Eurozone break-up fears persist despite EU bailouts

As the Eurozone sovereign debt crisis rumbles on into 2011, the threat of a country defaulting and even exiting the currency union grows ever more real. Credit looks at the remaining options available to Europe’s policymakers to prevent that from happening.

Patch job: Law makers have failed to alleviate the dangers of a country exiting the Eurozone

2010 was a rum year for Europe’s young currency union. While much of the world – particularly the developing world – has pulled out of recession, the Eurozone has had a limp recovery. Instead of robust growth, it has lurched from debt crisis to debt crisis. First Greece received a bailout in May; then Ireland was forced to accept external support in November. As the year drew to a close, markets had already shifted their attention to Iberia and even Italy.

The European Union and European Central Bank have both stepped in to prevent localised crises from spreading. But the Greek bailout did not end the troubles. Nor, bond markets have made clear, did the Irish package. Rightly or wrongly, the market has indicated that the problems of individual peripheral countries in Europe cannot simply be ring-fenced and dealt with on a case-by-case basis. Instead, more drastic action may be needed.

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“At some point somebody will have to take some kind of hit,” says Alberto Alesina, professor of political economy at Harvard University. Alesina is a member of both the US National Bureau of Economic Research and the Center for Economic Policy Research.

“There has to be an orderly way to solve [the debt crisis],” he adds. “But Europe does not have a crisis resolution mechanism. Europe has been trying to create such a mechanism but it is like deciding the structure of your fire department when the fire has already started. That is just not the way to manage it.”

Jean Monnet, one of the chief architects of European integration, once argued that the union’s closer integration would be forged in crisis. Instead, Europe’s response to the financial crisis that began in 2007 and the sovereign debt crisis of 2010 has been characterised by half-measures and discord. Even in public statements, leading players in European policymaking roundly disagree with one another.

Contradictions

In an op-ed published in the Financial Times on November 30, José Ignacio Torreblanca, head of the Madrid office of the European Council on Foreign Relations, wrote it would be disastrous for Europe’s economy if Germany forced bond investors to take haircuts on their holdings. The following day, influential German economist Otmar Issing, former member of the boards of both the Bundesbank and the ECB, wrote an op-ed in the same newspaper with the headline: “Germany is right: bondholders must pay”. Such divisions make solutions hard to agree on and implement.

“We need some kind of leadership who can look into the future and we just do not have that at the moment,” says Cinzia Alcidi, research fellow at the Centre for European Policy Studies in Brussels. “We have to see if the Eurozone is still a valuable project in the long run, but for this we will need change.”

To deal with the current conflagration, to use Alesina’s analogy, it has been agreed that insolvent countries will continue to receive official funding, allowing bondholdings to remain whole. But Germany is backing new proposals that would pave the way for all sovereign debt to be restructured and introduce losses for creditors of both banks and sovereigns, but only from mid-2013. That, according to Simon Johnson, former chief economist at the IMF, and Peter Boone, chair of effective intervention at the London School of Economics, would be a mistake.

“Given the vulnerability of so many Eurozone countries, it appears that Merkel does not understand the immediate implications of her plan,” they wrote in a column published on Project Syndicate, an online sounding board for prominent global economists. “As European Central Bank president Jean-Claude Trichet likes to point out, market participants are good at thinking backwards: if they can see where a Ponzi-scheme ends, everything unravels.”

What has become increasingly clear to all parties is that the difficulties faced by the Eurozone’s member countries and problem sectors cannot be resolved in isolation. The linkages – both real and perceived – are simply too great.

“We can look at the root of the different problems, but now Ireland and Greece are in the same situation,” said Alcidi on December 1, shortly after the EU-IMF bailout package for Ireland was announced. “Two weeks ago it was different, but now it is the same.”

While Greece’s principal problem was always excessive levels of public debt, Ireland’s chief problem, its banking sector, has become a sovereign issue too. The fear is that the same could happen with the Spanish real estate sector and the more troubled cajas. In short, Europe’s debts can no longer be simply divided off into private and public: the continent is discovering no sovereign is safe from the liabilities of its private sector.

