A QE taper trap for southern Europe

If Citigroup’s Willem Buiter right, once German elections and the Fed’s QE tapering are underway then Europe will face another wave of debt restructuring and potentially its toughest test yet.

There are a couple of major flashpoints nearing within the global economy with significant implications for financial markets.

The one that has grabbed most attention is the on-again, off-again discussion about the tapering of the US Federal Reserve’s quantitative easing program. Every time Ben Bernanke refers to tapering the markets gyrate.

The other, which may or may not coincide with the beginning of the US taper, is the September 22 federal election in Germany. There is a sense in Europe that once this is over and done, the task of restructuring the eurozone’s more troubled economies can finally get underway.

Citigroup’s renowned global chief economist, Willem Buiter, who is in Australia this week, believes the taper of the US stimulus program – which has involved $US85 billion ($94.275 billion) a month of bond and mortgage purchases by the Fed – could begin in September, as the QE3 program is now having very little impact on demand. To be effective, he argues, the Fed would need to switch its focus from government bonds and high-quality mortgages to riskier and less liquid assets.

In any event, while he says the risks in the taper lie on the “delay side” and the potential for lower employment and economic growth, he’s quite optimistic about the US economy. As he says, the US is managing nearly two per cent growth in GDP, even though it has experienced fiscal tightening that has also subtracted about two per cent from growth.

But the prospect of an improving US economy and the gradual withdrawal of the Fed’s interventions isn’t all good news for the rest of the world. As the tapering develops, US long rates will rise – as will the US dollar, which Buiter says will inflict pain on the emerging market economies.

He’s not optimistic about Europe, and is foreshadowing a major round of sovereign debt and unsecured bank debt restructuring within the more troubled economies of southern Europe once the German election is out of the way.

He says – perhaps with his tongue in cheek – that the day after the election Greece will ask its lenders for a haircut on its debt, and that Portugal and Ireland won’t be far behind. Cyprus too will need another round of haircuts because the authorities “got their maths wrong”, and he also queries whether Italy and Spain are safe.

The financial interconnectedness of governments and banks in Europe means that a restructuring of sovereign debt in southern Europe will necessitate painful recapitalisations of banks.

He thinks Europe’s banks could be about $1.5 trillion short of the capital they will require. Inevitably that means massive bailouts for both the governments and the banks, involving significant pain for both European taxpayers and private holders of the debt, and he believes the risks in Europe are under-priced.

While it is obvious that the eurozone needs some very substantial structural reforms of both sovereign and bank finances, it isn’t as clear that it has either the will or the capacity to manage them. Five years after the crisis erupted, it certainly has yet to do anything meaningful.

The European Central Bank takes over responsibility for supervising the eurozone’s banks from the middle of next year and is conducting what is expected to be a far more rigorous round of ‘stress tests’ than those previously overseen by the European Banking Authority. That transfer of oversight is part of the package of ‘banking union’ policies eurozone authorities have agreed to.

The outcome of the stress tests and the ECB’s even greater role within the eurozone could be the catalyst for a serious attempt to recapitalise the banks, with a painful and expensive combination of ‘bail-ins’ and ‘bailouts’.

The timing and path of the tapering of the Fed’s QE3 program has obvious implications for global financial markets and some adverse implications for other economies, but a recovering US is undoubtedly good news for the rest of the world.

The beginning of a belated attempt to address the structural fissures within the eurozone economies and the European banking system, however, would represent a potentially dangerous – and inevitably unpleasant – moment for Europe, and one with potentially wider implications for the global economy.

The rest of the world, of course, has had plenty of time to distance itself from the financial fallout of a restructuring of Europe’s sovereign and bank debt.