Euro decision time
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Euro decision time

The flaws in the euro project can no longer be managed with piecemeal bailouts. Leaders must now determine the future of the European project, writes Stephanie Baxter at Global Investor, a sister publication to EuromoneyFXNews.

“The Germans should be worried about the weakening of anti-inflationary policies, and the poorer countries must be told they would not be bailed out of the consequences of a single currency, which would therefore devastate their inefficient economies.” Not an assessment by a eurocrat at a recent summit, but Margaret Thatcher on the dangers of the currency union in 1990. The structural flaws of the euro have been well known and ignored since well before its creation. We are fast approaching the moment when they must be resolved.

The first such inefficient economy to be devastated was Greece. Its second national election in barely over a month, on June 17, will decide whether or not the country stays in the euro. To alleviate fears of bankruptcy in the meantime, the European Financial Stability Facility (EFSF) and International Monetary Fund (IMF) provided a second bailout of €18 billion.

As Global Investor/ISF went to press at the end of May, Greek opinion polls showed anti-bailout party Syriza leading on 30% with conservative New Democracy on 26.5%. The eurozone could cope with the estimated €1 trillion ($1.2 trillion) cost of a Greece exit – Natixis Asset Management says that €750 billion could be absorbed by the EFSF and the yet-to-be-ratified European Stability Mechanism (ESM), backed by a further €1 trillion IMF contribution.

The real issue has always been contagion to the vastly larger peripheral economies. Spain is central to the next stage of the crisis. It is the fourth largest eurozone country, has a rapidly increasing debt-to-GDP – although still below Germany’s – huge unemployment, little chance of returning to growth and a devastated banking sector.

Spain’s banks are in desperate need of recapitalization. Santander estimates €40 billion of funding is needed but others think this is hugely optimistic – the government says Bankia alone needs €19 billion. Yields on Spanish 10-year bonds are perilously close to the 7% that triggered other eurozone bailouts, so the government is in no position to deal with the situation.

The options

The G7 was set to meet on June 5 so the EU leaders could update their global counterparts on progress – and no doubt receive lobbying to take urgent action. The eurozone leaders are considering several plans of action with a view to making decisions at their summit on June 28-29.

To prevent contagion, the eurozone could build a credible firewall. Azad Zangana, chief economist at Schroders, estimates that to cover all the refinancing, deficit and interest payment needs of Portugal, Ireland, Spain, Greece and Italy for seven years would cost €3 trillion. However, as he says, “it’s a huge amount of money and there is no way eurozone countries will agree to raising this”.

Alternatively, the European Central Bank (ECB) could launch a hugely larger long-term refinancing operation (LTRO). While LTROs have been around in the eurozone for years, the terms – three years at 1% – offered by ECB president Mario Draghi meant that €1 trillion was injected into the EU financial system in just two months. It allows banks to borrow at a favourable rate and lend at a profit to sovereigns through the secondary bond market, helping to recapitalize banks and reduce sovereign yields.

However, contagion is as much about confidence as raw numbers. Darren Williams, senior European economist at AllianceBernstein, says it is not about ECB funds but convincing people that the euro is not going to fall apart and deposits are safe. “If you can’t convince people that the Spanish government is solvent, then there’s really no amount of money that you can put into the banks which would allow them to fund themselves on the open market,” he says.

The IMF has previously taken a less severe attitude than its troika partners, the European Commission and the ECB, prescribing a slower pace of austerity and an earlier restructuring of Greek debt.

Charles Goodhart, professor emeritus of banking and finance at the London School of Economics, thinks the IMF should play a bigger role: “To strengthen the firewalls, it’s highly likely the IMF will be called upon again and this time we want it to take a different tack.” He adds that “when the IMF differed from the Commission and ECB, the IMF’s position was better”, and suggests it should take on responsibilities such as forcing states to impose anti-tax-evasion measures.

