Yet Another European Council! Rescuing the Eurozone?

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What is the outlook for this summit?

At the eve of what is now being unofficially billed as the summit to save the Euro, things are not looking good at all.

To put it mildly, no one is expecting miracles from this summit. It would be enough if they can avoid this being a disaster.

The political space is now much smaller and the size of the economic problem now much bigger than at the last such comprehensive summit in March 2011. Despite this, the summit will devote far too much time on a highly ambitious political integration agenda, much of which is unachievable in the near future and devote far too little time to tackling the growing economic problems, where action is urgently needed now.

The biggest fault-line is between France with its demands for a looser fiscal and monetary policy and aversion to any loss of sovereignty on the hand and Germany’s aversion to a looser fiscal and monetary stance, at least as long as there has not been a much greater degree of pooling of sovereignty. (See our Note “Oui Nein & Non Ja : Franco German fault-lines and the Eurocrisis”)

Will the Eurozone Survive?

Up until a few months back, our answer would have been, of course yes. We are afraid we can no longer say this with total certainty. Our best answer now is, most likely yes.

However, an unambiguous positive answer to this question about the integrity of the Eurozone is necessary for any stabilization efforts or efforts to promote growth to be effective. As long as there is prevailing uncertainty about whether the Eurozone will survive or not, the crisis will continue to get worse.

A second question as important as whether the Eurozone will survive or not, is at what additional and avoidable economic, human and political costs will this survival come.

The path to a more stable Eurozone whose integrity is maintained is as important as the end goal of its survival.

Will the proposed growth compact work?

The growth compact, as being discussed by the EU leaders is politically important, particularly for some Member States such as France but is macro economically insignificant.

Much of the money committed, for example through structural funds, is not new; other sources of funds, such as the project bonds, are too small to have much impact. The recapitalization of the European Investment Bank is a good step, but not big enough and it will take time to deploy these funds.

The biggest positive impact on growth today would come from a freeze or slowdown of spending cuts together with a co-ordinated crack down on tax avoidance and tax evasion to mobilize additional revenues and spending powers. That neither of these measures is on the table undermines the credibility of the growth compact.

It is urgent that EU governments turn to the original growth compact proposed by us in January that can be found here (A growth compact for the EU)

Will the so-called Banking Union help?

Despite the fact that the phrase ‘banking union’ has become fashionable only in recent weeks, the concept is not new.  In fact, the Eurozone already has a banking union; what is new is the talk of completing it.

Unfortunately, the parts of the banking union that are politically feasible in the near run won’t help in tackling the present crisis and those that would be helpful are lie beyond the realm of political acceptability.

Putting banks under a more unified European supervision, for instance, may be politically feasible and there may even be a political agreement on this at the summit, but it will do little to calm the perfect storm that EU banks now face.

Other parts, such as a common pan-EU or Eurozone-wide deposit insurance scheme that may help stem the panic in the banking sector, lie well beyond the realm of political feasibility, and in all likelihood needs to be preceded by much stronger fiscal and political integration.

Setting up an agency that is capable of resolving (shutting down, selling or recapitalizing) banks is perhaps the most urgent part of such a banking union and can be done independently from pooled deposit insurance or common supervision, but is not being prioritized by EU leaders and will still take a long time to be set up.

The idea of allowing the European Stability Mechanism (ESM) to directly recapitalize banks is important but not new. It has been discussed and rejected several times. The reasoning behind the rejection has been that that it would put taxpayer funds at much greater risk than lending to the sovereign but with much less oversight, at least in the short term. It was exactly this logic that led Germany to reject this option for aiding troubled Spanish banks.

The banking union discussion has distracted policy-makers from the more important discussion on supporting troubled sovereigns; so it’s been a bit of a red herring.

In response to the terrible market reaction to the announcement of the Spanish bailout, policymakers are considering dropping the seniority of the ESM. However, unless the macro environment in the EU becomes more favourable or unless there is a direct injection of equity into Spanish banks, this will make little difference. We discuss this in detail here (The Spanish Bailout and the myth of Seniority)

What is being discussed to support sovereigns?

