Markets Insight
June 19, 2012 8:01 pm
EU policies lead to chaotic resolution
The eurozone member states, says the G20 communiqué, are dedicated to “breaking the feedback loop between sovereigns and banks”. Is this a Hallelujah moment for Europe? It would be good to think so, but recognition of the problem comes dangerously late in the day, while experience suggests that eurozone policy makers have a genius for creating unintended consequences with every new incremental firefighting move.
Consider how awareness of this problem dawned, starting with the European Central Bank’s longer-term refinancing operations. Since late last year the ECB has encouraged European banks to take up cheap three-year money to help meet the refinancing needs of southern European governments.
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In effect, this meant undercapitalised banks were propping up over-indebted sovereign debtors, who were supporting undercapitalised banks. The Basel regulatory regime underpinned the process by according risk-free status to government debt despite the fact that such debt cannot be risk free in the eurozone because national eurozone central banks are unable to print money.
We saw by the end of last month that it was temporary medicine. As the impact of the liquidity injection ran out, the yields of Spanish and Italian government debt started rising back towards the danger levels that prevailed before the ECB’s supposed master stroke. In other words, for the remedy to be more than a short-term palliative it would have been necessary to go on pumping out liquidity to prevent yields reverting to a genuine market rate.
Then we had a serious issue over the subordination of debt held by private sector investors to official creditors such as the ECB, national eurozone central banks and the European Investment Bank arising from Greece’s voluntary debt exchange. This was followed by last week’s proposal for a €100bn rescue of the Spanish savings banks.
If, as expected, the money is provided through Spain’s Fund for Orderly Bank Restructuring, a government-guaranteed body, this would add about 9 or 10 percentage points to public sector debt in relation to gross domestic product. The official forecast for this year from the Spanish treasury, before the proposed bailout, was slightly less than 80 per cent of GDP. It is a feedback loop that looks dangerously like a noose.
Worse, there are fears among the banks that the funds may be channelled via the European Stability Mechanism, which will enjoy preferred creditor status second only to that of the International Monetary Fund. The impact of such a retrospective, arbitrary move would cause credit risk on private sector holdings of government bonds to rise, squeezing investors and making the paper less attractive in future.
According to the Institute of International Finance, which speaks for the global banking industry, some €240bn of Spanish government bonds are held by Spanish banks, which amounts to 6.5 per cent of total Spanish bank assets. The IIF’s dry conclusion is that it might be “challenging” for banks to add to these holdings.
Maybe this proposal is just a way station en route to a full bailout of the Spanish government – an outcome that seems increasingly likely. Maybe the ECB will come back with further liquidity injections or purchases of government bonds in the secondary market. The subordination problem could of course be resolved by having the ESM recapitalise the banks directly, while moving towards a banking union with a single supervisor.
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The speed with which political impetus is building up for such a union is striking. Yet this looks another crabwise movement by eurozone policy makers towards a backdoor form of fiscal federalism of precisely the kind that has produced bond market rallies of shorter and shorter duration while leaving Spanish and Italian bond yields at levels that put these countries’ solvency back into question.
Now the Constitutional Court in Karlsruhe has – not unpredictably – muddied the waters by deciding that the German government failed to consult Bundestag members adequately over the European Stability Mechanism. More importantly, the political complexion of the eurozone has changed significantly with the shift to the left in France under François Hollande who is, if anything, more Gaullist on the point of national sovereignty than his predecessor. And there is little popular support in the eurozone for “more Europe”.
In the end, it boils down to the old issue of who pays to keep the monetary union show on the road. Angela Merkel no doubt has no wish to go down in history as the German chancellor who presided over the break-up of the eurozone. But nor will she want to dish her electoral prospects next year by signing a blank cheque at German taxpayers’ expense. There are just too many circles here to be squared for a quick resolution. Bar a chaotic, market-induced resolution, that is.
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The author is an FT columnist
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Copyright The Financial Times Limited 2012
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