Europe economy: In with the kitchen sink


Global stockmarkets, the euro currency and government bonds of fiscally weak euro area countries have rallied strongly in response to the latest emergency rescue package unveiled by European policymakers on May 10th, which over time could amount to a colossal €750bn (US$960bn). The stabilisation programme, comprising state-backed loan guarantees, additional IMF funding and unprecedented moves by the European Central Bank to implement quantitative easing via the purchase of government debt, is likely to be successful in resolving near-term liquidity concerns and dampening contagion pressures. The financial sector will certainly welcome another bailout deal, but the self-rescue package does little to address the underlying solvency position of a growing number of euro area countries.

Another week, another bailout, only this time on a scale far beyond any previous “rescue” effort. On the morning of May 10th European governments announced a daring €750bn (US$960bn; £650bn) package of emergency measures aimed at stabilising global financial markets that had become increasingly panicked by escalating fears of sovereign debt contagion. Just days after the euro area and IMF unveiled a massive €110bn rescue plan to address Greece’s spiralling debt crisis, European policymakers were forced to intervene once again in order to prevent a potential meltdown of the region’s financial sector.

The “stabilisation plan” reflects a co-ordinated response from the EU, the IMF, the European Commission and the European Central Bank (ECB). The main elements are:

  • a three-year emergency funding facility for struggling euro area countries comprising state-backed loan guarantees and bilateral loans worth up to €440bn, to be provided by euro area governments via a newly-created off-balance sheet special purpose vehicle (SPV). As with the Greek bailout, countries will provide credit guarantees to the scheme in line with their share of capital of the ECB, making Germany and France the largest contributors. Interest rates on loans are expected to be around 5%. Implementation of the scheme could face delays, with most countries having to obtain parliamentary approval;
  • the expansion of an existing balance-of-payments facility by €60bn (raising the total to €110bn), with the backing of all EU countries. This will come into effect immediately and will be based on Article 122.2 of the EU treaty, which allows for financial support for governments during “exceptional circumstances”, thus circumventing the euro area’s no-bailout principle. The European Commission will raise the money from capital markets using the EU budget as collateral. Use of the facility by euro area members will be in return for conditions set by the IMF;
  • additional IMF funding of up to €250bn, with €220bn to be made available for the emergency funding facility and €30bn for the balance-of-payments facility;
  • an historic decision by the ECB to purchase euro area government bonds and private-sector assets in secondary markets (contrary to firm denials just a week ago). This is a form of quantitative easing, although it differs from the bond-buying deployed in the UK, US and Japan due to the fact that the ECB plans to “sterilise” its debt purchases (for every bond that it buys, it will sell other securities back into the market to remove the additional liquidity it has created—the monetary base should remain unchanged);
  • reactivation by the ECB of its exceptional liquidity-boosting operations, offering unlimited short-term fixed-rate refinancing to the region’s banking sector (aimed at addressing recent signs that increased risk aversion was discouraging interbank lending and thus tightening liquidity); and
  • agreement by the US Federal Reserve (central bank), the ECB, the Bank of England, the Swiss National Bank and the Bank of Canada to reactivate US dollar swap facilities with respective domestic currencies in an effort to ease euro area tensions within the dollar interbank market.

Described by some observers as a “shock and awe” announcement, global financial markets rallied strongly in response to the bailout package as they opened on Monday morning. Driven by European financials, equities rose sharply (not least in Greece, Spainand Portugal), more than reversing last week’s losses, while the euro currency strengthened against the dollar, sterling and the Japanese yen.

Government bonds of fiscally weak euro area countries recorded unprecedented gains, driving yields markedly lower. Greek 10-year bonds made their strongest ever daily advance, with yields falling by more than 500 basis points, while yields on two-year Greek government bonds fell by more than 1,000 basis points, as investors reassessed prospects for future debt restructuring in light of the financing package and, perhaps more importantly, the ECB’s decision to begin purchasing peripheral euro area government debt. As a sign of returning risk appetite, yields of safe-haven US and German bonds climbed to their highest level in six months, as investors turned their attention to higher-yielding assets.

