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The Recurring Curse of the Euro
01/17/2012 8:00 am EST
Just when you think Europe has found a way out of its mess, a new twist emerges to derail the repairs. S&P’s debt downgrades are the latest example.
We’ve seen this plot before.
Everything seems peaceful after Carrie pulls her house down on herself and her mother, but the film ends with a dream of Carrie’s hand reaching out from her grave to grab Sue’s ankle.
Kyle Reese and Sarah Connor think they’ve killed the Terminator, but he emerges, reduced to a metal core, from the exploding gasoline tanker.
In “The Curse of the Euro,” Mario Draghi, president of the European Central Bank, proclaims on January 9 that the threat of the Euro debt crisis is receding and no longer threatens to sweep the Eurozone into chaos—only to have the crisis rise up from the grave a week later to threaten France, Italy, Spain, and indeed the entire Eurozone.
Only this time, the reality of the Euro crisis has topped the imaginations of Brian De Palma and James Cameron. In “The Curse of the Euro,” it’s not a solitary hand emerging from the grave or a single Terminator stalking out of the flames, but instead an escalation of all the dangers that have come before.
On January 13, Standard & Poor’s downgraded the credit rating of nine Eurozone countries (see my post on the S&P downgrade here). And Greece and its private creditors adjourned their meetings without an agreement that would prevent a Greek default in March.
And the European Central Bank warned that the proposed draft of the European fiscal-discipline treaty was dangerously weak. And the European Financial Stability Facility contemplated its own credit downgrade, which would leave it with even less money to rescue Greece, Portugal, and Ireland—let alone Italy, Spain and France.
Wow! And this story still isn’t over. But I think we can take a stab at writing a final ending.
The Many-Headed Problem
OK, here’s the story as we left it January 13.
By offering €489 billion ($616 billion) in new three-year loans to European banks in December, Draghi, the new kid in town, had restored peace to the Eurozone. Or so he announced on January 9.
Yields on the benchmark ten-year Spanish bond had fallen to near 5% and on Italian bonds to near 6.5%. Investors had new confidence in the euro and in the sovereign debt of Eurozone countries.
That sense of peace lingered through January 13, when it collapsed under assault from multiple directions.
Standard & Poor’s downgraded AAA-rated France and Austria to AA+, and put AAA-rated Luxembourg, Finland and the Netherlands on negative credit watch, a warning of an impending downgrade.
S&P also issued two-notch downgrades to Italy (now BBB+), Spain (now A) and Portugal (now BB). That pushed Portugal’s rating to the junk-bond level, territory already occupied by Greece (now rated C by S&P).
At virtually the same time, Greece and its private creditors adjourned their talks without reaching an agreement on how big a haircut the creditors would accept on the value of their holdings of Greek bonds, or what the yield would be on new bonds issued to replace current Greek bonds.
Half Off Isn’t Good Enough
In October, Eurozone leaders had put together a rescue package for Greece that was dependent on a voluntary 50% reduction in the value of Greek debt. That 50% figure has been left in the dust by the continued deterioration of Greek finances.
Now a 60% haircut seems like a minimum—and more would be desirable. But some private holders of Greek debt are balking at taking a bigger writedown, at least without a higher yield on the new bonds. The International Monetary Fund has said anything higher than 4% would make it impossible for Greece to stabilize its finances.
Greece will need to repay €14.4 billion in bonds in March. Without a new rescue fund payment from the European Union, the ECB, and the IMF, Greece won’t be able to make that payment. And without an agreement with creditors, those three institutions say they won’t cough up another euro.
That wasn’t the end of the news from Greece, though. It turns out that the average Greek doesn’t have much faith that this crisis will come out all right in the end, so money is fleeing the country’s banking system. In the past two years, Greeks have pulled about €65 billion, or about a third of total deposits.
The October rescue package included €30 billion to help recapitalize Greek banks. That’s now about €10 billion short of what’s needed, and the amount needed increases every day that uncertainty drives more deposits out of Greece.
This alone might be enough to make Draghi feel, like Carrie, that he’s been drenched with a bucket of pig’s blood at the prom. But there’s even more horror in the way these events fit together.
The Devil in the Downgrades
After the downgrades to Portugal, that country will need support from the European Financial Stability Facility, the Eurozone bailout fund. And after the downgrades to France, Italy, and Spain, investors will need more reassurance that the theoretical backstop to these countries, that same EFSF, will be there to help.
But any doubts about the adequacy of the facility before the January 13 downgrades (and there were many) have only grown more intense since.
Since the facility is structured as a set of guarantees from Eurozone countries, rather than as a pot of actual money, the amount of money that the facility can raise and the interest rate it has to pay to raise that money are very sensitive to the credit ratings of the Eurozone countries. The downgrades to Austria and France call into doubt about €180 billion ($227 billion) of guarantees to the facility from those two countries.
Before the downgrades, the facility had about €250 billion ($316 billion) left, after its support to Portugal and Ireland and its planned contribution to the Greek rescue plan, for backstopping Italy and Spain. That was terribly inadequate.
But with the January 13 downgrades, what was already terribly inadequate has become even more so. And the increasing size of the credibility gap between what would be needed to backstop Spain and Italy and what is actually available will put upward pressure on the bond yields for both those countries.
Two Key Players Show Their Hands
Now you can imagine two very different reactions by the parties that have the power to actually intervene in this crisis—the ECB and Germany—to the events of January 13.