The Eurozone crisis requires a solution on a continental scale, and there is growing consensus at policymaking level that only something both wide-ranging and far-reaching can work. In a report published by the think-tank VoxEU in June 2010, economists Richard Baldwin, Daniel Gros and Luc Laeven argued that, just as no single element caused the crisis, no one solution should be relied upon to bring it to a close. Bond purchases by the ECB are “merely a palliative”, they warn.

“Until Europe’s banking mess is cleaned up, every shock has the potential to create a systemic crisis,” the report said. “Limiting reform ambitions to tinkering with the Stability and Growth Pact would be widely regarded as indicative of a worrying inability to reform.”

Elsewhere, it is less the inadequacy of the currency union’s solutions to the crisis that receive criticism, as the risks policy responses sometimes pose to the very financial stability designed to buttress and restore. Paul de Grauwe, professor of economics at Leuven University in Belgium, argues the sovereign debt default mechanism recently announced by the Eurozone actually makes another crisis more likely, since giving countries the ability to impose haircuts so easily can only increase bond yields. Worse, he says, it risks just the kind of “speculative dynamics” that undermined the Exchange Rate Mechanism, encouraging investors to sell earlier and governments to haircut sooner.

One possible alternative that has gained attention in recent weeks was proposed by Daniel Gros, director of the Centre for European Policy Studies. Gros says the German-backed proposals to allow sovereigns to restructure from 2013 are akin to shutting the stable door after the horse has bolted. What the currency union should instead pilot is a “big bang” solution, whereby countries continue to pay debts but open restructuring talks with creditors immediately.

That, Gros argues, would allow insolvent countries to avoid technical default by making an exchange offer to investors while still paying down their debts. But, in keeping with the current muddle-through approach, if Europe simply waits for Ireland and Greece to run out of top-up money, the haircut for remaining private creditors would have to be enormous.

Outside in

A domino rally of sovereigns unable to support themselves is the EU’s greatest fear at present. Greece was at least a basket-case economy run by an administration that had serially underestimated the scale of the problems afflicting its finances. So long as it was a Greek problem, the risks elsewhere appeared muted. But when investors started to withdraw from Ireland, the EU got spooked and persuaded the country to accept a bailout. Trouble in Portugal would have scared everyone just a few weeks ago but it is becoming less of an issue now. Greece, Ireland and Portugal carry a combined rollover price tag that the European Financial Stability Facility can meet into 2013. The real worry surrounds two much larger countries: Spain and Italy. If their yields were to soar to unmanageably high levels, the crisis faced by the currency union would threaten its very existence.

“Contagion has already spread to Spain and perhaps even to Italy and Belgium,” says Reiner Back, head of fixed income at Munich-based asset manager MEAG, a wholly owned subsidiary of Munich Re. “You can also see that most European countries have yields well in excess of swap rates. In the past, government yields were usually below swap rates for most countries.”

Many economists expect the Spanish situation to play out differently to Ireland on the basis of stronger fundamentals. Javier Suarez, professor of economics at the Centre of Currency and Financial Studies in Madrid, wrote in June that Europe’s financial crisis will encourage Spain to make long-overdue labour market reforms. Already, Suarez noted, the household savings rate has jumped from less than 11% in 2007 to 18% in 2009. Spain’s commitment to the single currency project will mean that, in the current crisis, it feels obliged to make the necessary reforms, tough as they may be. So long as the ECB continues to provide liquidity when needed, Suarez believes Spain can manage its challenges.

Others agree. Jim O’Neill, formerly chief economist at Goldman Sachs and now head of Goldman Sachs Asset Management in London, argues that neither Ireland nor Spain had intractable problems just three years ago. He points to Spain’s debt-to-GDP ratio in particular, which remains lower than Germany’s. The real challenge, he argues, is not debt.

