Expect Neither ‘Sustainable’ nor ‘Comprehensive’ From Euro Area Leaders
On Sunday, Merkel and Sarkozy promised a “sustainable and comprehensive” solution to the euro debt crisis ahead of the November 3-4 G20 meeting. Along with this rather grand announcement are absolutely no details on their plan. However, Van Rompuy today pushed back the European Summit, which convenes now on October 23, to ‘finalise our comprehensive strategy on the Euro area sovereign debt criris’. Perhaps a real plan is in the works. I think not.
In the back of my mind, I have 5 necessary conditions that must be satisfied in order to achieve a ‘comprehensive and sustainable’ policy response to the Euro area debt crisis. None of these conditions will be satisfied in full, critical conditions not even partially (namely 3. and 4. below). I can only conclude that any response/strategy negotiated at the October Summit will be neither ‘comprehensive’ nor ‘sustainable’.
The 5 elements of a resolution to the European debt crisis:
- Element 1. There’s too much debt, and it must be written down. Banks are exposed to insolvent governments and defaults from a decade of leverage built in the private sector (Spain, Ireland, and Portugal). Europe is at just the initial stages of this process.
Expectation for October 23rd: Partial response. This may be partially addressed if they include significant haircuts to Greece’s debt as part of the bank recapitalization effort. However, there are no details as to how the bank recapitalization efforts will transpire (except for the elusive word ‘comprehensive’). And if they address Greece restructuring only, then we’ll likely be here again in coming quarters – Europe is a few years behind the US in their deleveraging cycle.
Furthermore, unless the bank recapitalization effort is done by some pan-euro body and ALL banks are forced to take capital jointly (not unlike TARP), I view any lesser, nationalistic effort, as a net-negative for medium-term market sentiment. Another positive response, in my view, would be a joint guarantee of bank deposits, which would require coordination at the supranational level. Full coordination would be welcome but is unlikely.
- Element 2. Near-term liquidity needs to be provided to those sovereigns/banks that are solvent but face funding pressures. The ECB has addressed the funding pressure for the near term and is likely to continue to do so.
Expectation for October 23rd: Partial response. This is only a partial response because the ECB has already sufficiently addressed fixed term liquidity operations. Currently, European banks hold about €200 billion in excess reserves (7-day average), up from roughly €25 billion spanning the bulk of 2011, and unlimited FX funding is available through March of 2012. The ECB continues to purchase Italian and Spanish bonds on the secondary market through its SMP in support of two arguably solvent sovereigns.
Notably, though, there’s still a large hole in the capacity of the EFSF to do it all: recapitalize the banking systems, provide emergency lending to national governments, and backstop Spain and Italy. Addressing the insufficiencies of the EFSF, either as a structure and/or a policy response-tool (or the permanent ESM counterpart), would entail a full response. However, I expect nothing to be announced regarding the capacity of the EFSF to address all efforts. An announcement that does alleviate the capacity problem of the EFSF would be a net-positive.
- Element 3. A move toward more fiscal interconnectedness should be more decisively established, including a fiscal ‘lender of last resort’. This function may be performed by ECB, but presumably a fiscal institution should act in this role.
Expectation for October 23rd: No response. In fact, this is the part of the ‘comprehensive solution’ that will likely require an acute worsening of economic and financial conditions (interrelated).’
- Element 4. Switch to 1st gear in the drive for fiscal austerity and competitiveness. True, some countries could benefit greatly from reform, which buffets long-term growth potential. However, fiscal and institutional reform to increase competitiveness takes years to pass through to potential growth, and the timeline needs to be extended.
Expectation for October 23rd: No response. This is the most challenging piece of a comprehensive solution. Martin Wolf calls it fostering a ‘credible adjustment’ of the flows (i.e., macroeconomic imbalances). Under a credible Euro-area adjustment plan, reform from ALL parties involved, rather than just by the weaker nations, must be implemented. Until Germany and the core ‘exporters’ (all of the core countries except for France run current account surpluses) institute reform alongside the weaker debtor countries, adjustment has no hope.
- Element 5. Macroprudential policies and new infrastructure needs to be erected in order to address and enforce macroeconomic Treaty rules.
Expectation for October 23rd: Wildcard, but probably nothing substantial. This would require (probably) amendments to EU Treaties and/or mandates for current institutions (like the EBA or the ECB).
In conclusion, markets may be making a mountain out of what is likely to be a molehill response to the current crisis, one that’s neither ‘comprehensive’ nor ‘sustainable’. If, however, we do get some response by way of required actions 3 or 4, that would be a great leap forward for the sustainability of the Euro area.
originally published at The Wilder View