Satyajit Das: European Death Spiral – Communicable Diseases

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

Communicable Diseases

European politicians and central bankers have provided useful geographical clarifications. Prior to succumbing to the inevitable, the Ireland told everyone that they were not Greece. Portugal is now telling everyone that it is not Greece or Ireland. Spain insists that it is not Greece, Ireland or Portugal. Italy says it is not in the “PIGS”. Belgium insists it was no “B” in “PIGS” or “PIIGS”.

EU pressure on Ireland to accept external “help” was to safeguard financial stability in the Euro area, as much as rescue Ireland. However, contagion is proving difficult to prevent.

Russian writer Leo Tolstoy wrote that: “All happy families resemble one another, every unhappy family is unhappy in its own way.” The same applies to beleaguered European countries.

Greece had a bloated public sector and an uncompetitive economy sustained by low Euro interest rates. Ireland suffered from excessive dependence on the financial sector, poor lending, a property bubble and an increasingly generous welfare state. Portugal has slow growth, anaemic productivity, large budget deficits and poor domestic savings. Spain has low productivity, high unemployment, an inflexible labour market and a banking system with large exposures to property and European sovereigns. Italy has low growth, poor productivity and a close association with the other peripheral European economies. Italy has recently started to rein in its budget deficit. The Italian banking system is relatively healthy but exposed to European sovereign debt. Belgium is really two ethnic groups that share a king and high levels of debt (about Euro 470 billion, 100% of GDP).

Portugal, Ireland, Greece and Belgium are also small, narrowly based economies which increases investor’s risks. The countries have in common, very high and potentially unsustainable debt levels. They also have in common a reliance on foreign investors to purchase their debt.

Contagion is transmitted through different channels. The rising cost of borrowing increasingly makes high levels of debt unsustainable because of the cost of meeting interest payments. Eventually, countries lose access to commercial funding sources, which is what happened to Greece and Ireland. By the end of 2010, the cost of funds for the relevant countries had risen, in some cases to punitive levels. Greek debt is trading around 12%. Ireland trades at around 9.50%. Portugal trades around 6.60%. Spanish debt now trades at 5.50-6.00%, while Italy is trading close to 5.00%.

Rising rates result in unrealised losses on investor holdings of the debt. If EU/ IMF support is not available and the debt is restructured or defaults when it falls due, then this loss is realised. This affects the profitability and potentially the solvency of investors or banks depending on the quantum of exposure or size of the losses.

In total, banks have lent over $2.2 trillion to the PIGS. French and German banks have lent around $510 billion and $410 billion respectively. British banks have lent $324 billion to Ireland and Spain. The problem is compounded by complex cross funding arrangements. Spain, which may need financial support, has $98.3 billion exposure to Portugal as well as a $17.7 billion exposure to Ireland.

The final channel of transmission is less obvious. Where stronger countries move to support the weaker countries, financing the bailouts affects their own credit quality and ability to raise funds. As concerns about the peripheral countries increased, interest rates for Germany and France, which would have to bear the burden of supporting others, rose. Europe increasingly resembles a group of mountaineers roped together. As the members fall one by one, the survival of the stronger ones is increasingly threatened.

European leaders see markets as the cause of the problems. George Papandreou, Greece’s Prime Minister, spoke of “psychological terror” that traders were inflicting. EU Commissioner Michel Barnier complained that traders were “making money on the back of the unhappiness of the people”. Others variously blamed “wolf-pack markets”, hedge funds and credit ratings agencies. But unsustainable levels of debt remain the heart of the problem.

Unpalatable Dishes

The EU and IMF are hoping that the bailouts of Greece and Ireland will restore market confidence. In combination with stronger growth, greater fiscal discipline and domestic structural reforms, they hope that the fear of default or restructuring will recede. Eventually, the troubled countries will regain access to markets. The emergency facilities and support mechanisms will be gradually unwound. While not impossible, the chances of this script playing out are minimal.

A more likely scenario is that the support measures do not work and increasingly Portugal and Spain, initially, find themselves under siege. As market access closes, they too will need bailouts straining existing arrangements, necessitating new measures. If Portugal (debt around Euro 180 billion) was to require assistance, then it will reduce the available funds in the existing EU’s bail-out mechanism. Spain (with debt of over Euro 950 billion) is simply too big to bail out using the present facilities.

Under such a scenario, available options include greater economic integration of the EU, expansion of existing arrangements or a decision to allow indebted countries to fail.

Greater economic integration would entail adoption of a common fiscal policy, encompassing strict controls on fiscal policy including tax and spending. It could also include the issue of Euro zone bonds (“E-Bonds”) to finance member countries, lowering borrowing costs for peripheral economies and facilitate access to markets.

Fiscal union would prevent default of over-indebted borrowers without necessarily addressing the fundamental problems of individual economies. The likelihood of greater fiscal union in the near term is limited, as it is unlikely that nations will surrender the required economic powers and autonomy.

The E-Bond proposal, for up to 50% of a State’s funding requirement, is unworkable given large differences in credit quality and interest rates between Euro Zone members of around 10%. The E-Bond credit support structure would resurrect the ill-fated EFSF on a larger scale.

In any case, Germany takes the view that national governments should bear responsibility for their own decisions. Germany also opposes E-Bonds, as they would increase its borrowing costs. France’s early enthusiasm for E-Bonds seems to have diminished.

The cost of full fiscal union is prohibitive, entailing between Euro 340 billion and Euro 800 billion, depending on the degree of fiscal imbalances. Much of this cost would have to be borne by Germany and other richer economies.

If Portugal and Spain experience problems, then in absence of a full fiscal union, the only available actions are further EU support or default.

There have been proposals to expand the EFSF/ ESM as needed. While Germany currently has opposed any expansion, it remains an option. Perversely, increasing the funding available to support troubled countries may signal that problems were imminent, with a resulting loss of confidence necessitating a bailout.

The ECB can increase support for the relevant countries, in the form of purchases of bonds or financing Euro Zone banks to purchase them. Interestingly, the ECB will increase its capital base, from Euro 5.76 billion to Euro 10.76 billion by end 2012, the first such increase in its 12-year history. The increase in capital allows greater support from the ECB, whilst providing reserves against potential losses.

In an extreme scenario, the ECB could simply print money, following the US Fed’s lead, to support its members, known technically as “unsterlised purchases”. Such action may not be permissible under its existing rules, requiring amendments to EU treaties. It would severely damage the ECB’s already tenuous credibility and be resisted by Germany and other conservative EU countries.

“Extend and pretend” measures would allow orderly default or debt restructuring by some countries over time. It minimises losses, controlling the timing and form of restructuring. It would also minimise disruption to financial markets and solvency issues for investors and banks with large exposures.

If the EU does not agree to fiscal union or continuing support, then pressure on Portugal, Spain, Italy and Belgium may reach a tipping point, making default or restructuring the likely end game. Presumably, existing programs, such as those for Greece and Ireland, would be suspended. Governments would announce debt moratoriums, defaulting on at least some debts and forcing write downs. This would be followed by a domino effect of defaulting countries within Europe.

The defaults would affect the balance sheets of banks, potentially forcing governments, especially in Germany, France and UK to inject capital and liquidity into their banks to ensure solvency. The richer nations would still have to pay, but for the recapitalisation of their banks rather than foreign countries.