“This is more about European economic governance and leadership than debt,” he says. “Spain and Italy did not have big debt problems three years ago. They only have debts because their housing bubbles burst. But they cannot devalue their way out of this problem, so Germany has to decide what it wants and it seems to want more centralisation of economic policymaking. People like Otmar Issing said before the Eurozone started that it would not be successful or sustainable without some form of fiscal and perhaps political union. I view all the current negotiating as tactics to get some kind of common fiscal ground.”

Nevertheless, Spain’s debts need to be taken seriously. Even if it manages its bank debt in the near term, the Spanish treasury estimates its end-2010 outstanding sovereign debt pile at €553 billion. But if the crisis spreads further, Italy has outstanding government bonds totalling €1.552 trillion, according to Treasury figures. The combined amount of central government debt securities outstanding for Eurozone members stood at €5.82 trillion at the end of September, according to ECB figures.

“The really big question is Italy,” says Harvard’s Alesina. “Will Italy hold on to the low deficit it has; will it continue to have a reasonably good fiscal stance? Italy is critical. It needs a good dose of fiscal adjustment.”

But he worries that neither the Spanish nor the Italian government has the stomach for the fight ahead. Already, he points out, both governments have backed away from planned cuts in government wages. There is a serious risk they will not act quickly enough. O’Neill, on the other hand, views Italy as a different case.

“Italy is doing well because it was not as cavalier as some of the other countries in its borrowing,” he says. “In some ways, having the high debt in the first place made the Italians very cautious in the first decade of monetary union, so they have not gone on any of these crazy binges. They do not have a huge leverage problem. Their debt-to-GDP ratio is roughly the same as when I first studied the country, 29 years ago.”

Indeed, even for some investors, the intensity of recent market pressure on Spain and Italy is indicative of an overreaction to recent events, a typical market swing that should eventually correct itself. But should that pressure continue, it will still cause major damage, however irrational it may seem.

“What you are seeing is a self-fulfilling speculative attack very much like the ones we saw in the early 1990s, except that then the issue was exchange rates,” says Willem Verhagen, chief economist at ING Investment Management in The Hague. “In this case the issue is debt sustainability. Irish debt may have become unsustainable because of the cost of a bailout of a highly leveraged financial sector, which itself is very large relative to GDP. Spain is in a fundamentally solid position, but if interest rates were to rise much higher, a much larger share of the current austerity measures would go toward interest payments rather than debt reduction. As a result, the sustainability of Spanish public finances would be reduced.”

Equal and opposite reaction

As markets come under growing pressure in southern Europe, putting even the security of traditionally safer markets at Europe’s core at risk, how and when the EU and ECB react will be critical. But the stakes may now be higher. According to the ECB, as of the end of October 2010, around 32.9% of outstanding euro area government debt securities will mature within two years. Unmanageable debts will increasingly need to be dealt with rather than simply postponed, but the ECB at least still has some slack left with which to support the market.

“The ECB can finance any conceivable rollover,” says Alfredo Pastor, professor of economics at IESE Business School in Navarre, Spain, and Spanish secretary of state for economic affairs from 1993 to 1995. “Bailouts are unpleasant but we have them all the time, like in Russia in 1998 and Argentina in 2001. They are a temporary inconvenience and they may fray the social fabric, but it will not lead to extreme anti-EU parties appearing in Spain.”

Even so, the current crisis is moving from sovereign to sovereign at a rapid pace. With two countries bailed out in less than a year during 2010, the response needs to be one step ahead if contagion is to be contained.

But even quick-witted containment may not be enough, as the EU discovered when the bailouts agreed for Greece and Ireland failed to satisfy markets. If the problem is to be dealt with, the response needs to be decisive. The bigger question, ultimately, is who pays?

Thus far, the answer to that question has been a combination of ECB promises of back-up and purchases of peripheral sovereign debt by the European Financial Stability Facility, a funding vehicle set up in May 2010 to provide support to over-indebted EU countries finding it difficult to roll over debt. The programme – in concert with the IMF – can offer up to €750 billion in funding unless additional resources are committed (subject to a unanimous vote by all Eurozone members).

