Yet another summit, yet another vague plan. France’s finance minister Francois Baroin said the EU summit due to be held later this month will agree “decisive” measures to tackle the crisis that is engulfing the euro zone. “Decisive” however, does not seem like the right word to use after European politicians delayed the disbursement of the next €8bn tranche of the rescue package for Greece until November, thereby disseminating even more uncertainty in the markets. Furthermore, all the public talk about a possible further restructuring of Greek debt has done precious little to soothe investors’ frazzled nerves.
The decision to postpone the next disbursement of money is the least of problems however, and was probably taken in an attempt to push Athens into further reforms as there are no big bond payments due in the next weeks. The medium and long-term decisions are the ones that European leaders are proving unbelievably loath to take, such as agreeing on a partial write-down of Greece’s debts, recapitalising European banks and bolstering the European Financial Stability Facility (EFSF). Yet everyone seems in agreement that the more European leaders prevaricate, the more entrenched and harder to resolve the crisis becomes.
Most experts agree that some kind of haircut on Greek bonds is necessary, as long as it is combined with bank recapitalisation and a significant increase in the size of the EFSF. In July, European leaders had suggested a voluntary debt restructuring on the part of private banks coupled with fresh inflows of official money, but both The Economist and Martin Wolf from the Financial Times argue that the deal fell short of helping Greece whilst providing excessive relief to the banks. Raoul Ruparel of Open Europe, a think tank, claims that around 50% of Greek debt ought to be restructured and that European banks ought to be able to weather the ensuing storm thanks to a recapitalisation program through the EFSF. However, the European Central Bank (ECB) has long been adamantly opposed to any form of write-down which also raises implications for how exactly the EFSF would be able to build a firewall around endangered economies Italy and Spain without ECB funding. Gavyn Davies, writing on the Financial Times, explains that in order for Greece to reach an ambitious debt target of 80% of GDP by 2016, the rescue package would have to amount to €200bn. A 50% haircut on Greek debt that is held in private hands and which currently amounts to €240bn would thus raise €120bn, which still leaves a hole of €80bn. Furthermore, it is highly unlikely that the 50% haircut could be implemented voluntarily, thus raising the spectre of a technical default which is anathema to the ECB.
A corollary of the debt write-down is the problem of banking liquidity (or lack of it). Martin Wolf explains that the debt overhang impairs both solvency and liquidity in the banking sector, and proposes financing through capital injections and central bank support as the solution. However, as Gavyn Davies rightly points out, the amount of recapitalisation needed depends on the size of the write-downs on Greek debt and on the market’s expectations of possible future write-downs on other sovereign debt because of a loss of confidence. This is why it is absolutely vital to protect Italy and Spain from being engulfed in the crisis by putting Europe’s banking sector on sound footing. George Magnus, a senior economic adviser at UBS Investment Bank, believes that the ECB ought to be prepared to stand by and buy any amount of Spanish and Italian bonds to prevent banking contagion.
Unfortunately, the need to build a firewall around Italy and Spain entails a bolstering of the EFSF, which at its current €440bn capacity, is insufficient to ring-fence the crisis. Policy-makers have been bending over backwards to get around the ECB’s unwillingness to buy struggling economies’ bonds and to lend to the EFSF, touting various ideas which involve borrowing from public institutions that already have a banking license and that therefore have access to ECB funding. Another option would be for the EFSF to guarantee the first 20% loss on any new bonds issued by ailing countries; it would be able to implement this without requiring money from the ECB but the prospect of a bank recapitalisation will sharply deplete its reserves rendering this harder. Gavyn Davies argues that the EFSF however could use its remaining capital, estimated at €200bn after various rescue packages and possible recapitalisation programmes, to insure about €1000bn bond purchases in Spain and Italy which would cover their bond issuances for the next three years. This would soothe markets’ nerves and more importantly, buy European leaders a window frame in which they could tackle the euro zone’s underlying problems, namely lack of competitiveness and growth in the periphery countries.
Fostering growth in Greece and its neighbours is a daunting task, to say the least. Yet without growth the debt burden will linger on, as Vicky Pryce, senior managing director of economics at FTI Consulting, has said. The fiscal austerity to which Europeans have been adhering so zealously is only one side of the coin and does not solve the structural problems that affect the Mediterranean countries. One need only to look at the ominous slashing of growth forecasts in the United Kingdom, which has embarked on an audacious deficit reduction programme, to see how austerity can tighten the tap of an economy reducing it to a mere trickle. Christopher Smallwood, writing for Lombard Street Research, claims that the Club Med will restore competitiveness by falling wages and mass layoffs, both of which are likely to have extremely painful repercussions. External financing may mitigate the shock but will also have the corollary effect of slowing down the adjustment process. Furthermore, Martin Wolf points out that if external deficits are to fall in Greece and its neighbours, then surpluses must fall in other countries, notably Germany. Yet discussion on this aspect has been conspicuously absent. The quagmire in which the euro zone finds itself then, is only the beginning of a very long and tortuous process to address the fundamental imbalances within it which were disastrously overlooked in its inception.
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