It is our view that in the long run a European currency union cannot survive without a complementary fiscal union.
The euro flourished over the pre-GFC decade due to an excessive build-up in debt in the European region. Cheap credit fuelled real estate bubbles; consumer spending booms; fiscal profligacy; and lack of necessary structural reform.
Only Germany, in the region, embraced reform during that period and that has now resulted in a wide disparity in productivity and competitiveness between Germany and the rest of the region. The Global Financial Crisis exposed the excessive debt levels in the European periphery and the private sector in the region is now going through an inevitable and painful deleveraging process.
In addition, to restore competitiveness the usual mechanism of competitive devaluation is not available to the periphery, so painful internal devaluation (including wage cuts) is the only path towards improved competitiveness. The urgency for Germany to embrace structural reform during that period was brought about by the excessive build-up of sovereign debt during the 1990s as it dealt with reunification. The austerity required to close competitive gaps and deal with excessive debt in the periphery will be too painful and eventually lead to both social chaos and a very messy demise of the euro unless the region adopts a fiscal union.
That will require substantial fiscal transfers from Germany to the periphery. In return, the periphery will have to adopt major structural reform and transfer significant effective power to 'the centre'.
Unfortunately for them, 'the centre' is likely to be dominated by Germany. Another dimension of the problem is the fervour with which banks are embracing Basel III, which requires European banks to achieve a nine per cent tier 1 capital ratio. Banks have committed to setting out plans to achieve these targets by mid-2012 in order to assuage concerns about their solvency. With new capital being too expensive, banks will only really be able to achieve that objective by shrinking their balance sheets (in effect – a credit crunch).
The combination of austerity; private sector deleveraging; a credit crunch; painful but necessary structural reform and no flexibility on the exchange rate poses severe challenges to the near term growth outlook for the periphery. Westpac is forecasting that the European economy will experience a recession in 2012, contracting by one per cent. Growth is required to manage the sovereign debt problem.
Sovereigns need to borrow at rates below the rate of nominal income growth to stabilise their debt to income ratio. In the absence of fiscal surpluses, low growth rates require even lower funding costs for debt stability. However, markets are aware of the €1.4 trillion which European governments will be required to borrow in 2012 to cover maturing debt and accumulating budget deficits. In late 2011 the rates at which Italy/Spain/France borrowed in the bond market were the key drivers of global market sentiment.
With long-term Italian and Spanish bond rates in the six to seven per cent range (3-4 percentage points above nominal income growth) and fiscal deficits accumulating, markets watched the debt positions of these countries deteriorate. Consequently, with growth certain to stall under the weight of the austerity/deleverage/credit crunch/restructuring forces, borrowing rates need to be contained. Periphery countries have an additional dimension to their funding challenges.
In Japan, the US and UK we saw that countries with large funding tasks and suffering recession at least benefitted from falling bond rates as their domestic investors were forced to buy bonds. In Europe, domestic investors in the periphery are able to buy German bonds without incurring a currency risk, exacerbating the periphery's limited access to funding.
Initiatives with the EFSF (a fund which is designed to issue its own bonds and reinvest in periphery bonds) have stalled with the fund being downgraded due to the multiple downgrades of the European countries (excluding Germany) which guarantee the fund's bonds. The EFSF has only actually borrowed around €5 billion at this stage. German fears of the inflationary risks associated with "printing money", conditions which are embedded in the Maastricht Treaty, restrict the European Central Bank from purchasing sovereign bonds on a non-sterilised basis (the style of Quantitative Easing which the US Federal Reserve, the Bank of England and the Bank of Japan have adopted). In other words, if the ECB purchases a sovereign bond in the market it must offset it by issuing another security.
The biggest short-term threat to the stability of the euro is the assessment by the market that the sovereign debt problem for the periphery is spiralling out of control. The key signal will be if the funding costs of the new issuance significantly exceed nominal GDP growth
A major relief in this regard has been the introduction in December of the long term refinancing operation. In that operation the ECB offered unlimited three-year funding to banks against an expanded list of collateral (which includes peripheral sovereign bonds). The offer was taken up by 523 banks for €493 billion. This facility has allowed the ECB to support the sovereign bond market without breaching Maastricht, with banks now bidding in bond tenders for short-term maturities and funding them with the ECB at around one per cent.
This initiative has allowed considerable relief, particularly at the short end of the yield curve. For example, secondary market yields for six-month Italian debt have come down from 6.5 per cent in November last year to 2.2 per cent. Even in the five years there has been some discernible improvement – down from 7.5 per cent in November to five per cent in current markets; 10 years down from 7.2 per cent to 6.2 per cent compared to 4.8 per cent at the beginning of 2011. Conditions for Spanish bonds have also improved. Six month bond rates are down from two per cent in November to 1.2 per cent today, with five year rates down from six per cent to four per cent.
