Saturday, 22 October 2011

Eurozone crisis and Greek default – summary and suggestions

Last few weeks saw a decline in banking shares throughout the markets, huge uncertainty regarding political responses on whether to recapitalize the banks and set higher capital standards, the privatization of another bank highly exposed to peripheral eurozone debt Dexia, and further questions on what to do with the eurozone system – to resolve the issues by boosting cash reserves of the EFSF, by higher political integration or something else.

Fears are rising concerning the possibility of a Greek default to bring down with it Italy, Spain and Portugal as well as sovereign debt infected European banks. All the countries in the EU could be exposed, if not directly via common currency or through losses of domestic banks and another credit squeeze, then indirectly through declining trade and a severe blow on confidence. The financial linkages would spread quickly worldwide, just as they did after the fall of Lehman Brothers in 2008. Read about the effects of the euro break up worldwide in the previous post.

In order to prevent such an outcome, the European summit held tomorrow, 23rd October should find a way to resolve the following issues: agree on private sector Greek debt holders’ losses and figure out what to do with Greece; create a credible recapitalization plan for European banks exposed to peripheral countries sovereign debt; and protect other countries from the effects of a possible Greek default or debt restructuring.

The general plan is to push higher losses on private Greek debt holders (a ‘haircut’ of around 50%) in order to restructure the Greek debt. In order to do this, precautionary steps need to be taken. The European Commission (EC) wants to step in and protect all the banks exposed to peripheral eurozone debt by recapitalizing banks and giving more firepower to the European Financial Stability Facility (EFSF) to stop contagion and protect other European countries in threat of sovereign default. 

The first thing to make clear is which eurozone countries are insolvent (unable to repay its debts) and which are illiquid (temporary unable to settle its liabilities) in order to back up the illiquid ones by offering more lines of credit and restructuring the debts of the insolvent economies. A lot of policymakers already agree on this as Greece is pictured as the only insolvent country so far, since the current austerity measures are crippling its growth and its economy. Italy and Spain are illiquid and need temporary signs of liquidity in order to pay its liabilities.

The next step is ensuring which European banks will be able to endure and withstand a potential sovereign default of the country they were invested in. This should be done by a credible stress test - not like the one done in July 2011 by the European Banking Authority (EBA). Even though that stress test pointed out to serious instabilities and 8 potential bank defaults, it didn’t account for a potential sovereign default. The new stress test should take not only the potential losses from the default into account but also the possible reactions on the capital markets, policymakers’ reactions, and the hit to consumer and investor confidence. The idea of the stress test is to find out what capital-asset ratio (core tier one capital to risk-weighted assets) is sufficient enough for the exposed banks to survive the default and all the turmoil that will follow it. The EC has signalled a 9% ratio to which the banks responded by rather selling assets than raising new expensive capital in order to meet the target. Dangers were also a further credit contraction to the eurozone small and medium sized businesses, which are highly dependent of bank loans (accrding to FT, European companies rely on banks for 80% of their funding, compared to only 30% of the US companies). Furthermore, the FT reports, the bankers are unwilling to raise new capital knowing that the newly raised money will only be used to cover up sovereign debt writedowns. This is why the banks would rather chose selling assets to reach their target, so that the result might be a decrease of lending – something that a recovering economy does not need!

The policymakers will go around the banks and fill them up with capital coming from governments, i.e. they will raise capital through solvent states or via the EFSF. After the stress tests are initiated and the capital ratio reached the policymakers will use this to assess which banks require recapitalization. Here is where the powered up EFSF should step in.

The EFSF should act as an enforcer of stability in the eurozone banking system. It has the role of creating a ring-fence around Spain and Italy after a potential Greece default and will use its increased funds to recapitalize exposed banks and reduce future risks to the banking system, and furthermore to restore confidence. EFSF was created in order to avoid seeking parliamentary approval for every decision on bailouts and to reduce the risk of credit rating downgrades of Germany and France.

Recapitalization of banks and sufficient liquidity into the system to prevent panic and contagion

The EFSF should inject capital into banks and purchase bonds from weakened countries on the open market lowering borrowing costs to these countries. The EFSF should therefore ‘isolate’ Greece in order to protect European banks highly invested in the peripheral eurozone debt and other countries from possible sovereign default.

