This
week’s summit was supposed to put an end to the euro
crisis. It hasn’t
Europe’s
rescue plan
The
Economist, October 29th 2011
You
can understand the self–congratulation. In the early hours
of October 27th, after marathon talks, the leaders of the
euro zone agreed on a “comprehensive package” to dispel
the crisis that has been plaguing the euro zone for almost
two years. They boosted a fund designed to shore up the euro
zone’s troubled sovereign borrowers, drafted a plan to
restore Europe’s banks, radically cut Greece’s burden of
debt, and set out some ways to put the governance of the
euro on a proper footing. After a summer overshadowed by the
threat of financial collapse, they had shown the markets who
was boss.
Yet
in the light of day, the holes in the rescue plan are plain
to see. The scheme is confused and unconvincing. Confused,
because its financial engineering is too clever by half and
vulnerable to unintended consequences. Unconvincing, because
too many details are missing and the scheme at its core is
not up to the job of safeguarding the euro.
This
is the euro zone’s third comprehensive package this year.
It is unlikely to be its last.
Words
are cheap…
The
summit’s most notable achievement was to forge an
agreement to write down the Greek debt held by the private
sector by 50%. This newspaper has long argued for such a
move. Yet an essential counterpart to the Greek writedown is
a credible firewall around heavily indebted yet solvent
borrowers such as Italy. That is the only way of restoring
confidence and protecting European banks’ balance-sheets,
thus ensuring that they can get on with the business of
lending.
Unfortunately
the euro zone’s firewall is the weakest part of the deal.
Europe’s main rescue fund, the European Financial
Stability Facility (EFSF), does not have enough money to
withstand a run on Italy and Spain. Germany and the European
Central Bank (ECB) have ruled out the only source of
unlimited support: the central bank itself. The euro
zone’s northern creditor governments have refused to put
more of their own money into the pot.
Instead
they have come up with two schemes to stretch the EFSF. One
is to use it to insure the first losses if any new bonds are
written down. In theory, this means that the rescue fund’s
power could be magnified several times. But in practice,
such “credit enhancement” may not yield much. Bond
markets may be suspicious of guarantees made by countries
that would themselves be vulnerable if their over-indebted
neighbours suffered turmoil.
Under
the second scheme, the EFSF would create a set of
special-purpose vehicles financed by other investors,
including sovereign-wealth funds. Again, there are reasons
to doubt whether this will work. Each vehicle seems to be
dedicated to a single country, so risk is not spread. And
why should China or Brazil invest a lot in them when Germany
is holding back from putting in more money?
Together,
these schemes are supposed to extend the value of the EFSF
to €1 trillion ($1.4 trillion) or more. Sadly, that looks
more like an aspiration than a prediction. And because the
EFSF bears the first losses, its capital is at greater risk
of being wiped out than under a loan programme. This could
taint France, which finances the rescue fund and has
recently seen its AAA credit rating come under threat. Since
the EFSF depends partly on France for its own credit rating,
a French downgrade could undermine the rescue fund just when
it is most needed.
If
the foundations of the firewall are too shallow, then the
bank plan plunges too deep. By the end of June 2012, banks
are expected to establish a core-capital ratio of 9%. In
principle, that is laudable. But if banks have months to
reach their target, they can avoid raising new equity, which
would dilute their shareholders' stakes, and instead move to
the required ratio by shrinking their balance-sheets. That
would be a terrible outcome: by depriving Europe’s economy
of credit, it would worsen the downturn.
Then
there is Greece. Although the size of the writedown is
welcome, euro-zone leaders are desperate for it to be
“voluntary”. That is because a default would trigger the
bond-insurance contracts called credit-default swaps (CDSs).
The fear is that a default could lead to chaos, because the
CDS market is untested. That is true, but this implausibly
large “voluntary” writedown will lead investors in other
European sovereign bonds to doubt whether CDSs offer much
protection. So while the EFSF scheme is designed to offer
insurance to bondholders, the European leaders’ insistence
that the Greek writedown be voluntary will make euro-zone
debt harder to insure.