The €85 billion Irish bailout included up to €35 billion of funds to support the country’s ailing banking system. Irrespective of how the proceeds of support programmes are used, some economists believe that if other, larger economies run into trouble, other measures will need to be introduced.

“The appetite for governments to repeat what they did after Lehman Brothers is not there because it is difficult to convey those messages once again to the taxpayer and the electorate,” says Norbert Walter, former chief economist at Deutsche Bank and now head of Walter & Daughters, a financial consultancy firm in Frankfurt. “I do not think the package for Ireland will put an end to things, so if this chain of events continues, I think we will probably end up finally having haircuts for quite a few banks.”

For haircuts to be effective, there needs to be political co-ordination between member states of the Eurozone, and that is proving hard to achieve.

“Until the Irish problem, I would have put the risk of political gridlock in Europe at 1% or 2%,” says Walter. “Today we are entering a probability that is relevant. It might be 5% or 10%. It is therefore only responsible to consider such a scenario. When the Greek stuff was going wrong, some Germans said that if Greece wanted help, it should sell a few islands. Those kinds of comments are just not helpful.”

But Walter sympathises with the view expressed by German chancellor Angela Merkel: namely, that bondholders could not expect to receive a high interest rate on their investments and then be spared their share of the losses before taxpayers’ money is used.

“It is very important that investment bankers, life insurance companies and pension funds understand that if they are not happy with a Swiss bond return of 1.5% or US return of 2.5%, they cannot assume that they can buy Greek bonds with an 11% return that the taxpayer will guarantee,” says Walter. “The return on asset classes will be a far cry from what was paid between 1985 and 2005.”

In the immediate future, the timing and management of such haircuts will be highly sensitive and needs to be carefully managed, lest Europe scares investors away altogether. But haircuts on debt will need to be taken, say experts.

“There has to be some way to spread these costs in an orderly manner that does not create panic and crisis,” says Alesina. “But it is pretty clear that some debt in the most badly hit countries will have to be restructured at some point.”

Fiddling while Rome burns

The danger is that Europe continues to dither and the risks continue to mount. Mario Draghi, governor of Italy’s central bank and one of two frontrunners tipped to succeed Jean-Claude Trichet as president of the ECB in October 2011, recently argued it was acceptable for peripheral sovereigns to trade far wider than core Europe, given the higher risk. That may be reasonable, but it should not mean politicians simply continue to employ reactive tactics alone.

Such an approach would pose a threat to the very unity of the Eurozone, with potentially disastrous – and expensive – consequences. It is doubtful whether Europe will be granted the luxury of muddling through 2011 as it did through 2010.

“The deadline was yesterday,” says Alesina. “They should have been clear that Greece was the tip of the iceberg but, between the Greek crisis and today, we have wasted several months introducing tough policies like fiscal adjustment and specifying how those debt burdens would be split between countries, taxpayers and bondholders in ways which were orderly. All this time has been wasted and now we are too late.”

The ECB will be fundamental to this process. The bank used to insist it would never buy government bonds, but was forced to renege on that pledge in order to stem a systemic crisis. While its capacity to act is more limited than that of the US Federal Reserve, for example, because of its narrower mandate, it has already played a key role in supporting Europe’s overindebted periphery. That will continue.

“What is at stake right now is the stability of the European financial system,” says Verhagen at ING. “Only that stability can ensure the appropriate working of the European monetary transmission mechanism. Even a very conservative bank like the ECB, when confronted with its own survival, can turn on a dime and do stuff it would not even have dreamt of three years ago, like buying sovereign bonds. There is room for the ECB to do more, although I do not think it will engage in outright financing of budget deficits, which is explicitly forbidden under EU law.”

There are other possible answers, however. One area that draws passionate disagreement is government austerity measures. Some economists fear markets will punish overly indebted countries that fail to introduce austerity measures, but at the same time economists see austerity as capable of putting growth at risk, without which any solution becomes useless anyway.

“When I hear people worrying that if we do fiscal adjustment, we may have short-term cost in terms of growth and that could be a problem, I start to get a little mad,” says Alesina. “The risk of a financial crisis far outweighs the possibility of a couple of quarters’ downturn because of a fiscal adjustment. But growth is important too, so the best thing to do is make the savings in spending, not through higher taxes.”