Clearly, banks will be much less willing to purchase long-term paper due to the default risks which of course become greater as the maturity of the bond increases. For example, if a bank purchased a five year Italian bond at, say five per cent, and funded it through the LTRO facility it could repo it for one per cent for three years, but would still be required to repurchase the bond after three years with two more years to maturity – by then, as we are seeing with Greek bonds, the two-year Italian bond might be trading at a huge discount with the four per cent per annum carry trade advantage being insufficient compensation.
Nevertheless, market pricing suggests that some banks are being attracted to the 12 per cent (three times four per cent) carry profit. Another LTRO is scheduled for February, providing further general relief for bank funding and specific assistance for short term sovereign debt in particular. However, sovereigns will not be able to rely on only short-term issuance. Liability maturity structures need to be risk managed.
In our view the LTRO facility needs to be complemented by a genuine Quantitative Easing initiative from the ECB where it buys sovereign debt, unsterilised, on a full term to maturity basis
The emergence of a huge new investor in that market would quickly bring down yields and buy the market considerable time to address the key issue of a full-scale fiscal union, including structural reform, which will be "growth negative" in the short-term, but "growth positive" over the long term (as we have seen with Germany which introduced painful structural reform in the first years of the current century).
It is not clear how long QE from the ECB could be sustained to buy time for the fiscal union. The ECB's balance sheet (€2.7 trillion) is already around 30 per cent of European GDP compared with the Fed's balance sheet of 20 per cent of GDP and the Bank of Japan's 30 per cent.
The risk of ongoing expansion of the central bank's balance sheet comes from the eventual recovery in the money multiplier and a take-off of inflation. There is little risk of that as growth in the European region (with deleveraging; austerity; and credit crunch) is already in negative territory. Output gaps are already widening and inflation risks are receding. The deleveraging process has years to run in Europe and the size of the ECB's balance sheet should not pose a threat to inflation. The Germans, who are the major hurdle to the ECB adopting QE, should look at the inflation records of US and Japan, who have adopted QE with no threat from rising inflation.
Other issues such as credit concerns with the ECB itself (negative mark to market of its portfolio of periphery bonds might overwhelm actual capital base although the present value of the profits of the monopoly of providing central banking services should also be taken into account) and the expected difficulty in shrinking the balance sheet at the appropriate time, should not affect current decisions.
Nevertheless, these issues are likely to constrain the pace at which the balance sheet will be allowed to expand. However, we believe that is the only viable solution to keep the euro in place during the transition period to full fiscal union.
Without that fiscal union, in the long term, the currency union will eventually fail
However, the barriers to establishing a functioning fiscal union are huge. Germany would have to sign up for necessary fiscal transfers; the peripherals would have to effectively abrogate sovereignty on most fiscal matters (e.g. retirement ages, tax rates, industry policy, health care policy etc); and Germany would have to pay more to borrow given that each member of the union would borrow through a single "Euro bond" where rates would be significantly higher than the Bund rate.
For the periphery, such an arrangement is probably by far the most efficient route to genuine structural reform – the restoration of growth through competitive devaluation will not be as easy as it was in the 1990's since it will be occurring in an environment of deleveraging by the private sector and a credit crunch
Progress towards the fiscal union is going to need a total change of mindset. Policies need to be adopted which will encourage growth – structural change is required. Germany's current position seems to be a balancing act of withholding fiscal support to emphasise the need to avoid moral hazard (easy bail out of offenders) against recognition that, at some stage, it will have to act.
The fiscal pact, which was adopted in December, was limited to austerity and deficit rules – no initiatives to foster growth and in due course, is certain to require some growth-enhancing amendments.
Considerable attention is also required for the banking system. The implementation of Basel III needs to be delayed to avoid a credit crunch; adequate funding from the ECB is not sufficient to spur the banks to support growth if they are focussed on shedding assets for regulatory reasons. There is also the lack of confidence which banks have in lending to each other with the preference being for the ECB to ‘wash’ the credit risk. €493 billion is held on deposit by banks with the ECB.
Only growth (and therefore improved risk environment) will restore banks' confidence in other banks
We have seen in Japan and the US that banks are unlikely to expand their lending, despite adequate liquidity from the central bank, if there is no confidence. That will only be restored with improving economic growth which in turn must evolve from structural reform and an easing in austerity measures. Results will be slow, inevitably because of the ongoing deleveraging process, but this appears to be the only answer for an ‘unlucky’ Europe which has been unfortunate enough to be faced with this currency crisis just as the great debt super cycle has come to an end.
Bill Evans is Westpac’s chief economist