…but
trust is nowhere to be found
Europe
has got to this point because German politicians are
convinced that without market pressure the euro zone’s
troubled economies will slacken their efforts at reform.
Despite a list of promises presented to the summit by Silvio
Berlusconi, Italy’s prime minister, Germany has good
reason to worry. But it needs to concentrate on
institutional ways of disciplining profligate governments,
rather than starving the rescue package of funds. As it is,
this deal at best fails to solve the euro crisis; at worst
it may even make it worse. As the shortcomings of each
component become clear, investors’ fears will surely
return, bond yields will rise and banks’ funding problems
will worsen.
Yet
again, disaster will loom. And yet again, the ECB will end
up staving it off. Fortunately, Mario Draghi, the ECB’s
incoming president, made it clear this week that he realises
that is his job. But therein lies the tragedy of this
summit. An ECB pledge of unlimited backing for solvent
governments would have had a far better chance of solving
the crisis months ago, and remains the best option today.
At
this summit Europe’s leaders had hoped to prove that their
resolve to back the euro was greater than the markets’
capacity to bet against it. For all the backslapping and
brave words, they have once again failed. There will be more
crises, and further summits. By the time they settle on a
solution that works, the costs will have risen still
further.
The
euro deal: No big bazooka
Europe’s
leaders have agreed on how to prop up the euro. For now
The
Economist, October 29th 2011
Brussels.–
It was four in the morning in the Justus Lipsius building in
Brussels when word at last filtered out that, after nearly
ten hours of arduous bargaining, the euro zone’s leaders
had reached the long-promised “comprehensive” deal to
save the euro. Diplomats called contacts in the sanctum to
find out what, precisely, had been agreed. “We think we
have an agreement, but we are not sure what it is,” came
the reply from one weary negotiator.
By
their own admission, the leaders themselves at times
struggled to understand the complex financial engineering
which they were being asked to approve to turn their
inadequate financial slingshot into the “big bazooka”
that the world had asked them to assemble. But by dawn on
October 27th they could proudly announce a “comprehensive
set of additional measures reflecting our strong
determination to do whatever is required to overcome the
present difficulties”.
The
result was better than some had dared hope. Just a week
earlier the summitry had seemed doomed, with Angela Merkel,
the German chancellor, rejecting a push by Nicolas Sarkozy,
France’s president, to boost the euro zone’s bail-out
fund by allowing it to borrow money from the European
Central Bank (ECB). Unable to cancel a summit planned for
October 23rd, the leaders decided instead to call a second
one three days later. The ruse worked; the discussions, said
one participant, had gone “from worse to bad to better”.
Markets rejoiced.
But
is it a good deal? This was, after all, the third
“comprehensive solution” devised by the euro zone so far
this year. With each “unprecedented” effort, the problem
has only worsened (see chart 1). Sadly, this latest deal
promises to be no more enduring. At best, it will buy time
before the next round of panic. At worst, it may push the
euro zone into catastrophe. “This is certainly no summit
to end all summits,” said Sony Kapoor, managing director
of Re-Define, an economic think-tank in Brussels. “Once
again, good economics has fallen victim to bad politics.”
The
package consists of three connected parts: reducing
Greece’s debt to a sustainable level by a “voluntary”
agreement with private creditors to accept the loss of half
the value of the bonds, in exchange for safer debt;
recapitalising Europe’s banks to the tune of €106
billion ($146 billion) to help them absorb the losses on
Greek and other distressed debts; and creating a €1
trillion firewall to prevent the spread of panic to
vulnerable, bigger but still-solvent states, above all
Italy, the euro-zone country with the second-biggest debt
burden. In the word of one well-placed source, “the more
zeroes the better”. The trouble is, the more zeroes are
added, the more holes are likely to be found in the plan.
The
good news is that the euro zone has woken up from the lie
that Greece could one day repay its debts. A supposedly
confidential new assessment of Greece’s prospects, drawn
up earlier this month by the “troika” of the ECB, the
IMF and the European Commission, makes dire reading.
Austerity has pushed Greece further into recession than
expected; this year output is expected to shrink by 5.5%,
and the country will not return to growth until 2013.