Alesina also believes austerity is politically palatable. In October 2010, the first draft of a report co-authored by Alesina and two other academics was published. The Electoral Consequences of Large Fiscal Adjustments studied electoral data across 19 developed countries from 1975 to 2008. It found governments that introduced austerity measures did not suffer adverse effects at subsequent national elections, as is often claimed. If anything, the data pointed in the opposite direction.

Nuclear scenarios

The Eurozone faces risks that go beyond taxpayer bailouts, bondholder haircuts and bank debt restructurings. Should it continue to postpone the resolution of bad debts, papering them over with occasional bailouts and ECB bond purchases, the sanctity of the currency union itself could be at risk.

“Even by the most optimistic projections, they are not solving the problem,” says Jim Rogers, a Singapore-based private investor, who co-founded the Quantum Fund with George Soros. “Their debt is going to get higher so the pressure is going to continue to build. They are making the euro weaker and corroding it from within by propping up zombie countries and zombie banks.”

Leaving the Eurozone may seem an extreme scenario, but a country will only remain in the union for as long as the benefits outweigh the negatives. There are major complications involved in leaving, especially if much of a country’s debt is held by foreigners and denominated in euros, since it cannot simply be transferred into a new currency. But if a country were to default on its debts anyway, it might elect to leave the zone in order to cheapen its currency and regain export competitiveness.

“Of course it is a possibility,” says Alcidi. “But I really have problems imagining a country leaving because the euro is a political project. If one country leaves, my impression is that many will do the same. That would shrink the credibility of the euro and there would not be much point in keeping it alive.”

The economic fallout of a Eurozone break-up would be enormous, but thus far political will has been sufficient to hold it together, making effective fiscal transfers (via the EFSF or ECB) in order to maintain unity. Norbert Walter also believes leaving the currency zone is too disastrous to contemplate.

“You can never rule out someone losing his mind but it would take a masochist to leave the euro, because everyone would be informed by one expert or another of the consequences,” he says. “It would mean your debt rising unless you forced a haircut on everyone. That would mean being at each other’s throats and would lead to excessive national policies and protectionism.”

Alesina is more circumspect on the impact of a Eurozone departure and believes it could yet happen. Although he questions the benefits of such a move to the departing country, he believes it is nevertheless a scenario worth considering, given the severity of the situation.

“If a country like Greece or Ireland left, that would not necessarily mean the Eurozone was finished,” he says. “Ireland’s economy is too much based on financial integration for it to consider leaving. The cost for Greece would probably be lower. It is a complicated issue for Greece but it would not bring down the euro.”

As for a break-up of the Eurozone itself, the economies involved might enter a nuclear winter in its wake, given the linkages between countries and cross-border holdings of sovereign and bank debt. Moreover, such is the political will behind the project that this outcome is probably the least likely to be considered. Fiscal centralisation, argues Pastor, is far more likely.

“Germany and France will have to convince investors they stand as guarantors of PIIGS debts, but they will only do this if they are given a say in debtor countries’ finances, and that is as it should be,” he says. “Fiscal sovereignty will be a thing of the past for improvident countries, and that certainly includes Spain.

“I cannot believe the Anglo-Saxon scenario of a reduced Eurozone as Simon Johnson [cited above] has argued for,” adds Pastor. (Johnson has estimated that a bailout of Portugal, Italy, Greece and Spain would cost the EU and ECB €1 trillion, putting the entire currency zone at risk of collapse.)

“Firstly, the periphery’s fiscal and banking mess is probably a one-off event and may not happen again any time soon. Secondly, the fate of French and German banks is tied to the periphery. Thirdly, the periphery is a big market for the core countries. Besides that, there is a lot of will among German and French politicians to make the Eurozone a success.”

