After what has seemed like a two-year marathon race, the eurozone appears to have snatched defeat from the jaws of victory.
Hardly was the ink dry on the deal between eurozone leaders and the continent’s banks to resolve the Greek sovereign debt crisis, that the errant nation pulled the rug out from under their feet.
The decision on the eve of the G20 Summit by Greek Prime Minister George Papandreou to call a referendum of the rescue package stunned financial markets that had earlier rewarded eurozone leaders with a sharp spike in stock markets and a renewed risk appetite among investors.
“The risk of a Lehman-style disorderly default now looms a bit larger than before, including some residual risk that Greece may leave the eurozone if it rejects the offer of orderly debt relief,” says Holger Schmieding, chief economist at the German bank Berenberg.
Even World Bank president Robert Zoellick struggled to keep his patience when quizzed over the u-turn. “It is a roll of the dice”, he told Emerging Markets in a conference call.
“If it passes that could be a positive signal for people but if it fails it will be a mess. It will add uncertainty to markets at a time when people thought that the eurozone and the actions they had taken would help alleviate that uncertainty.”
The debacle has clearly tarnished the October deal that had appeared at first blush to be the three-pronged strategy markets had been crying out for: a rescue package for Greece, E106 billion recapitalization of weak EU banks and proposals to leverage up the firepower of the European Financial Stability Facility (EFSF) to as much as E1 trillion.
However even before the Greek drama, the lack of clarity over the EFSF plans saw borrowing costs on Italian government debt soar to euro-era highs.
OPTION ONE
Leaders left two options on the table for finding additional funds to ringfence core eurozone nations: provide “credit enhancement” – risk insurance – to private investors who buy sovereign bonds in the primary market; or maximize the funding arrangements of the EFSF using “a combination of resources from private and public financial institutions and investors, which can be arranged through special purpose vehicles”.
The first option is a “nice idea in theory”, according to Karen Ward, an economist at HSBC, because it gives the EFSF more firepower without having to increase the fund’s size upfront. “Insurance of E1 trillion would enable it to guarantee all of the new issuance of Italian and Spanish government debt for the next three years,”she says.
But for many commentators the proposal raises more questions than it answers. Is the insurance credible? Would core economies honour their commitment? Is the guarantee large enough? What maturity of debt would be guaranteed?
“This may create an extremely fragmented bond market,” says Ward.
Schmieding says the role of the European Central Bank (ECB) will be “crucial” in how this operates. “Without ECB support, the chances of this deal putting an end to the euro debt crisis now are probably below 50%,” he says. “If it were to signal a willingness to act as a backstop of ultimate resort by buying bonds, the chances that the deal could put an end to the euro debt crisis would be well above 50%.”
Mario Draghi, who took over as ECB president on Tuesday, last week backed the use of “non-standard measures” – code for buying up Spanish and Italian bonds – and spent his first day on the job doing just that. The fact that German president Angela Merkel, who has publicly resisted such a move, kept silent was seen as good news.
SECOND OPTION
The second option was even less clear and is the area where markets will be looking to the G20 to pick up the baton.
“The last time the G20 met was for Europe-bashing, so now they have promised to do something it is the other way round,” jokes Christian Schulz, an economist at Berenberg. “I would expect them to commit something themselves.”
One route would be to use the IMF. The eurozone statement envisaged “cooperating even more closely with the IMF”. The most likely option is a special investment vehicle to attract non-European investors. “It appears that China is the main target,” says Schulz.
But hopes of a 2009 London Summit-style $1 trillion (E720 billion) injection of capital into the fund seem remote. Both the UK and the US have insisted the IMF has the resources it needs.
Schulz adds: “There is a further difficulty with the emerging markets, who could do this but they would ask a price in terms of more power. It is unclear whether the US in particular would be prepared to give them that.”
HSBC’s Ward plays down hopes that the G20 will offer a “silver bullet” to kill the crisis. “Significant outside assistance seems unlikely.”
However, by setting a target for recapitalizing weak eurozone banks, leaders have at least responded to the unequivocal calls by both the G20 and IMF on them to take action to shore banks exposed to Greek sovereign debt.
Under the terms of the E106 billion deal, which aims to raise banks’ core capital ratio to 9% by mid-2012, new capital should come first through markets, then from national governments, and from EFSF only as last resort.
French and German banks are likely to find the E14 billion their 17 identified banks need while Greece’s E30 billion and Portugal’s E7.8 billion are covered by existing bailout programmes.
This leaves a question mark hanging over the requirements on banks in two of the other so-called PIIGS – Spain (E26.2 billion) and Italy (E14.8 billion), who may require at least partial EFSF support.
But until it is known how much of the EFSF’s remaining E290 billion – out of the original E440 billion – is left, it is impossible to calculate how close to the E1 trillion headline the leveraging plan can deliver.
TOUGHEST TALKS
The toughest negotiations were those with the banks about the Greek debt reduction. The banks voluntarily agreed a 50% haircut, which could allow Greece to reach a debt-to-GDP ratio of 120% by 2020.