Moreover, structural reforms to boost growth have been
implemented slowly while the forecast for European economies
has dimmed, further darkening the outlook for Greece. As a
result, the report found that its debt would probably peak
at about 186% of GDP in 2013, instead of the 160% predicted
three months earlier, even with a 21% haircut on debt held
by private creditors that was agreed on in July. If the euro
zone and IMF wanted to avoid lending more billions to
Greece, private creditors would have to take much bigger
losses.
So
alongside the bad-tempered bargaining among politicians,
there was an equally arduous negotiation with Greece’s
creditors. At one point on October 26th Mrs Merkel and Mr
Sarkozy broke away from the summit to bargain with bankers.
The banks would not accept the troika’s bleak forecast. A
paper produced recently by the Institute of International
Finance, a club of big banks that has been negotiating debt
forgiveness on their behalf, argued that Greece’s public
debt would stand at a hefty, though manageable, 122% of GDP
by 2015. That always seemed fanciful.
In
the end, negotiations settled on a bond exchange that will
cut the face value of Greece’s debt to private creditors
by half. Although the numbers are sketchy, it appears that
Greece’s partners will have to lend €130 billion,
instead of the €109 billion they promised in July. Details
of the bond exchange have still to be negotiated with the
banks, but it is hoped that it will take place early next
year. Taken with the concessionary terms agreed on in July,
the package gives Greece its best chance yet of emerging
from the crisis. “We finally see hope,” said one Greek
official.
The
bond exchange is billed as “voluntary”, but it is not
clear that the International Swaps and Derivatives
Association, a trade body, will agree. If it judges that a
“credit event” has taken place, then payouts will be
triggered on credit-default swaps (CDSs), insurance
contracts against default on government bonds. This is
something that the governments and the ECB had been
determined to avoid, fearing it would lead to financial
catastrophe, rather as the bankruptcy of Lehman Brothers did
in 2008. There is no clarity about who the biggest issuers
of default insurance on Greece are. The net exposure on
Greek CDSs is thought to be less than €4 billion, though
this is likely to be unevenly distributed, with some banks
big winners and others big losers. “You don’t have to be
paranoid to be terrified,” says a senior figure involved
in the deliberations.
Bankrupting
the banks?
Even
if the euro zone succeeds in avoiding CDS payouts, this
could prove a Pyrrhic victory. If losing half the face value
of a bond does not amount to a default, what does?
Undermining the value of CDS insurance could deeply distort
the market. If banks or other investors lose faith in their
ability to hedge risks, they will be tempted to cut back on
risk or demand higher yields. So, perversely, sparing a CDS
payout on Greece could push up the borrowing costs of other
countries.
That
said, the danger of contagion is real. If holders of Greek
bonds can incur losses on what they once thought were safe
investments, what of holders of Italian or Spanish debt? The
initial deal on Greek debt in July was followed in August by
the dumping of Italian and Spanish government bonds.
One
of the obvious channels of contagion is the banking system.
So the 27 governments of the EU—both in and out of the
euro zone—agreed to force banks to take on more capital to
reduce the risk of collapse. The new recapitalisation
package will oblige banks to reach a minimum core Tier-1
capital ratio of 9% (somewhat higher than current
requirements) by the middle of next year, after
recalculating the value of their bond holdings at market
prices. That would mean writedowns of Italian and Spanish
bonds and gains on German and British ones. This will push
much of the burden of raising new capital onto Spanish and
Italian banks while leaving British and German ones largely
unscathed.
The
criteria are suspiciously kind to France. Its banks have
been battered in the markets in recent months, and the
government is alarmed by the prospect of losing its AAA
credit rating. The recapitalisation will be reckoned
according to bond prices on September 30th, when French
ten-year bonds were still yielding 2.6%. Since then the
price has fallen, and the same bonds are now yielding 3.1%.
In all, banks will have to come up with €106 billion in
extra capital. That sounds like a lot, yet it is at the
lower end of many estimates, largely because it will not
include a “stressed” scenario that models the impact of
a recession. That may be a mistake, given the slowdown in
Europe’s economy.