The fund is however no longer big enough to complete the new tasks. It should borrow money from the ECB or from the market. It could also issue guarantees instead of loans in order to offer more leverage. The fund currently has 250bn firepower but this may need to be increased to at least 440bn by most estimates or even to 1000bn or more.

There still isn’t consensus on how the recapitalization should be done. The idea to impose more commitments of countries to the EFSF isn’t likely due to several reasons – fear of a credit rating downgrade, political opposition in many eurozone countries (Slovakia’s prime minister already lost her vote of confidence in Parliament during a decision on further support for Greece) and simply the fact that some countries can’t afford to put in more money (Spain, Italy) since it would be absurd to use highly leveraged vehicles backed by weakened countries to rescue those very same countries and their banks.

Another option is to have the EFSF guarantee losses up to 20% on sovereign bonds rather than buying them off Italy or Spain. This could increase their power by not raising extra money. There is also an option of making the EFSF a bank so that it can borrow unlimited amounts from the ECB, a solution Germany finds unacceptable. Another idea is for the ECB to keep buying bonds and having the EFSF guarantee them. Finally, there is still the idea of creating Eurobonds which could prove to be a good vehicle to raise liquidity but very hard to set up immediately as there is a need to build a good oversight system in order to prevent potential misuse by reckless member states. This requires a much closer integration into a full fiscal union with coherent and strict rules which would apply for everyone.

Even though the policymakers still do not agree how the recapitalization should be enforced one thing is certain – any solution will require huge amounts of money to be funded, printed or guaranteed in order for the EFSF to restore confidence, financial stability and growth in the eurozone.

Without even knowing how they plan to initiate the action, possible (negative) consequences can already be recognized and anticipated. The first thing a highly leveraged EFSF would do is create a temporary rise of investor confidence, meaning that the markets would react positively to the plan. After the positive reinforcement, problems will arise. The first one that comes to mind is moral hazard as the banks and governments that become dependent on outside funding may find it hard to return to their old ways which could result in further instability for the eurozone in the form of political concessions and a switch of balance of powers within the eurozone. The private sector will not react immediately and may wait for some time before increasing investment, which is a bad sing for the policymakers who hope to see immediate results, before they run out of “ammunition” to fight the banking crisis. The uncompetitive countries won’t see their problems solved by the EFSF and would still need a radical restructuring of their economies and removing high political interference in the economy. There is a need now to prevent peripheral countries from future instabilities and misbehaviour. Here is where the idea of a full political European Union, an idea imbedded in the Mastricht treaty and a long desire of European policymakers, comes to mind and one can expect more and more arguments for a tighter fiscal Union, even though this will be extremely hard to initiate especially due to big opposition in euro sceptic countries like the UK.

Greece is ready for default

The idea of bank recapitalization and a huge financial injection into the banking system should hardly come as a surprise. The uncertainty over Greek’s ability to implement the enforced austerity measures has increased severely and Italy’s credit downgrades haven’t helped either. The austerity package enforced upon Greece is not working. Investor confidence surrounding Greece is close to nothing as every sign that its government is not fulfilling the austerity measures further decreases faith in Greece and raises its bond yield, which is now at a whopping 78%, not to mention its CDS spreads. Unwillingness to accept that Greece needs to go under only adds up to the uncertainty around banks and undermines the austerity measures even further. Not to mention the vast protests and social instability currently going on in Greece. A default is the only plausible option and the only way Greece and the eurozone could be saved from this vicious cycle of uncertainty and threat to economic recovery. The whole set up around the new role of the EFSF and different ideas on how to carry out the recapitalization can mean only one thing – the eurozone leaders are preparing to default Greece.  

The policymakers are hoping they could forestall investors and create a credible plan now in order to avoid a mass panic and slipping into another recession after the Greek default. They wish to secure the system with enough capital so that the banks can endure another systemic crash. In short, the policymakers seek to ease the burden of Greek default and isolate it from hitting other troubled countries and exposed banks.

Final step – a shift to growth?

