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Here we go again
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Chris Scicluna, Economic Research
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6 December 2011
Despite the improvement in market sentiment seen over the past week or so, this Friday’s European summit increasingly looks like crunch time for the euro. Following Moody’s threat a little more than a week ago of significant downgrades to several European sovereigns in the New Year, S&P followed suit overnight, placing the ratings of all euro area sovereigns that matter, including Germany, on negative creditwatch. That implies a probability of more than 50% that these ratings will be downgraded, with S&P aiming to complete its review as soon as possible after the summit. And, of course, any sovereign downgrades will hit the rating of the EFSF.
So, what hope is there that the rating agencies will hold their fire? Among the key reasons justifying S&P’s decision, the agency cited the ‘open and prolonged dispute among European policymakers’, which has allowed the crisis to escalate. Over recent days, however, euro area policymakers have appeared, for once, to be singing from the same hymn sheet, albeit a German one. Yesterday’s bilateral meeting between Merkel and Sarkozy saw the two leaders outline joint proposals to enshrine in law balanced budget rules and automatic sanctions for member states which flout them. The new Italian government has already spelled out new fiscal measures consistent with the spirit of the Franco-German proposals, while ECB President Draghi has suggested that such a new ‘fiscal compact’ would be the crucial first step to resolving the crisis. And at this week’s summit, more likely than not, the other euro area member states are set to agree to work towards drafting Treaty amendments by next spring to deliver the Merkozy plan.
But with issuance of common Eurobonds not included in the proposals, the new policy framework to be agreed this week is likely to fall well short of the kind of ‘fiscal union’ necessary to bring the crisis to a decisive end. Indeed, instead of representing a lasting solution to the euro’s troubles, the Franco-German proposals look set to deliver an ‘austerity union’. And with the euro area economy probably already in recession, that will accentuate the pro-cyclicality of fiscal policy, risking sending several countries, including Italy and Spain, into a dangerous deflationary spiral. To the extent that S&P also cited weakening growth prospects as a factor driving its decision to revisit its ratings, the proposals seem likely to increase, not decrease, the likelihood of future downgrades.
By only tackling fiscal irresponsibility, moreover, the latest proposals fail to remedy the principal factor behind the intensification of market stress evident since the summer: investor perceptions of an inadequacy of resources to guarantee that Italy and Spain can continue to meet their financing needs. And with the threatened downgrades meaning that the EFSF looks even more of a busted flush than it already did, Friday’s summit also needs to provide credible assurances that a stronger firewall capable of containing contagion can be put in place. That would have to include a credible commitment to reinforce the lending capacity of the IMF, e.g. through euro area central bank loans. But to be most effective, Friday’s deal needs to open the door for the potential introduction of Eurobonds. And at a very minimum, it needs to provide the ECB with enough reassurances to allow it to signal more clearly its willingness to increase significantly its sovereign bond purchases if and when necessary.
Despite yesterday’s warning from S&P, with Italian government 10Y yields remaining below 6% this morning, euro area policymakers might be lulled into thinking they are on the right track. Yet, with limited further Italian bond issuance due until the first quarter of 2012, when the Tesoro has more than €40bn of debt to refinance, the present period looks more like the calm before the storm. Indeed if, as we fear, this week’s summit fails to live up to expectations, it is difficult to see why the ratings agencies would withdraw their threats to downgrade the bulk of euro area sovereigns. And since, more than anything, that would strike a fatal blow to the EFSF, even if we see a relatively peaceful run-up to Christmas in the markets, the New Year could see the crisis return with a vengeance.
Chris Scicluna, Head of Economics
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