Satyajit Das: Europe’s Debt Crisis Refuses to Die

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (forthcoming August 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
overwhelm attempts to contain and solve the European sovereign debt crisis.

Recent frantic efforts that secured release of Euro 12 billion to Greece avoided immediate default but have not solved the fundamental problems. Greece is unlikely to meet targets for tax revenues, spending cuts and sales of public assets.

A recent International Monetary Fund (“IMF”) report on Greece suggests that the loans to Greece would not meet normal IMF lending criteria, in the absence of European Union (“EU”) support and pressure. Christine Lagarde, the new head of the IMF, recently was equivocal about ongoing further support, reflecting the real risk that it now faces in relation to its exposure to Greece.

Efforts to secure a new package of Euro 115 billion have stalled. German insistence on token participation by private banks and investors has proved divisive. A French plan, Gallic in complexity, appeared and disappeared. Slanging matches between Greek Prime Minister and the EU, the EU president and the German Chancellor and the European Central Bank (“ECB”) President and the Chancellor have taken the place of substantive progress.

In the meantime, contagion has become a reality. Financial markets recognised belatedly that the authorities are not in control of the situation and there are no real solutions to the problems.

Greek 2-year debt now trades at over 30% per annum while both Ireland and Portugal are above 20% per annum – loan shark territory. Spain’s benchmark 10-year bonds now command around 6.50% per annum. Interest rates demanded by markets are above that before the announcement of the recent measures to “assist” Greece in June 2011. Most alarmingly, Italy has been drawn into the ever-widening net of infection.

Italy’s problems are well publicised – a level of debt ($2.3 trillion) to Gross Domestic Product (“GDP”) of 120% and a public debt per Italian (about $39,000) greater than Greece ($34,000). The Italian economy suffers from low growth and similar structural problems to some other Mediterranean economies.

The triggers for the recent concern were puzzling. Some Italian banks were downgraded, based on their exposure to other beleaguered Euro-zone economies. The rating agencies placed Italy’s debt on negative watch, citing the economy’s poor fundamentals and the cost to Italy of financing the European bailout. There was a typical spat between Prime Minister Berlusconi and his Finance Minister Tremonti about budget cuts. Before you could say “bunga bunga”, the financial markets panicked, pushing up the cost of borrowing to Italy sharply by around 1.00% to around 6.00% per annum.

The rushed approval of an austerity package cutting government spending by Euro 45 billion and successful, albeit expensive, auctions of Italian government debt, stage-managed by the Bank of Italy and ECB, have not eased fears. Suspicion that Italy is infected persists. The fear is that Italy will lose access to commercial sources of funding at reasonable rates requiring a bailout, repeating the cycle that engulfed Greece, Ireland and Portugal.

Given the size of its debt and economy (the third largest in the Euro-zone), Italy like Spain is probably too big to save and too big to fail.

On Friday 15 July, European banking regulators issued the result of a stress test of some 90 banks. The test, the second in 2 years, was designed to reassure investors that the European banking system was sound. It failed miserably. While the test showed that only 8 banks “failed” by having insufficient capital, the basis of the tests was fatally flawed.

Crucially, the stressed scenario consisted of a 15% loss on Greek sovereign bonds whilst market prices suggests around 50%. It did not fully factor in the increasing pressure on other European nations such as Spain and Italy, the deteriorating economic outlook for Europe and the global economy or the possibility of large falls in housing prices in countries like Spain. Suggestions that the tests had been made easier due to pressure from governments and banks and concerns about the accuracy of data and disclosures confirmed investor concerns.

In fact, the stress tests were being performed on the wrong entities – the banks. As most large banks are “too big to fail”, it was really the ability of individual countries to stand behind their banks should problems arise that remained the issue.

The EU now plans to meet on Thursday 21 July 2011 to “urgently” deal with the situation. Chancellor Angela Merkel has indicated that she will not attend unless there is agreement on the new Greek bailout.

The meeting represents an increasingly narrow window of opportunity for the EU to try to regain control of a position that threatens to spiral out of control. The required actions, both political and economic, are fairly straightforward, although difficult.

