Research Blog
Euro area: Crunch time round the corner?
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
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16 December 2011
The morning after last week’s EU summit we were cautiously optimistic that euro area leaders had taken a small step forward towards a more meaningful resolution of the debt crisis. We should have known better. As ever in the “doublethink” world of euro area summits, it has rapidly become apparent that what leaders apparently signed up to bears little resemblance to what they will actually do.
We never thought that much of the fiscal compact. It did nothing to address the immediate challenges posed by the debt crisis, while forcing the euro area into a deflationary fiscal straitjacket. In any case, it has becoming increasingly clear that putting in place the beefed-up sanctions regime without a Treaty change, something that the UK has effectively vetoed, will be impossible. The fiscal compact, therefore, looks to have been drowned at birth, at least in the form envisaged Thursday evening.
But we were hopeful that agreement on stricter fiscal rules had opened the door for the possibility of additional financial resources for bailouts. That hope now looks to have been misplaced. First, Chancellor Merkel, who increasingly resembles a fifth-columnist for those who want to see the euro destroyed, on Tuesday ruled out any increase in the euro area’s own bailout resources above €500bn, pre-empting a commitment made at the summit to reassess in March 2012 whether €500bn was indeed adequate. Meanwhile, the €200bn of additional resources for the IMF from EU central banks alluded to in the summit communiqué appears to have been largely a figment of euro area politicians’ imaginations. Perhaps inevitably the Bundesbank is at the vanguard of the foot-dragging over this, saying that it will not contribute unless non-EU countries also contribute. And with the US, UK, Canada and Japan having all ruled out additional significant contributions of their own for now at least, arguing plausibly that the euro area has sufficient resources to deal with its own troubles, we may have already reached an impasse with the €200bn never to materialise.
So, just a week on from the summit, the euro area once again appears no further forward in dealing with the crisis. Indeed, the failure of the summit to produce anything concrete risks deepening the crisis, with both S&P and Moody’s now looking odds on to follow through on their threatened downgrades of euro area sovereigns. S&P could well move before the year end, with Moody’s hot on its heels early next year. At worst, these actions could see all euro area sovereigns, Germany included, downgraded. The best outcome would be that the strongest would retain their AAA ratings with Moody’s, but there would be multiple downgrades across the area, including for France.
As we have argued previously, multiple downgrades, with the threat of potentially more to come, would almost certainly lead to an intensification of the crisis. Funding costs for both Italy and Spain would almost certainly rise, reflecting not only the direct impact of those countries’ downgrades but also the impact that the downgrades would have on the EFSF and (ultimately) the ESM’s credit ratings. For the EFSF, if it was to maintain a €440bn borrowing capacity (i.e. with France remaining as one of the guarantors), then its ratings would fall to France’s level (i.e. for S&P, AA). The EFSF is already struggling to issue – a downgrade would just make that even harder.
And with severe doubts about the EFSF’s ability to raise significant funds at affordable rates, in the absence of additional IMF resources the market will be all too aware that the cupboard is looking pretty bare to fund meaningful packages for Italy and Spain. This realisation could prove self-fulfilling at the start of 2012, when the Italian Tesoro alone has more than €40bn of debt to refinance in the first quarter. If, as we expect, the EFSF’s insurance scheme will not do the trick to catalyse investor demand, despite their successful bond auctions this week Italy and Spain will ultimately require external assistance. But even assuming the EFSF is able to raise €440bn there still simply are not the resources available to provide the multi-year financial assistance packages that both countries would require. At best some sort of short-term packages could be cobbled together. But if Moody’s does indeed downgrade both countries to junk as it has threatened for countries requiring a bailout, they would most likely be locked out of capital markets for years. Markets will know this, and will rapidly start to price in appropriate haircuts accordingly.
All the while, the second Greek package looks as though it is starting to unravel, with talks on private sector bondholders accepting a 50% “voluntary” haircut apparently stalled. Failure to get agreement will require either the euro area authorities to commit significant additional resources to a second bailout, further reducing the funds available for Italy and Spain, or impose a forced haircut, which would also have to be applied to the ECB’s €45-50bn of Greek debt holdings. The alternative of no second programme and a chaotic default, after Greece has done so much to try and meet the requirements of the first bailout package, would send a signal that the rest of the euro area is simply no longer willing to help the periphery even when countries (broadly) do as they are told. Markets would react with even heavier selling of peripheral debt.
A weakening economy, additionally weighed down by bank deleveraging as the euro area’s banks move to hit the new 9% tier 1 capital ratio and cope with closed unsecured lending markets, meanwhile, will only add to investor and rating agency concerns that the politicians can ultimately deliver the fiscal austerity promised. Some euro area governments are likely to find themselves with two unpalatable choices – ease deficit targets in the face of a weaker economy and risk a market and rating agency response, or implement more and more austerity measures, risking a deflationary spiral.
All the signs therefore point to a further marked escalation in the crisis in the New Year. And so, having vacillated for far too long, as we and many others have been arguing the policy choices facing euro area governments will become stark – either throw away the euro in its current form, threatening global economic depression, or work towards establishing a true fiscal union, with joint and several guarantees on all member states’ debts. The options have narrowed to this – the unlimited ECB bond purchases advocated by many are not a viable policy framework for the medium-term survival of the euro; a currency in which the central bank has an open-ended commitment to funding governments is one that will ultimately fail.
We continue to believe that euro area policymakers do not want to see the euro fail, and will ultimately end up going down the Eurobond route. That will require political change in Europe, not least a new government in Germany. But that is not a forlorn hope, given that the current ruling coalition could collapse in the New Year over a vote on the ESM. But delivering a Eurobond, even if the German government is persuaded of its merits, would face innumerable obstacles. It would potentially be a multi-year process that would require major Treaty changes, which even if the belligerent Brits could be brought on board, would require parliamentary approval in all euro area countries, and potentially tricky referendums in many. So, the implementation risks would remain huge. And since euro area policymakers’ credibility with markets is now shot – they have tried to pull the wool over the market’s eyes too many times – the announcement of a move towards Eurobonds, by itself, is unlikely to be sufficient to calm markets once and for all.
So, crunch time for euro area policymakers could well be approaching rapidly. But the much hoped for “silver bullet” perhaps doesn’t exist in the near term. An announcement of Eurobonds would give the market a brief fillip. But until the ink is dry on the revised Treaty, markets will rightly remain sceptical. And, of course, the risk remains that German opposition to Eurobonds is not overcome, threatening the whole existence of the euro. Either way, 2012 doesn’t look set to see a swift end to this long-running crisis. Indeed, things could get a whole lot worse.
Grant Lewis
Head of Research
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