WEEKEND ECONOMIST: Europe's dark clouds
The mood in Europe is one of great uncertainty, but three issues stand out: Spanish banks, Italian sovereign debt, and government austerity packages.
There are some clear facts. Greece has its own dedicated fund of €110 billion (€80 billion from European entities, €30 billion from the IMF). That fund is assessed to be sufficient for Greece not to have to tap the market for three years, either for new lending or for refinancing. Tough austerity conditions are attached to the availability of the funds.
The second 'fund' is a stabilisation fund for any other Euro zone country which runs into financing difficulties. That €750 billion, made up of €60 billion from EU guarantees; €440 billion from a special purpose vehicle (SPV) which is backed by the 16 EU members plus Sweden and Poland; and €250 billion from the IMF. The SPV will fund itself by issuing its own debt. It has not yet begun the process of issuing its own AAA debt (each government guarantees 120 per cent of its share in the scheme). It has not therefore begun lending directly to countries for purchasing their debt.
The political hurdles to establish the SPV appear to have been overcome with both Germany and France getting approval from their parliaments. Once 90 per cent of the parliaments have approved the guarantees the vehicle can start functioning (around 75 per cent believed to be there so far). In the meantime, the only official support for other troubled countries (apart from Greece) comes from the ECB.
The ECB is not showing the clear structured approach which we saw from the US Fed in 2008 when it set about expanding its balance sheet. The ECB's actions are also not clearly signalled to the market. It is not clear when troubled issuers, such as Spain or Portugal, go to the market whether the buyers are the ECB, indirectly through the secondary market, or fund managers/banks who are attracted to the record wide spreads. One contact, for instance, assessed that the ECB had lent €70 billion to Spain in May and €90 billion in June in short dated liquidity. Up until Thursday evening (June 17), when Spain sold a batch of 3s and 10s, the only successful raisings by the Iberians have been short dated.
Our meetings naturally covered a wide range of issues. In Germany, the view from most of the visits was that the European Club would do whatever was necessary to hold the Euro together in the current form. It was considered unthinkable that the Euro would have to be restructured after 60 years of progress for the Club. However, one strong doubter noted that Ms Merkel was already plummeting in the polls. There is an important election for the German Presidency on June 30 that would see Merkel's preferred candidates defeated and a possible dissolution of the ruling Coalition. His key thesis was that the German taxpayer would not accept the constant subsidisation of southern Europe just to keep a failed financial union together.
The view in France was also that the union would hold together due to the strong collective commitment. Naturally the views in London were more hard-headed. Some were doing their macro analysis and deciding what markets were acceptable – Ireland and Italy seem to get support. But these investors were opposed to those cases where issues were opaque or, like Greece, there appears to be little hope of achieving the fiscal results required to ensure ongoing support for their finances.
Other fund managers were attracted to the current wide spreads being offered by Portugal and Spain, arguing that the SPV and the ECB would ensure full capital at maturity while the carry was extremely attractive. Most were overwhelmed by the uncertainty.
Investors voiced disapproval of the lack of transparency from the ECB and the failure of the European authorities to release the results of the stress testing of the banks. At best, it seems that a reluctant ECB is playing a holding operation until the SPV is up and running. There is no clear plan to permanently support liquidity through quantitative easing. The issue is still shrouded with political difficulty. Clearly the German and French governments have to sell their commitment to the SPV on the basis that a country's access would be tied to fundamental reform and rapid progress towards fiscal stability.
If a country lost market support and failed to quality for the SPV's support then it would surely find it almost impossible to refinance and issue new debt. It also appears that the SPV will only be available for sovereign borrowers. Spain's problems hinge around private sector debt, specifically the ability of the banks to finance and refinance their ongoing commitments. The only solution offered here appears to be the ECB permanently supporting bank issuance.
That is not considered to be viable. The funds available from the SPV and stabilisation fund would be sufficient to cover new issuance and refinancing for Spain and Portugal's sovereign commitments for three years. However, if Spain's government is required to refinance its troubled banks and issue paper to finance those activities the open ended nature of that activity may threaten the capacity of even the SPV and the other associated funds.
While the German attitude was one solidly behind the maintenance of the status quo, the discipline of the ECB was considered an even more important condition. There should be no slippage in the ECB towards higher inflation and the balance sheet should not be expanded to accommodate an easier monetary policy.
As we know, markets detest uncertainty. The key issues of uncertainty appear to be:
• Can Greece satisfy the macro-economic conditions to allow continuous access to the stability fund?
• Will Spain and Portugal be able to convince the European authorities that they can adopt sufficient restructuring and discipline to access the SPV?
• How will the new issuer, the SPV, affect market conditions?
• Would Spain's government commitment to refinancing/recapitalising its banks require even more funds than are currently available for the SPV and stabilisation fund?
• If the establishment of the SPV is delayed will the ECB be prepared to substantially expand its balance sheet?
• Will market instability spill over to Italy in which case the SPV will be utterly insufficient?
• Germany's commitment to low inflation seems even stronger than its commitment to European unity. Might it choose to leave the union if the ECB is forced into a bloated balance sheet should other refinancing alternatives fail?
• How will markets stabilise when there is so much uncertainty about funding Spain and Portugal?
• Can these countries realistically achieve the macro-economic conditions through "internal devaluation", i.e. become more competitive by cutting prices? Without the obvious flexibility afforded by autonomous monetary policy and currency regimes this seems a very difficult stretch.
• With the ECB remaining cautious, how will the private sectors of the troubled economies finance their debt?
Others who are true experts on Europe may have solutions to some of these problems. For myself, the key to a permanent resolution to these worries are:
• New currencies for Greece, Spain, and Portugal;
• Restructuring of debt, both public and private; and
• Clarity around bank balance sheets.
All this may take years to be reached. In the mean time, Spanish banks, Italian sovereign debt, and government austerity packages bear the closest need for attention.
Bill Evans is chief economist at Westpac.