A debt restructuring plan for Greece, Ireland and Portugal needs to be drawn up and implemented. A significant portion of the current debt would be written-off, to enable the countries to have some chance of attaining solvency. All lenders, private sector banks and investors as well as official lenders, must bear the losses. Debt restructuring should entail lengthening the maturity of debt and renegotiating terms to try to ensure the ability to service the debt.

At the same time, all relevant countries must announce measures to support their banks, as required, to prevent losses on sovereign bond holdings from setting off a European banking crisis. Governments would stand ready to subscribe capital to banks or guarantee bank deposits and borrowing. The ECB itself, which is heavily exposed to the peripheral economies, may itself require recapitalisation and financial support. In the case of Greece, Ireland and Portugal, government support may need to be backstopped by the EU or stronger Euro-zone members to be able to finance such commitments.

Efforts to arrest contagion should be directed at Spain and Italy. The country’s will have to implement credible efforts to bring public finances under control and ensure the solvency of their financial institutions. Existing facilities, such as the European Financial Stability Fund (“EFSF”) or its planned successor the European Stability Mechanism (“ESM”) may need enhancement and expansion to become a viable emergency backstop supporting these countries.

All this is merely prelude. The primary problems of European growth, intra-European financial imbalances and competitiveness of some countries will also need to be addressed. Europe will either need to move to greater financial and economic union or restructure its monetary and currency arrangements.

Greater integration will require sacrifice of national sovereignty. It will also require a cultural shift – Northern Europeans will need to become Southern (spend more, save less) and Southern Europeans will need to become Northern (spend less, save more). It will need to embrace an even greater degree of “transfers” and support from the stronger Euro-zone economies to the weaker members. The political, economic and social problems of such a strategy are formidable.

The alternative is a radical restructure of the Euro and Euro-zone itself. Some countries would, in all probability, leave the Euro, reintroducing their own currency – a considerable challenge. One commentator has suggested that this would be a temporary “sabbatical”, probably for the next hundred years or so. The resulting devaluation of the new currencies would help these countries regain competitiveness through the reduced domestic cost structures. The countries would gain added flexibility without the monetary and fiscal strictures of the Euro. Debt restructuring and a lower currency could potentially restore competitiveness and growth more effectively than successive round of ever more astringent austerity – the favoured and to date unsuccessful treatment.

It is not certain that the above actions will work. But they remain, on balance, probably the best option. Of course, the chances of the above steps being implemented is highly uncertain, especially given the EU’s track record over the last 15 months in dealing with the crisis.

In the absence of decisive action, Europe risks a certain and potentially rapid deterioration in financial conditions. This would affect the peripheral economies first, making any recovery near impossible. It would engulf Spain and Italy and perhaps Belgium. Increasingly, it would affect the stronger countries like Germany, France and the Netherlands.

RBS analysts in a recent research piece estimated that containing the crisis could require a bailout facility of around Euro 3.0-3.45 trillion, giving it a lending capacity of around Euro 2 trillion. The size of the facility is dictated by the fact that maximum lending capacity is limited by the guarantee commitments of the AAA countries. A facility of this size would add Euro 727 billion to its existing Euro 212 billion of gurantees (an increase of around 28% of German GDP that would brings its debt to GDP ratio to around 110% if the guarantees are treated as debt)). France’s guarantee commitments would increase to Euro 705 billion from Euro 159 billion (around 27% of GDP bringing its debt to GDP to around 112%). The Netherlands’ France’s guarantee commitments would increase to Euro 198 billion from Euro 45 billion (around 25% of GDP bringing its debt to GDP to around 89%).

This level of commitments might affect the ratings of these countries and cause severe financial problems if the contingent liabilities were ever triggered. Reacting to Chancellor Merkel’s all too obvious reluctance to deal with the issues, Giulio Tremonti, Italy’s Finance Minister, tartly pointed out the risks for the stronger members of the Euro-Zone: “Just as on the Titanic, not even first class passengers can save themselves.”

The combination of the European debt crisis and the theatre of the absurd, that is the debate over the US debt ceiling playing in Washington, conditions have rarely been more uncertain since the start of the global financial crisis in 2007. The global economy faces a future of prolonged stagnation or financial catastrophe as sovereign debt problems escalate rapidly. Let us hope the masters of the universe make the correct choices.