Euro crisis: the end of the beginning?

“This is not the end. It is not even the beginning of the end, but it is, perhaps, the end of the beginning…”

Winston Churchill, 1942

“We have reached the end of the line with the present system of a monetary union that refuses to be a fiscal union. We are right at the edge of what is legally, politically and financially possible under the current legal and political structures.”

Wolfgang Munchau, FT

It is a surreal world we live in when investors are glued to their screens awaiting parliamentary votes in Slovakia, with the future of the euro-zone and global financial markets in the balance. More depressing, yet no less surreal, is the reality that even before the latest crisis-fighting measures are approved, there is widespread agreement that they are inadequate and must be enhanced.

The votes this week surround the amended EFSF[1] which was proposed back in June and July this year. Back then the European Council agreed to boost the fund’s lending capacity to €440bn (from €255bn) and broaden its scope to include acting on a precautionary basis, recapitalising banks and intervening in government bond markets. We argued then that the amended EFSF was insufficient to resolve the European crisis. Recent events have made this abundantly clear.

A persistent problem throughout this crisis has been the cacophony of voices coming from different corners of Europe. This, alongside a general hesitancy and lack of commitment to previously announced policy interventions, has undermined confidence in the region. Greece’s second bailout was announced on 21 July, detailing further EU/IMF financing alongside ‘voluntary’ debt restructuring for private holders (PSI[2]), sufficient to cover Greek financing needs into 2014. And now, less than three months on, the whole bailout is very much up in the air. As things stand, it is unclear (i) how much further official funding Greece will receive; and (ii) how PSI will be renegotiated. For every politician that says Greece must be saved, another talks of the inevitability of default.

So where do we stand today?

Last weekend, Merkel and Sarkozy promised a decisive plan by the end of the month, including a recapitalisation of Europe’s banks. Since then, the EU summit has been delayed to 23 October (from 17 October) to allow time to finalise a “comprehensive strategy”. The FT reports that this plan will be presented at the G20 summit on November 3-4.

Expectations, therefore, have been raised that EU leaders can come up with something decisive. As Credit Suisse strategists have argued, a successful package – even if only on a short-term basis – will require (i) clarity over Greece; (ii) recapitalisation of Europe’s banks; and (iii) a strategy to build a firewall around Spain and Italy.

On the first issue, it is clear that Greece is insolvent. Either the country receives further official funding or it will be forced into a much larger debt write-down than in the July package. It is unclear currently which way policymakers will go, but further official support would only be delaying the inevitable and, realising this, it seems that sentiment has shifted towards a larger write-down. If policymakers choose to force a ‘hard[3]’ default then measures to shore-up the banking system will likely be required (e.g. support for Greek banks, ECB liquidity provision etc…), even if the value of Greek debt held by European banks is small in relation to aggregate capital. This is the second requirement.

Talk of recapitalising Europe’s banks was pushed to the forefront by Christine Lagarde in August. Support for such action has grown considerably since and now seems to be endorsed by Europe’s leaders. The recent failure of Dexia may have made up politicians’ minds.

Implementation could be problematic, however. Will a third stress test finally provide a realistic measure of capital required? Where will capital come from and in what form? EFSF money could be used, but then what funds would be left to stabilise sovereigns under threat? European banks need to strengthen their balance sheets, but certainly not at the expense of weakening the safety net around sovereigns, which remain the source of the problem. Should Italy default, no amount of capital will be enough.

This leads to the third requirement: safeguarding Spain and Italy. It is now widely acknowledged that the EFSF’s lending capacity is insufficient to protect these two countries. Fiscal union, with collective issuance of ‘Eurobonds’, has been proposed by some as the solution but will not happen anytime soon. For obvious reasons there is not yet political support (German taxpayers have little appetite to pay for Greek retirees), nor the institutional framework.

The EFSF, therefore, somehow needs to be ‘leveraged’. How this will be done is unclear, but it seems very unlikely that the ECB will be the conduit, judging by recent statements. Some form of EFSF insurance scheme is rumoured, whereby any future losses are shared with private sector lenders. In our view, such a scheme could be effective but the devil will be in the detail.

Euro exit?

Various prominent commentators believe Greece would be better off outside the euro. This might be so, but who knows for sure? A new, substantially devalued Greek currency might restore competitiveness to some extent but would also come with major disruption and significant cost. Capital controls, an extended ‘bank holiday’, a significant loss of wealth imposed on Greek depositors (as deposits in euros turn into drachma), widespread bankruptcies across the financial and non-financial sectors (depending on which assets and liabilities are converted from euros), rising inflation and high interest rates would all be likely consequences. Major reforms would still be necessary for any chance of success.

This should make it clear that a decision to abandon the euro would be highly risky. (At this point, it should be clarified that Greece cannot legally be ejected by other countries, but could leave the EU and euro-area voluntarily).

In our view, for the time being a Greek exit remains very unlikely – not because it would necessarily be bad for Greece, but because it would be bad for the rest of Europe. If one country leaves, so can others. The taboo is broken. The consequence would be bank runs across much of Europe as depositors, watching events in Greece, rush to withdraw their money. We therefore think other periphery countries will push hard for Greece to stick with the euro. And these arguments should persuade the French and Germans – an Italian bank run is very quickly their problem too.

Great Expectations

Noises coming from Europe’s leaders have calmed markets this week. Expectations have risen that some form of solution will be in place by the end of the month. This much is reflected in recent market movements.

As a consequence, policy decisions taken in the coming weeks will have a significant bearing on the near-term direction of financial markets. While uncertainty persists, markets will remain highly volatile.

European leaders have made a habit of delivering short-term fixes that quickly disappoint. This time they need to come up with something better. Regardless, in the absence of an unlimited ECB commitment to purchase sovereign debt (which we are repeatedly told is not on the cards) or fiscal union (which is years away, if ever), there is no magic solution to this crisis.

Whatever is decided in the next few weeks, government debt outstanding in Europe will be higher in 12 months time; so too may be unemployment rates. Many will be feeling the pain of another year of austerity measures. Social, political and economic instability will remain a threat even if tensions ease periodically with the help of effective policy.

Europe’s future is in the hands of its policymakers. The outlook is challenging. In the short-term, a strong policy response could alleviate the risks and reassure markets, which have been fearing the worst.