice but to do so in order to ward off deflation. In doing so, the ECB could rightly argue the purchases would be fully consistent with its mandate. 

Where does that leave the Eurobond? Well, with the ECB’s balance sheet loaded with peripheral debt and Germany – the single largest shareholder of the ECB – guaranteeing nearly 30% of any potential losses, Chancellor Merkel might rapidly realise that a Eurobond is the lesser of two evils if the alternative is a central bank providing permanent funding to fiscally-troubled member states. Let’s all hope she’s bluffing when she says that a Eurobond is not the answer.


Tobias S. Blattner
Euro area Economist

 

 

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