One possibility would be for them to step up and say, “We’ll do more to put this crisis to an end.” The second possibility is for them to distance themselves and say, “We’ve done enough and don’t expect more.”
If you’ve been following this crisis, you know very well that only Possibility No. 2 would be in character with these two players.
On the same day that S&P announced its downgrades, the ECB voiced strong criticism of revisions to the draft of the fiscal-discipline treaty that outlined the Eurozone nations’ response to the crisis back in early December. The bank declared that the treaty revisions, which would allow heavily indebted countries to exceed budget deficit limits during an economic downturn, amounted to an escape clause that made it too easy to get around the rules.
The deficit limits, the central bank declared, should apply except in cases of natural disaster—and any country running a deficit above the limit of 0.5% of gross domestic product should be forced to bring it within limits by an unspecified automatic mechanism.
Germany’s reaction to the S&P downgrades was to emphasize that it would not raise its contribution to the EFSF; that the best solution to the limits of the facility would be to speed up the June timetable for getting into operation a permanent backstop fund, the €500 billion ($632 billion) European Stability Mechanism; and, finally, to press ahead with the fiscal-discipline treaty.
Next Steps Toward the Brink
What happens now? Either everything collapses quickly, or the Eurozone puts off collapse until June or so—at which point, the hand of “The Curse of the Euro Crisis” thrusts out of the grave again.
Avoiding collapse will require:
- Negotiators for the fiscal-discipline treaty putting together a draft in the next week to ten days, in time to make it ready for submission by an end-of-January deadline. And getting the treaty passed won’t be easy after that—opposition to its big transfer of budget power from national governments to the Eurozone bureaucracy in Brussels has been growing. But the failure to even get a draft to the table on schedule would be a huge defeat for Germany and the ECB.
- Greece and its private creditors reaching an agreement within the next month or so that will allow the IMF, the EU, and the ECB to approve the next tranche of rescue cash in time for Greece to meet its March bond repayments. The agreement will have to be voluntary, by the extremely loose standards of the International Swaps and Derivatives Association—otherwise it would trigger the insurance features of credit-default swaps, and bond owners who had bought swaps as insurance against a Greek default would be able to collect. That would be fine for those who had purchased such insurance, but expensive for those who had sold it. Since no one knows how positions would net out and which banks and other financial institutions might be on the hook for making those insurance payoffs, the result would be a period of intense uncertainty as the accountants tried to match the two ends of these deals.
- The ECB stepping up its buying of Italian and Spanish bonds, to prevent yields from climbing back near the 7% level that spooks financial markets. Spain and Italy face very large net refinancing in February.
- Investors buying the EFSF bonds at only modestly higher yields.
- The markets greeting the three-year ECB debt offering in February with the same sense of relief that greeted the December offering. European banks are likely to add to the €489 billion they borrowed from the central bank in December. That month, investors decided this was a good thing since it added needed liquidity to the banking system and removed fears of a liquidity crunch. In February, investors will need to look past evidence that banks are borrowing and then quickly re-depositing the cash with the ECB. Some might see that as a sign of how weak the Eurozone economies are and how afraid banks are. That attitude can’t become general, or the central bank’s efforts will become a negative rather than a plus.
If all these things go right, the Eurozone will reach the end of January without a crisis, and might well finish the month with a sense of momentum and optimism. Look at all we’ve achieved, players like Draghi and Germany’s Angela Merkel will say. The Euro debt crisis might once again look as if it was headed to an ending.
Even the Rosiest Scenario has Thorns
The problem is that this best-case scenario doesn’t actually defeat the Euro debt crisis. Consider what will remain ready to resurface.
Deposits will continue to flow out of Greece, and the Greek banking industry will require at least an additional €10 billion of recapitalization above what was in the October rescue deal.
As the economy of Greece sinks further into recession, I’d estimate that by April, investors will see another round of projections from the IMF saying that whatever the deal struck by Greece and its creditors in January, it wasn’t sufficient to put Greece on the path to sustainable debt.
Italy and Spain will face a similar problem to that of Greece: As their economies shrink under the impact of recession, they will be forced to find even more budget cuts in order to retain even a pretense of meeting the budget deficit limits promised to the ECB.
The cuts are a necessity if financial markets are to be persuaded to keep lending to Italy and Spain. But the problem of budget cuts further slowing economies that are already slowing will become acute as the recession drags on and worsens.
The election schedule might be the trigger for the next stage in the Euro crisis. Greece now looks likely to hold elections in April, rather than February, but the current caretaker government looks no more likely to win in a later contest. The likely winner, the New Democracy Party, would be less committed to pushing austerity reforms than the current government.
There’s a good chance that New Democracy would renege on promised reforms or refuse to meet new demands from Greece’s rescuers. The odds are high that one side or the other would walk away after the March refinancing is done.
And then, of course, there’s France, where the S&P downgrade of the country’s AAA credit rating has done nothing to improve the electoral prospects of President Nicolas Sarkozy.
The most likely winner in the elections that begin in April is Socialist François Hollande, who is running against the current French-German policies on the euro debt crisis. (For more on the way voting in France could change the politics of the euro, see my column.)
In other words, as early as March but probably before June, the leaders of the Eurozone are likely to be facing the Euro debt crisis again—and this time, the discussion would center on a Greek default, the departure of Greece (and possibly other countries) from the euro, and the shape (who’s in and who’s out) of a reconstituted Eurozone/EU.
Investors could well see a period of calm in late January and into February. But it won’t be time to relax. I think “The Curse of the Euro” still has a few more plot twists to throw at us.
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