The IMF is likely to pay a visit to Greece soon after its election.

However, whatever form a troika bailout takes, it would only provide short-term relief. Long-term stability will require structural reform and some form of fiscal union. One package under consideration involves three key building blocks: a pan-eurozone guarantee bank deposit scheme; centralized banking regulation/supervision; and Eurobonds.


Eurobonds, the joint issuance of eurozone government debt, are political poison in countries such as Germany and Finland. Mutualizing debt would increase their borrowing costs, which is the equivalent to taxing the north to spend in the south. It also creates moral hazard; if countries do not pay the full cost of borrowing money – in the form of a higher interest rate – or risk being frozen out of the market, it reduces the incentive to impose tough austerity measures.

One compromise is to mutualize all debt beyond 60% of a nation’s GDP. Each country would issue or refinance with Eurobonds until its debt fell below that level. Based on current ratios, Cyprus, Germany, Spain, Austria, Malta, Portugal, France, Ireland, Belgium, Italy and Greece would enter the scheme – and it would have a calming effect on the others.

However, some believe that joint bonds can work but only if they cover total eurozone debt. “I don’t agree with proposals that suggest only 60% of eurozone debt-to-GDP would be covered, because that wouldn’t work,” says Zangana.

To have a chance of persuading Germany to back Eurobonds, eurozone-wide fiscal rules would have to be created to prevent moral hazard. “The introduction of Eurobonds would need to be accompanied by rules to avoid a situation where one country causes problems and contagion across entire region,” says Zangana.

A eurozone or, worse, German veto on a member state’s budget would be seen as profoundly undemocratic and could provoke a backlash. The most powerful nation in a union is seldom thanked for its efforts – Scotland is set to hold a referendum in 2014 on leaving the much more redistributive UK – and German chancellor Angela Merkel already regularly appears mocked-up in a Nazi uniform in Greek tabloids.

Moral hazard could be alleviated if the agreement is time-limited to see out this crisis, providing a bridging loan ahead of permanent arrangements. Safe-haven governments might also be persuaded by a moral argument – their ultra-low yields are as much due to investors fleeing peripheral debt as their own appeal.

Another option is to create a jointly guaranteed debt-redemption fund, a facility to partly finance debt from a jointly funded entity. But Williams says countries would be less likely to opt for this and that it couldn’t be created quickly enough to solve Spain’s problems.

More plausibly, EFSF/ESM could be allowed to directly recapitalize eurozone banks. The advantage of this is that the infrastructure is in place. The downsides are that some see this as a step towards federalism (although some might see this as an upside) and the stigma of accepting a bailout could mean some are reluctant to borrow.

Barriers to progress

The euro was conceived by the Kohl-Mitterrand generation admirably determined not to repeat the devastation of the world wars. But the political fudge to cement monetary unification left the difficult economic issues to a future generation. The bet was that presenting a fait accompli would later force compromise and the creation of a superstate. The resulting Maastricht Treaty both rules out bailouts and makes no provision for exit.

The election of new socialist French president François Hollande might appear to mark a new post-war low for the Franco-German axis but the reality of the shift in power in Germany’s favour during the past 30 years means that Hollande’s pro-growth rhetoric could be short-lived.

Iain Anderson, director and chief corporate counsel, Cicero Group, notes that Hollande’s campaign was aimed at a domestic audience. “We have to keep in mind that Hollande is a very pragmatic politician, which means that despite his anti-austerity stance he will be keeping a close eye on bond-market reactions to his decisions,” he says.

Merkel might opt to relax austerity, but for domestic reasons. Merkel’s conservative Christian Democratic Union spectacularly lost Germany’s most populous state North Rhine-Westphalia to the Social Democrats and Greens, which campaigned to slow down public sector cuts. It provides a warning ahead of the 2013 national election and, as Anderson says, it is “not the case that German voters are purely in the austerity camp”. He predicts that the German electorate will listen to Hollande’s ideas if they gain traction in France.