What is clear is that the borrowing costs for sovereigns, particularly Italy and Spain, has now reached unsustainable levels.

At this level, the cost of credit in the real economy is choking growth and the countries are getting caught up in a self-fulfilling trap. The more their borrowing costs rise, the less sustainable their debt burden becomes. Rising concern about debt sustainability then translate into even higher borrowing costs.

European Central Bank support, in the form of bond purchases through its secondary market purchase program, was ineffective in stemming borrowing costs, particularly because of its limited nature which left market participants wondering when the support would end and what would happen after that. Particularly after the ECB claimed seniority on its holding of Greek government bonds, the program, which has not been activated for several months, would become even less effective unless it was accompanied by an open-ended credible commitment. Such a commitment is very highly unlikely and will definitely not be announced today.

The other credible mechanism for reducing borrowing costs for sovereign would be allow for a mutualisation of debt so the fiscally stronger countries such as Germany agree to stand behind the debt of other weaker countries such as Italy. All the forms of Eurobonds and the debt redemption pact are variations on this theme and all have been roundly rejected by Germany which has said that stronger political integration, in the form of much greater powers to the EU institutions must presage any such discussion.

The options that are now supposedly being considered are

1) Getting troubled sovereigns to issue the equivalent of what in banking are called ‘covered bonds’. These would be backed either by specific assets such as real estate or shares in government owned companies which would be ring-fenced for the repayment of these bonds. Alternatively, specific tax revenue streams would be ring-fenced for the payment of these bonds.

2) Instructing the EFSF and/or ESM to buy substantial amounts of Italian and Spanish sovereign bonds, in either the secondary or the primary market.

The first option is interesting. It is designed to make new bonds safer than existing bonds in the hope that investors would buy these at a lower cost. It essentially subordinates the existing bondholders to the new ones. The first impact of this would be that the price of existing bonds would fall causing a big loss in the market value of bonds held by banks. This may further destabilize the banking system.

The issuance of these bonds may also be challenged in court as this makes them senior to existing bondholders and may breach covenants on existing bonds including ‘negative pledge’ clauses and obligations for ‘pari-passu’ treatment. This may then need to be tackled through retrospective legislation of the kind that was used in the restructuring of Greek debt, which raises the question: Why not restructure debt outright?

The third issue that arises is that the ‘ring-fencing’ or pledging of sovereign assets could be reversed by an act of parliament so may not be completely credible. It’s also hard to see how the seizure of these assets or revenues can be credible in the event of a sovereign default.

This will lead to a situation where all of the countries’ stock of debt is backed by assets - essentially a country would have mortgaged itself.

This approach will undoubtedly generate a large political backlash within Spain and Italy.

The second option, of the EFSF/ESM buying sovereign bonds could also reduce borrowing spreads, at least for a while. But it’s unclear what the attraction of going through this mechanism is over activating a cheap loan to Italy and Spain instead.

Clearly, Germany and the other stronger economies are unlikely to allow this to happen without fully-fledged conditionality under a program, which presumably was one of the reasons to go through the bond purchase route instead of getting a loan from the crisis funds instead.

The other matter of concern is the seniority of the ESM. As long as this is not waived, its bond purchases, like those of the ECB, would be ineffective in sustainably bringing bond yields down.

The limited size of the ESM/EFSF is yet aspect of this strategy that may limit its effectiveness , as borrowing costs can best be credibly brought down if it is demonstrated that the sovereigns in trouble have access to reasonable cost funding for as long as they need it.

Another complication is that fact that when one includes Italy and Spain, the effective capacity of the crisis funds could shrink by almost 25% as then the bailed-out countries would constitute nearly a quarter of the fiscal capacity that supposedly stands behind these funds.

The effectiveness of the ESM/EFSF to credibly support Italy and Spain is rather limited and the most this approach will buy is a bit more time.

Sony Kapoor

Managing Director