The shift of macroeconomic policies from austerity towards a new agenda for growth can only be done by setting a stage to spur back investments into the economy. Kick-starting investments in order to increase production and employment and thus boost demand requires restoring confidence back into the economy – something the regulators have in mind but have no clue on how to approach it (based on their proposals).

Regulators are making serious omissions in their proposals. They require more capital to be held by the banks and are willingly letting the banks cut their assets in order to reach the capital standards and therefore reduce lending. On the other hand they expect their plan to restore confidence and lead the eurozone back on the path to growth. The two desires of the policymakers are in contradiction one with the other. Stiffing bank lending, upon which European businesses strive on, is not a way to restore growth. A strive for fiscal consolidation is one thing, but discouraging banks from lending by imposing higher capital standards won’t help anyone and is very likely to push Europe and consequently the entire world into a double-dip recession. 

Furthermore, designing a new system to stop future crises of confidence isn’t a guarantee against future recessions. No matter how prudent the new regulation will be it is very likely that it won’t be able to cope with a new future crisis. We cannot anticipate what will happen in the future and we cannot be certain how will the economies react and which part of the economy will be taken down – which asset price bubble. All we know is that the debt crisis is likely to cause a new economic downturn – just like so many times before. Due to animal spirits it’s only a question of time when another asset bubble tied with rising debt levels will decrease consumer and investor confidence and increase the prospects of a new recession. Unless the regulators are going to constrain the long term debt and maintain a balanced budget that will ensure the credibility of the sovereign as a borrower, the situation may (or better yet, will) repeat itself, only under different circumstances and causes but with the same impacts and outcomes. 

5 comments:

  1. the eurozone was a wrong idea to begin with. I say they close shop and move on! Greece should go under, while the rest of the countries should think about how to go back to their own currencies and forget about the euro. It may cost a lot, but in the long run, it'll better for all of us. I mean the idea of having a monetary union without a fiscal union was faulty from the very start. This literary meant that countries like Greece, Portugal, Spain or Italy could borrow in the same low rates a fiscaly responsible Germany was borrowing. The inter stability of the fiscal systems of these countries meant nothing. Well, it means something now.
    In times like these, I'm glad that Britain stayed out of the euro - it's all just a big mess

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  2. I see your point, and I agree there were a lot wrong with the eurozone idea from "the very start" as you put it.

    However, don't you feel that breaking up the euro can bring about severe consequences not only to the eurozone countries, but to the UK as well? I wrote a post about that here, with the picture summing up the negative consequence spiral: http://im-an-economist.blogspot.com/2011/10/euro-break-up-effects-beyond-eurozone.html

    Basically, breaking up the euro will give rise to the sterling and hit UK exports (this is from a UK perspective, but may be very well from any other country with strong trade ties with the eurozone). Consumer and investor confidence would suffer a severe blow, banks would incur huge loses which would lead to a credit contraction and a freeze on the money market. The very trigger of a euro break up could be the next thing to lead the world into another depression - even more sever than the 2007-2009 recession, I'm afraid.

    Sorry for being a bit on the pessimist side, but the eurozone is one of those things in life that once your in it - there's no way out! :)

    ReplyDelete
  3. All the things you said may be true, but I still think that in the long run, a monetary union without a fiscal union is unsustainable. A consequence would be either a break up or more integration. And if Europe sees more integration of the eurozone countries, than all those outside of the eurozone (UK, Sweeden, Denmark) might form a counter alliance. There is then a big political risk at stake and there will be rising euro pessimism in all the countries outside the fiscal union. As a consequence, the people will be fed up with it and demand that countries like the UK just leave the whole thing..

    John Major wrote about that in the FT this week and I think he makes a good point. (not that I'm a John Major fan)..I can't seem to find the link though
    anyway, I think the FT is running a whole debate on how to save of reorganize Europe..there's quite a few good ideas there actually

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  4. I agree, the political risk is grave for Europe at the moment. And I don't see any plausible way of dealing with the rising dissatisfaction and loss of optimism among Europe's citizens, apart from kick starting growth immediately - and this is hard to imagine at the moment.
    I'll keep an eye on the FT's debate, maybe someone comes up with something reasonable for once

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