By ensuring that it was a voluntary agreement, the threat of a credit event that would have triggered payouts of billions of dollars of credit default swaps has been averted. There had been growing speculation that banks, which had signed up to an initial plan for a 21% haircut, would refuse to share a greater burden. The official contribution to the Greek rescue was stepped up from E109 billion to E130 billion.
The Institute of International Finance, the body that represents the large global banks, described it as a “concrete voluntary agreement” and it reiterated this week that it will stick with last week’s deal, despite the threat of a Greek referendum.
Meanwhile the IMF approved the release of the next tranche as well, meaning that a Greek default has been averted.
Greece has been on a knife edge for exactly two years. On November 5, 2009 prime minister George Papandreou’s new socialist government said the 2009 budget deficit would be 12.7% of GDP, more than double the previously published figure.
That admission triggered a series of events that led to the exhausting series of summits of finance ministers and leaders that culminates this week in Cannes.
If there was a link between the number of meetings held and the odds of agreeing a deal, then the crisis might have been solved by now: European heads of state and finance ministers have met no fewer than 22 times this year.
CRISIS OF CONFIDENCE?
The reason that the situation has worsened over the past two years is, says Schmieding, that the euro crisis is a “crisis of confidence”. The underlying fundamentals are “mostly fine by the standards of mature economies”, he says. Serious doubts over the euro project have remained only because prior European attempts to “soothe the fears of hyper-nervous global investors” had all in the end failed.
The question facing the G20 is whether Europe has finally drawn a line under the situation in Greece and, by extension, the rest of the monetary union areas.
Many observers doubt that. “The statement is an exercise in ‘kicking the can along the road’, like all the other eurozone statements so far issued during the debt crisis,” says Stephen Lewis, chief economist at London brokerage Monument Securities. “It has just been more skilfully presented than past statements.”
He says that while the Greek deal has bought time, it is hard to say how Greece will be able to return to the capital markets with debt still at 120% of GDP, which may require more bailouts further down the road.
Others fret that even the three-pronged deal does not tackle the long-term problem that lies at the root of the debt crisis – the imbalances within the monetary union and the lack of competitiveness of the PIIGS.
“The critical factor remains healing the eurozone’s wounds through improving the competitiveness of not only Greece, but of all weaker performing economies, including Italy and Spain,” says Howard Archer, chief European economist at IHS Global Insight. “Without this the eurozone will remain vulnerable to tensions and speculation over its long-term ability to survive in its current form.”
RECESSION FEARS
Richard Baldwin, editor of the VoxEU website and a professor at the Graduate Institute, Geneva, forecasts a recession next year that will require another crisis meeting. “Banks will create a massive credit crunch in trying to meet capital adequacy ratios, and the renewed emphasis on austerity will create a massive fiscal contraction.”
One breakthrough was the acquiescence of Italian prime minister Silvio Berlusconi to abruptly phrased demands from Germany and France to produce a plan for long-term economic and budgetary reform. He committed to deliver a balanced budget by 2013 and a structural budget surplus in 2014, and make a domestically unpopular pledge to increase the retirement age to 67 years by 2026.
Capital Economics, the forecasting house led by former UK government adviser Roger Bootle that has long forecast a break-up of the eurozone, believes the latest deal has answered few of the questions.
“While there are plans for closer economic integration and stronger governance, there are still few indications of the move towards wholesale fiscal union which may ultimately be needed to keep the euro together,” says Jonathan Loynes, its chief European economist.
He fears the crisis will prompt a prolonged recession in the eurozone, create further turmoil in global financial markets and, “at some point, the end of the euro itself in its current form”. This is a minority view, however, mainly because a break-up could cause an even deeper shock than the collapse of Lehman Brothers and perhaps one as bad as the Great Depression.
Most people believe that – albeit little by little – policymakers will do what is needed to keep the currency intact. Keeping the eurozone together will involve huge financial resources and considerable ingenuity, but the alternative would be worse,” says Stephen King, chief economist at HSBC.
At the heart of that solution is fixing the flaw that was built into the euro at its creation – a European monetary union (Emu) without any parallel unified treasury. “Most observers of the eurozone crisis appear to have recognized that, without fiscal union, Emu was always going to face challenges,” says Steven Major, a senior analyst at HSBC.
The eurozone leaders committed themselves to “further integration” but detailed plans on improving fiscal discipline and deepening economic union, including “exploring the possibility of limited Treaty changes”.
An interim report on this is to be presented next month with a final report on how to implement agreed measures due by March 2012.
Fiscal union raises two thorny issues: the potential for fiscal payments between rich and poor countries; and a system of penalties for states that flout any new fiscal rules. Eurozone leaders have said that member states must enact the Stability and Growth Pact – the limits on debt that were serially broken in the run-up to the crisis – into national legislation.
While agreeing that closer monitoring and “additional enforcement were warranted”, there was little detail on the mechanism that might be used.
No matter what eurozone leaders ultimately decide, for now it’s the G20’s turn to reply to the many unanswered questions thrown up by last week’s deal – and by Greece’s shock intervention.