Currently without a government, support is growing for anti-bailout parties ahead of a June 17 election that is billed as a referendum on euro membership. It a debt-to-GDP ratio of 153%, huge unemployment, unpayable debts and a slow-motion bank run has begun. Civil disobedience could tip into full-scale rioting or even revolution if austerity is not relaxed. The crisis is caused by excessive government spending and tax evasion. The economy is hopelessly uncompetitive in euro.


The banking sector is riddled with €180 billion of bad loans from real-estate bust and third largest bank Bankia needs €19 billion urgently. Regional governments have racked up €140 billion ($175 billion) due to weak federal controls. Its debt-to-GDP ratio of 79% is low and prime minister Mariano Rajoy insists no bank or region will fail – but a large deficit and recession mean the government can only borrow at 6.4%.


Portugal has met the terms of its EFSF/IMF bailout but its debt-to-GDP ratio of 112.4% is high. Its exports and current account are improving but it remains vulnerable to the fallout of a Greek exit. Rob Burnett, European equities head, Neptune IM, calls Portugal the “next weakest link” and says 2013 funding needs could force a debt restructuring. It might even need a second bailout this year, according to Ted Scott, director of global strategy, F&C Investments.


Concern has receded since technocratic prime minister Mario Monti was installed. While Monti’s austerity is becoming more unpopular, parties supporting him did well in local elections ahead of the 2013 national poll. Despite the IMF predicting the economy will contract by 1.9% in 2012, borrowing costs only briefly peaked above 6% at the end of May. Its debt-to-GDP is very high at 123.4%


The May 31 referendum approved the European fiscal stability treaty, facilitating access to ESM bailout cash and reinforcing a popular commitment to the euro. It is approximately two thirds of the way through painful fiscal consolidation mandated when accepting its original EFSF/IMF bailout. Debt-to-GDP of 105% resulted from accepting boom-time real-estate liabilities.


There is modest debt of 52.5% in this country, but its weak banking system needs a €1 billion recapitalization after the real-estate bust. The coalition government has to face down strong unions trying to stymie its plan to reduce the deficit to 3.5% by 2014. East Capital AM chief economist Marcus Svedberg says a referendum is quite likely and could result in its austerity plan being watered down. It is uncomfortably close to Greece geographically.

Upcoming events

June 6: ECB governing council meeting in Frankfurt

The central bank takes its monetary policy decision for the euro area

June 10 & 17: French parliamentary election (two rounds)

Results will determine the extent to which president Hollande can push his agenda over the next five years

June 17: Greek national election

If anti-bailout party Syriza wins, Greece could reject austerity measures and leave the euro

June 22: Emergency summit

Leaders of France, Germany, Spain and Italy meet in Rome to form a common position ahead of the full EU summit

June 28 & 29: EU summit

European leaders to discuss Eurobonds and deposit guarantee scheme

June 30: Spanish bank deadline

Bankia and others must meet new provisioning standards; contingency plan not yet agreed

July 1: ESM established

Permanent bailout mechanism ESM created – if the Fiscal Stability Compact is ratified – ahead of its replacement of the EFSF, which expires next year

September 12: Dutch national election

Dutch voters are becoming more eurosceptic due to a combination of austerity and their large contribution to the EU budget and bailout funds

December: Another LTRO?

The ECB is likely to launch another LTRO for banks facing funding problems in 2013

January 2013: European Fiscal Compact established

Stricter budget rules will be implemented if 12 eurozone countries have ratified it; Hollande’s call for it to be redrafted to bolster growth might cause delays

April 2013: Italian national election

Recent local elections supported austerity measures but Italians might become more frustrated; the upstart Five Star movement will offer anti-austerity option

September 2013: German federal election

Chancellor Merkel will battle Social Democrats, which will campaign to water down public sector cuts. The result will have a profound effect on European politics

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