A
far bigger mistake is in the plan’s timetable. Banks are
being given almost nine months to reach the targets,
ostensibly to allow them to raise capital themselves through
cutting dividends or bonuses and selling shares. Yet few
investors are willing to buy bank shares, cheap as they may
seem, given the perceived risks of a series of sovereign
defaults in Europe. This means that the burden would fall
first on national governments and then on the increasingly
stretched resources of the European Financial Stability
Facility (EFSF), Europe’s main bail-out fund.
Given
too much time, moreover, there is the risk that banks will,
in fact, shrink their balance-sheets to bolster their
capital ratios. Their first strategy will be to trim
economically essential but capital-intensive businesses such
as trade finance or lending to small businesses. Huw van
Steenis, an analyst at Morgan Stanley, reckons that European
banks may go on a “crash diet” and cut their
balance-sheets by as much as €2 trillion by the end of
next year. They may also sell government bonds of peripheral
countries, worsening the bond-buyers’ strike that afflicts
Italy and Spain.
Capital
is only one issue facing banks. A second is their own
ability to borrow. The ECB can step in for short-term
funding, but long-term markets are frozen. European banks
have, to all intents and purposes, been unable to issue
bonds since the start of July. Governments could reopen the
market by guaranteeing bonds issued by banks, but they are
wary of putting their own public finances at risk; this was
the path that led to Ireland’s ruin. In any case, few
investors would trust guarantees from Italy or Spain.
Debased
sovereigns
All
this suggests that an essential part of shoring up
Europe’s banks is to restore faith in government bonds.
That means protecting countries, such as Italy and Spain,
that are solvent but have lost the confidence of bond
investors. Even fundamentally solvent countries can quickly
go bust if their borrowing costs rise too fast.
This
is where the EFSF comes in. It was designed to protect
smaller peripheral states. European policymakers insisted it
should have a gold-plated AAA credit rating, lowering its
costs but limiting its capacity. It is now too small to
shield the bigger economies. The EFSF can lend €440
billion (see chart 2). But given its commitments to Ireland,
Portugal, Greece and, perhaps, the recapitalisation of the
banks, it may have as little as €200 billion for future
contingencies. And yet in the next three years Italy and
Spain will have to refinance about €1 trillion-worth of
bonds, not counting additional borrowing to finance their
deficits.
Countries
guaranteeing the EFSF’s funds do not want to increase
their burden, not least because some cannot afford to do so.
France’s AAA rating is already at risk. What is more,
France and the EFSF are like tottering drunks holding one
another up. If France is downgraded, the EFSF will be close
behind.
How
to conjure a bigger EFSF without more taxpayers’ money?
The answer is “leveraging” through financial engineering
of the sort that helped cause the global crisis in the first
place. “If you want leverage, you can always find it,”
says one senior policymaker disdainfully. “Just get two or
three investment bankers in a room.” Herman Van Rompuy,
the president of the European Council, who chaired the
summit, sounds even more cavalier. For centuries, he says,
banks have taken deposits and used them to multiply money.
The
favoured option is to get the EFSF to insure government
bonds, acting, in effect, as the issuer of the much-maligned
credit-default swap. By guaranteeing to take, say, the first
20% of any loss on government bonds, the EFSF could, in
theory, support €1 trillion-worth of Italian and Spanish
debt.
A
second option is to set up SPVs, or Special Purpose
Vehicles. These would seek to attract funds from private
investors or sovereign-wealth funds in Asia and the Middle
East, again by offering to take the first losses in
sovereign defaults. In effect they would be creating
something that looks a lot like the collateralised-debt
obligations (CDOs) that became infamous during the subprime
crisis. How much leverage each vehicle would take on, and
which countries they might apply to, are questions that
still have to be resolved over the next few months.
Many
wonder why any investor would put money into such vehicles
when they can buy bonds directly at a discount or get the
insured version. One reason may be that the direct-insurance
version may breach “negative pledge clauses” in
contracts governing some bonds. These prohibit countries
from doing anything that would set holders of new classes of
debt above those of the old.