Buying time

After months of head-in-the-sand bluster and prevarication, often interspersed with blind optimism, the magnitude of the emergency package suggests that European policymakers have finally recognised that their oft-repeated “whatever it takes” strategy has to be backed up with a credible framework (in terms of scale and intent). As well as demonstrating an impressive degree of solidarity, both within the euro area and with the IMF (whose financial role in supporting the future of the euro area is getting larger by the day), the depth and breadth of the backstop measures announced should, if nothing else, bring national governments a degree of breathing space over the coming months, as many prepare the ground to implement painful fiscal consolidation measures. Both the Spanish and Portuguese governments announced on May 10th that they planned to accelerate their deficit-reduction programmes, although neither offered any details of how this would be achieved.

The large emergency funding facility and the ECB’s new-found willingness to purchase government debt should significantly reduce the likelihood, as occurred with Greece, of countries being effectively closed off from the capital markets, at least for the next year or so. The total funding requirement for all 16 euro area counties’ government bonds is estimated at around €550bn for the rest of 2010. The countries most at risk of encountering near-term financing problems (in addition to Greece) are Portugal, Spain and Ireland, and with the announcement of the latest rescue deal there now appears to be sufficient scope (and political willingness) to provide a temporary support programme similar to that offered to Greece, should one be needed—with the caveat that if Spain or Italy lost the confidence of investors to honour their debts, such support probably wouldn’t be sufficient to last that long. Moreover, liquidity can now be expected to continue to flow around the region’s banking sector, helping to keep a lid on funding costs and avoid any incipient runs on deposit institutions.

Crisis postponed

The dramatic bailout package may have provided an immediate boost for financial markets, but with policy now in wholly uncharted waters, many questions still remain unanswered. On the one hand there are the institutional implications—what it could mean for greater fiscal union across the euro area, how deep a role is likely to be played by the IMF in enforcing fiscal adjustment, and the extent to which the independence of the ECB is being politicised—while on the other hand there is also huge uncertainty over how the plans will operate in practice. Will the stabilisation mechanism actually be approved by all euro area members? How quickly can the €440bn SPV become operational? Would Ireland(having already implemented hugely painful austerity measures) really be willing to contribute to bail out countries such as Portugal or Spain? How much government debt of fiscally weak countries will the ECB purchase? And if prices of these lower-quality bonds fail to recover and/or restructuring of countries’ debt is forced by the markets, will the rest of the euro area be in a position to meet the costs of the scheme two or three years down the line?

It is important to note, however, that the latest bailout plan, like those before it, is primarily aimed at solving near-term liquidity problems in the financial sector (and on this front it is likely to succeed—policymakers have made it clear since the crisis hit in 2008 that any systemically important bank will be protected). It can’t address the underlying solvency issues in countries such as Greece, Portugal, Ireland, Italy and Spain, all of which have uncompetitive economies and are faced with having to impose significant wage and price cuts in an effort to restore competitiveness, while at the same time implementing deep fiscal austerity measures to return their public finances to a more sustainable medium-term position.

Recent events in Greece suggest that the public don’t necessarily agree with politicians that this is the most appropriate course of action, perhaps questioning why more and more taxpayers’ money is being used to bail out the region’s financial sector at the same time as they are being told to accept swingeing wage cuts and tax rises. Such strains are likely to develop in other fiscally weak euro area countries over the next 12-18 months, as the markets (and the IMF) demand clear evidence that progress on deficit reduction is being achieved. The concern is that in a few years’ time, fiscal deficits are still at unsustainable levels, debt stocks are still continuing to expand and the region’s economy is still struggling to recover, just as the costs of the latest rescue plan fall due. Policymakers’ ongoing efforts to solve a sovereign debt crisis by creating even more debt also appear increasingly unsustainable.