Saving the euro zone: Not so fast

Not so fast

Jan 20th 2011, 17:07 by Charlemagne | BRUSSELS

IN DECEMBER the leaders of countries using the euro declared that they stood “ready to do whatever is required to ensure the stability of the euro area as a whole”. One month on, they are plainly not ready to agree on what needs to be done. This week's meetings of finance ministers from the euro area, and then of the European Union, broke up without agreement.

The latest round of bickering may yet lead to the crystallisation of a new, elite club comprising the six euro-area members with a AAA credit rating: Germany, France, Austria, the Netherlands, Finland and Luxembourg. Call them the AAA-6, or the A-Team.

One can sympathise with the argument of Germany's finance minister, Wolfgang Schäuble (pictured above, right), that, rather than rush more half-measures, it would be better to have a comprehensive package that, in the words of one German official, “answers all the questions”. Indeed, the questions are many, and interconnected.

Here are just a few of them: are Europe's bail-out funds big enough? Should they do more than save countries at the point of collapse? Should they, specifically, take over the European Central Bank's emergency bond-buying role? Are bailed-out countries paying too punitive an interest rate? Will Greece, in particular, need to restructure its debt even after its bail-out? If so, can Europe's banks take the hit?

The European Commission says time is short. Markets may fall back into a frenzy at any moment. It wants progress at the next summit of EU leaders in February. Germany says more time is needed, and is aiming for a deal at the following summit, in late March. José Manuel Barroso, the commission president, thus finds himself once again publicly at odds with Angela Merkel, as he was last May when he urged her to move faster to rescue Greece.

Size matters

The most immediate question centres around the market's doubts about the ability of the EU's bail-out funds, worth €750 billion (including a €250 billion chunk from the IMF), to save Portugal, which is close to financial seizure, and Spain, which is at risk of contagion, while having money left over for other contingencies.

Belgium has called for the EU to double the funds, to €1.5 trillion. Willem Buiter, chief economist at Citibank, reckons [PDF] €2 trillion is what is needed. Such figures make euro-area countries, particularly the A-Team, blanch.

Nobody will want to pay for such a bazooka. But Germany has said it is ready to consider ways of making the current weapon more credible. The biggest of three pots of bail-out money is the €440 billion European Financial Stability Facility (EFSF), a special-purpose loan fund created last May by member-states. Each country contributes a quota of loan guarantees, to be drawn upon when the fund is activated, for example to rescue Ireland last year.

The trouble with the EFSF is that it can lend only about €250 billion while maintaining its AAA rating. Raising its lending capacity to the official ceiling would provide an extra €200 billion.

But how to do it? The obvious way to increase its firepower is for everybody, particularly the AAA-rated countries, to offer bigger guarantees. But this could be contentious in Germany. Another is to increase the fund's cash content. One German official suggested that A-Team countries could offer more guarantees, while the B-team could put in more cash.

Everybody is pulling out calculators and preparing arguments for why others should pay more. Giulio Tremonti, the Italian finance minister, told colleagues that Italy's share of the Greek and Irish bail-outs was already disproportionate to its banks' exposure to the debt of those two crippled states.

Flex that muscle

Even assuming that the EFSF is made bigger, there are questions about its future actions. Should it, for example, issue short-term credit lines to countries facing liquidity problems?

Another question is whether the EFSF could buy bonds of vulnerable members. Such action in the bond markets by the ECB has doused the fire but is unpopular on the ECB's board. Would it be better for the EFSF to take it over, leaving the ECB free to concentrate on its core tasks of managing monetary policy and watching out for inflation?

The opacity of the ECB's bond-buying has an advantage. It has stayed out of the public eye, and has kept the market guessing about when and how it would intervene. Handing over the role to the EFSF may make it more public, so more contentious in AAA countries.

One idea is that the EFSF could lend money to countries such as Greece to buy their own bonds. This would be more palatable, but may amount to a form of debt restructuring. Germany and Greece have both denied reports that such a proposal has been under discussion.

Greek wobbles

As The Economist noted last week, Greece is bust. Even after its bail-out, it will end up with such a large mountain of debt that it will never be able to repay its creditors. For now, though, everybody rejects the idea of debt restructuring, for fear of the knock-on effects across Europe.

One idea being pushed by Ireland, which may benefit Greece too, is to reduce the interest rate being paid by the two countries. This was deliberately set high—about 3% higher than the EU's cost of borrowing—to reduce the danger of moral hazard. The problem is that, by making it harder for countries to get back to a sustainable level of debt, it makes restructuring more likely.

Don't bank on it

The weakened state of Europe's banks is a common thread through the sovereign-debt crisis. The bursting of property-price bubbles crippled banks in Ireland and damaged Spanish ones too. The banking sector, moreover, is a channel of contagion. Any plan to restructure the debt of Greece or Ireland will have to consider the effect it would have on European banks.

The EU is preparing a new set of bank stress-tests that, it says, will be more rigorous than last year's exercise, now discredited because it failed to detect the full scale of the horror in Ireland's banking system. The precise methodology is being discussed, with questions about whether scenarios will include the prospect of sovereign default or debt restructuring in the coming years. Other questions are how the new liquidity standards in the Basel III regulations on banking will be incorporated, and, more importantly, whether the results of the tests will be published.

In short, the question is whether governments really want to hear the bad news, and whether they are prepared to do what it takes to re-organise and recapitalise the banking sector. This, in turn, could raise further questions about public finances.

2013 and beyond

All these discussions are coloured by the debate about what the permanent bail-out fund will look like when the current one expires in 2013. Conversely, decisions about changing the EFSF will set a precedent for the future system.

The EU is pushing for treaty change to allow a new mechanism to be set up. It also wants to make it easier to restructure the debt of countries that, in future, are deemed insolvent. This is supposed to apply only to new debt issued after 2013, with collective-action clauses that make it easier to reach agreement on imposing haircuts on bondholders. But it is reverberating back to today's market conditions, as holders of Greek, Irish and other peripheral debt fear they will be wiped out.

Whether a deal is done in February or March, it is hard to believe that all of these questions will be settled.

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pedrolx wrote:

Jan 20th 2011 7:48 GMT

I would like to know why so much strees is put in Portugal when its fiscal health is actually better than - countries in the EZ (see data in der spiegel), with a deficit of lower than 7.3% (the government in Portugal just announced it beat its 2010 target). This is better than Greece, Ireland, SPain, France and Slovakia within the eurozone, and better than the UK, which has a public deficit of 10%. I think it's time for the media to stop this hypocrisy towards Europe. Everybody knows that the FED is printing money to buy US treasury bonds, which explains why yields aren't sky-rocketting as in some parts of EUrope (and in many cases due to speculation). It's time to stop being critical about Europe's choice not to print money. This is already giving bad results in the UK, which is seeing an extremely high inflation.

and by the way you're lagging behind a bit, CDS and yields are incredibly down this week, for the non-AAA countries. AAA, with some hypocrisy it should be noted.

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Saving the euro zone

Not so fast

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