Growing together

But to avoid such drastic scenarios, Europe will need to manage the crisis better in 2011 than it did in 2010. It cannot afford for Spain and Italy to suffer the fate of Greece and Ireland. In the end the ECB may even be forced to ditch its most closely-held principles in order to ensure the Eurozone’s survival. Johnson and Boone argued in an article in November 2010 that such a move is inevitable.

“At a minimum, the ECB will probably need to match the $1 trillion annual US rate of quantitative easing, and front-load much of it,” they wrote. “The euro will fall, and Trichet will miss his inflation target. But Germany will boom.”

Problems would be more manageable if Europe were to grow more rapidly, but there are few signs of that on the horizon. In the past, the Eurozone authorities stuck to an ‘impossible trinity’ of policy principles: no defaults, no bailouts, no exits. Already, it has sacrificed its ‘no bailout’ principle. If it wishes to prevent exits, it will probably need to sacrifice its ‘no default’ principle too.

“Out of the three options – no exit, no bailout and no default – you can only have two,” says ING’s Verhagen. “The crisis has pushed politicians and the ECB to temporarily give up on the ‘no bailout’ principle. In the medium term they wish to reinstate this, and because we believe they want to retain the ‘no exit’ principle as well they will need to drop the ‘no default’ principle. ECB peripheral bond buying is done to ensure liquidity in those markets, but it is essentially a form of monetary bailout, since without it the liquidity premium would have been higher. We firmly believe in the ‘no exit’ principle because of the determination of the European political and intellectual elite to move the European project forward.”

Until 2013, however, the EU has made clear that it will not allow countries to default but will offer all the liquidity necessary to allow the status quo to be preserved. That, inevitably, means more debt building up while growth remains slow.

“The message is that nobody will default,” says Alcidi. “But we will need some sort of restructuring as there is an excess of debt. The ECB is hoping that by saying nobody will default it can prevent investors selling their bonds. But this is a dangerous strategy because we are not even sure if everyone is solvent. If it is an insolvency issue then you must restructure, because nobody can support the losses.”

Such thinking has yet to find a leading role in Europe’s response to the crisis. Instead, muddling through looks set to continue in 2011. Under this scenario, sovereign debt ratios will rise, distressed bank assets will not be dealt with, bond vigilantes will continue to put pressure on the currency zone’s periphery, the ECB will continue to buy unpopular sovereign debt, and both the risk and impact of defaults will continue to grow.

“The best scenario is that this is a wake-up call for Europe and that its near-death experience makes countries realise we cannot continue relying on fiscal reforms, which are just pushing paper around,” says Alesina. “We need to do what we have never done before. We need to cut the salaries of state employees, increase the retirement age, make entitlement reforms and whatever else it takes. Different countries may have different ways to do it, but it is better to take 15 minutes more to get from Lyon to Paris by train than to have a debt crisis,” he says.

Alesina may be right, but Europe’s governments have a famously bad record on making successful labour market reforms, let alone rapid ones. That will need to change because, soon enough, Europe is going to have to pay for its debts. The only question is how.

Banks and the future of the Eurozone

One of Europe’s most pressing challenges is its banks. Although the results of bank stress tests were announced in the summer of 2010, investors and economists alike are worried by an ongoing lack of transparency. Banks offer a continental contagion risk of their own.

“If you do not tackle the banking linkage you are going to have a lot of volatility and uncertainty in other financial institutions and in the bond markets in many other countries, following on from Ireland,” says Didier Haenecour, head of the European fixed income group at Vanguard. “The ECB, in its role of making sure financial systems run efficiently, will have to tackle that. Otherwise that risk of contagion, not of sovereigns but of the banking system, could reappear.”

Alfredo Pastor at IESE Business School views the management of the Eurozone’s banks as fundamental to Europe’s successful handling of the crisis. He estimates the claims of French and German banks against the banks of Portugal, Ireland, Spain and Greece amount to 15% of GDP in France and 16% of GDP in Germany.

“By and large, all parties concerned are not going to be made whole so it is just a question of making sure debtors pay as much as they can,” he says. “Since the banks’ capital cushion is not above 7–8% of total assets, that is the limit on how much they will be able to suffer. That goes for both debtor and creditor banks.”