Against the tide: Bleak midwinter in euroland

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: CHUNT@EUROMONEY.COM

By:
David Roche
Published on:

Europe’s leaders aren’t giving the currency what it needs: reform, fiscal discipline and international support.

It’s not looking good for the euro this year. Europe’s leaders failed at last month’s summit to deal with the unending sovereign debt crisis. There was a lack of new resources to back a fiscal compact that risks being short on implementation and long on delay.

This will deepen the eurozone recession, as will credit contraction and loss of confidence. There will be widespread cuts in credit ratings.

To mark a turning point we needed: the European Central Bank to support reforming economies – principally Italy and Spain – in the form of limitless buying of their bonds; a new treaty or protocol to enforce fiscal discipline credibly and immediately; and large-scale international support, from the IMF and other central banks. We got none of these.

Last month, the ECB cut interest rates by 25 basis points to 1%, and deepened and widened its capacity to finance banks using longer-term facilities. The quality of collateral for ECB lending was reduced. This means banks can roll over their maturing debts using ECB funding that has a three-year maturity.

However, ECB support for the debt markets of reforming eurozone economies was ruled out by ECB president Mario Draghi, as were loans to the IMF by the ECB that could be recycled to fund eurozone sovereign debts.

The new treaty or protocol is now the subject of eurozone – plus six other states, potentially nine – inter-government negotiation. Many of its measures will run into problems with national legislation; for example, automaticity of corrective mechanisms. It is not clear how the new treaty will be policed. Its effectiveness will not command credibility.

The EU agreed to lend €200 billion to the IMF for a special fund to help eurozone reforming economies. The sum is paltry compared with financing needs. Italy and Spain need about €1 trillion in gross financing through 2014 and €600 billion this year.

A further commitment was made to leverage up the European Financial Stability Facility, the EU’s emergency funding mechanism, into action. However, the EFSF guarantees of sovereign debt won’t be effective as: the percentage insured covered will be too low at 20% to 30% to cover default losses; the amount (€600 billion to €800 billion) of sovereign bonds covered will fall well short of the existing stock (€3.2 trillion) and issuance of Piigs debt (€1.2 trillion through 2014); and the quality of the EFSF credit default swaps is vulnerable to manipulation by participating governments.

European bank loans to emerging market regions
Source: IMF, Independent Strategy

At the summit, it was also agreed to bring forward the operation of the permanent European Stability Mechanism to June. But the ESM is no all-encompassing remedy, given that its resources of €500 billion are initially almost as unfunded as those of the temporary EFSF. So, there was not a whit of extra resources to fight the euro crisis.

Also, the European Banking Authority’s new stress tests for eurozone banks point to a huge increase in capital financing needs. Italy’s €15 trillion bank-financing needs could add 1% to the budget deficit and sovereign liabilities; Spain’s could add 1.7% of GDP and Portugal’s 4%. And these tests are understated due to inadequate allowance for economic stress and recession, and overestimation of the value of sovereign bond holdings. The figures could rise substantially if economic recession was to produce higher bank bad debts.

Without further measures, the euro will survive – but as a chronically weak currency. There will be failed sovereign bond auctions and credit-rating downgrades. Economic growth will fall below the level needed to achieve sovereign-debt sustainability.

So sovereign debt-to-GDP ratios will get worse in 2012. Germany will be sucked into the vortex of the eurozone crisis as the cost of resolving it will be seen as unaffordable for the Germans, and as banking problems spread to Landesbanken and Commerzbank.

Global risk assets, including emerging markets, will be hit by European recession (falling demand for their exports), European banks’ credit contraction and financial asset (CDS) contagion. European banks have provided 90% of foreign credit to emerging Europe, 63% to Latin America and 46% to Asia.

The euro, euro assets and global risk assets will head down without external funding from the Federal Reserve or the Bank of Japan, a Damascene conversion of Draghi, or a step-up in ECB purchases of sovereign debt.



David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com