On Wednesday, news circulated of a letter to European Council president Charles Michel signed by the prime ministers or presidents of nine European countries. These include France’s Emmanuel Macron, Italy’s Giuseppe Conte, Spain’s Pedro Sánchez and the prime ministers of Belgium, Greece, Ireland, Luxembourg, Portugal and Slovenia.
The letter calls for the activation of all existing common fiscal instruments to support national efforts to sustain economies in the face of the coronavirus.
“In particular, we need to work on a common debt instrument issued by a European institution to raise funds on the market on the same basis and to the benefits of all Member States, thus ensuring stable long term financing for the policies required to counter the damages caused by this pandemic.”
The financial world is moving like a film on fast-forward. We have seen movies a bit like it before. But this one is different.
After the collapse of Lehman Brothers in 2008, the cost of bailing out banks, the loss of tax revenue and soaring social costs of large-scale unemployment eventually led to a euro-area sovereign debt crisis in 2011 and to former European Central Bank president Mario Draghi’s famous “whatever it takes” proclamation.
This time, we got to worrying about sovereign debt within a month. All governments are now closing down their economies while issuing state guarantees through banks to keep households and businesses solvent.
Failure to do so risks severe recession becoming depression and social breakdown.
Sovereign debt sustainability
Sovereign states are on the hook. Their debts will rise, and the big worry is that if they fumble their efforts to sustain economies through the lockdowns, GDP may fall goodness knows how far.
In that event, debt-to-GDP ratios are going to look horrible and ultimately raise concerns – even if ECB buying keeps a lid on debt service costs for now – about sovereign debt sustainability.
Back at the start of this week, economists at Societe Generale were wondering if the crisis might at some point shift the German government to even contemplate issuing common Eurobonds.
They noted that chancellor Angela Merkel had not flatly rejected suggestions to leverage up European institutions such as the European Investment Bank (EIB) or the European Stability Mechanism (ESM) by issuing so-called coronabonds, albeit pointing to the legal obstacles and limited political appetite for such measures in her own country.
“Moreover, a number of other smaller northern countries remain firmly opposed to increased risk sharing," they added. "Likely, the crisis would need to transform into an existential threat to the euro area for Germany to be forced to decide which way it would want to go”.
That existential crisis may already be upon us.
We are in a new world today. And this either accelerates the move toward more Europe, or Europe eventually breaks up- Bank source
Euromoney speaks to the leader of one large bank who is in doubt.
“Europe needs to come together now for unified action and to do so quickly,” says the leader. “There has been a relaxation of some budget deficit rules, but beyond those first steps it now needs to ensure different countries can fund themselves, whether that be through joint coronabonds, borrowing without conditions or stigma from the ESM or unlimited bond buying from the ECB.”
This source says: “We are in a new world today. And this either accelerates the move toward more Europe, or Europe eventually breaks up.”
Other senior bankers Euromoney speaks to are looking at potential execution gaps in the implementation of the state-support programmes now being rushed through various legislatures. They see a need for greater coordination on the design of these across different countries.
The two most important questions are on the structure and extent of guarantees.
To ensure banks retain the capacity to keep credit flowing, these must be first-loss guarantees to ensure that, for example, a subsidized loan to a B-rated small and medium-sized enterprise that might normally attract a 200% risk capital weight attracts instead the zero-risk weight of the sovereign when the loan is first made.
Writing in the Financial Times this week, Draghi appeared to question the conventional language of loans and debt service even being applied to what might well turn out to be grants of public money to SMEs. These loans, he suggests, are going to be written off.
Bankers agree that it is almost impossible to conduct conventional credit underwriting in these circumstances and say that if loans meant to prevent lay-offs during a period of no income subsequently suffer severe credit deterioration, as seems likely, they must not then go into their non-performing loan buckets.
Some even suggest use of 100% state guarantees, but, for now, there seems to be a consensus that 80% or perhaps 90% guarantees are an understandable way to contain moral hazard.
A third question is whether or not European states can agree a consistent size of state support programmes, though the question here becomes whether that should be a simple calculation of size relative to GDP or if it should also take account of the structure of different economies and the relative dependence on large corporations, which may sustain themselves through the capital markets supported by the ECB's buying of corporate bonds.
Economies where SMEs make up a higher proportion of GDP and of employment are more funded through banks, and so may need larger loan guarantee support programmes.
Bankers and policymakers are already thinking about what state their economies will be in once we are all through this. When a fire first breaks out, the natural reaction of any householder is to turn the hose on his own house. But the time may quickly come to turn it on the rest of the street as a means of self-preservation.
It may sound like a side issue right now, but if governments with bigger hoses do a better job of saving their own companies so that they are in a position to dominate the continent in years to come, that will cause deep national resentments.
In a crisis, urgent decisive action, sometimes ignoring standard processes, is vitally important. So too is symbolism.
Think of Jack Ma and his airlift of face masks to the US. Think too of the widespread reports of Germany dragging its feet over sending facemasks to Italy, then suffering the worst outbreak at the start of March.
There were many presidents and prime ministers who did not sign the joint letter, but the ones that count most are Germany, the Netherlands and Austria.
As another banker tells Euromoney: “This is about leadership.”