A
difficulty with the leverage scheme is that those insuring
the debt of euro-zone issuers would themselves be grievously
weakened if a neighbour defaulted. How credible can their
insurance policy be? “We have really struggled to find
investors who want to buy the ‘part-insured’ government
bonds, for fear the insurance is so highly correlated to the
risk,” says a banker.
An
even bigger problem is that levers can work both ways.
Leverage may enlarge the size of the fund, but it can also
concentrate greater risk onto the sovereigns that guarantee
it. If the EFSF were simply to buy the debt of a vulnerable
country such as Italy, it would expect to get back more than
half of the money even if there were a default with a
relatively high haircut of, say, 40%. If, on the other hand,
it promised to cover the first 20% of losses on the bonds,
then a haircut of just 20% on the value of the insured bonds
could wipe out all the money pledged by the EFSF as
insurance. So instead of assuaging market fears, leveraging
may yet become a mechanism that transmits panic and weakens
the sovereigns, above all France. That is why, in practice,
the EFSF could probably support Spain or perhaps even Italy,
but not both.
Debtor,
save yourself
The
new weapons for the euro zone come with a political price:
closer monitoring of national budgets and economic policies,
particularly in the case of states that need the greatest
help. After a dressing-down from Mrs Merkel and Mr Sarkozy
at the first summit, Italy’s prime minister, Silvio
Berlusconi, came back with a long letter setting out his
promises to reform the economy. In December European leaders
will consider whether they need to change the EU’s
treaties to allow more integration. And there is pressure
for greater harmonisation of taxes. But even if a
re-engineering of the euro zone is possible, such measures
are for the longer term, to avoid a repetition of the crisis
in the future. The priority must be to deal with the
present.
The
euro’s crisis boils down to this: national treasuries do
not have enough spare cash both to guarantee outstanding
debt and maintain their own credit ratings. Even mighty
Germany cannot stand alone behind the whole euro zone.
Some
hope that more money can be found from non-European creditor
countries, such as China, by convincing them to invest in
SPVs. Or perhaps the IMF could do more, particularly if
China increases its contribution to the fund. But even if
the Chinese were game, this raises a serious political
question: does the euro zone want to be so obviously in hock
to China just as it is fretting about Chinese firms buying
up European ones? “If the Chinese are going to chuck money
into an SPV or the IMF there will be a price,” says a
European diplomat. “The Chinese want two things: one is
greater voting rights in the IMF, the other is
market-economy status.” Such status, which is granted by
the EU, would make it harder for the trading block to impose
anti-dumping duties on imports from China.
There
is a better answer: use the unlimited liquidity that only
the ECB can provide by dint of its power to print money. The
ECB could credibly stand ready to buy debt of a country like
Italy. As such, it would be treating a sovereign almost as
it would a bank suffering a run. The danger is that this
will stoke inflation. Germany, in particular, has a deep
aversion to anything that looks like printing money, an
orthodoxy forged in the experience of the Weimar
Republic’s hyperinflation.
The
ECB guards its independence, but has not entirely kept to
these rules; it has already gone into the markets to buy
distressed bonds, ostensibly to ensure that a country’s
bond yields do not stray too far from the interest rates the
bank sets. Having seen off France’s attempt to get the ECB
to lend to sovereigns indirectly, through the EFSF, Germany
removed even a passing exhortation for the ECB to keep
buying bonds from the summit communiqué. “We have no
demands and we have nothing to request,” said Mr Van
Rompuy.
In
private, though, most hope the ECB will not withdraw from
bond-buying. Its incoming president, Mario Draghi, who takes
over from Jean-Claude Trichet on November 1st, has signalled
his willingness to buy bonds to ensure the transmission of
monetary policy. “The blanket prohibition against directly
lending to governments is a complete idiocy,” says Willem
Buiter, chief economist at Citigroup, and a former member of
the Bank of England’s monetary-policy committee. “That
is what central banks do. Just because it can be mismanaged
does not mean you have to throw the tool away. You can drown
in water, but it does not mean you cannot have a glass when
you are thirsty.”
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