Euro: disaster beckons

Another summit, another failure. Despite repeated attempts to 'stop the rot' and save the euro there is still no sign of a 'comprehensive plan', writes Eddie Ford

To nobody’s great astonishment, the October 23 Brussels meeting of European Union leaders failed to come up with the promised “comprehensive plan” to save the euro zone from collapse. Rather, they agreed to reconvene on October 26 to “finalise” the details on how to tackle the Greek crisis, recapitalise the banks, bolster the European Financial Stability Facility bailout fund and in general prevent debt contagion sweeping the continent - an eventuality that would trigger a world slump.

Not happy, Jean-Claude Juncker, the prime minister of Luxembourg and chairman of the euro group, said that the delay portrayed a “disastrous” image of the euro zone to the rest of the world - seeing how the October 23 emergency summit itself was originally scheduled to take place the previous week. As I write, it seems certain that the October 26 meeting will fail to produce any sort of definite rescue plan and some are now talking about the G20 summit on November 3-4 in Cannes being the “ultimate deadline” for resolving the euro zone’s sovereign debt crisis. The can keeps being kicked down the road. But very soon the end of the road will be reached - then crunch time.

Feeling the heat, David Cameron cancelled visits to Japan and New Zealand so that he could attend the Brussels meeting - albeit in an ‘informal’ capacity. No doubt he urged the euro zone leaders to get their act together - maybe even get their big “bazookas” out - so as to solve the crisis that is having a “chilling” effect on the world economy and threatens to tip the UK too into a double-dip recession. Chancellor George Osborne declared that he was fed-up with “short-term sticking plaster” that solved nothing. Of course, the spectacle of Cameron pleading with the ‘Brussels bureaucrats’ to show firm and decisive leadership will further infuriate the Tory Eurosceptics (“the bastards”, as John Major called them), who at the start of the week effectively delivered a ‘no-confidence’ verdict on Cameron’s own leadership by defying a three-line whip and voting in favour of motion calling for a referendum on the UK’s continued membership (or not) of the EU.

EFSF leveraging

After the October 23 meeting, officials in Brussels had claimed that finance ministers were “close” to agreement on new rules to recapitalise the EU’s biggest banks - a necessity in order to offset the losses that Greek debt holders will be forced to take on when a deal is eventually struck. The figure that seems to have been arrived is €108 billion, a far cry indeed from the €200 billion that was initially bandied around by Christine Lagarde, the managing director of the International Monetary Fund, and also by the Financial Services Authority in the UK . Many commentators believe €108 billion is quite inadequate for the job in hand or, at the very least, regard it as a wildly optimistic figure in terms of what it will be able to achieve.

For instance, the European Banking Authority has recommended that banks should be forced to increase their reserves so that they have core ‘tier 1’ capital equal to at least 9% of their risk-weighted assets, after marking down to the market price the loans they have made to the Greek, Italian, Spanish, Portuguese and Irish governments. Significantly higher, that is, than the 6% that only in July was deemed enough to pass the ‘stress tests’ conducted by the EBA and which at the time was widely treated with derision - a ‘test’ purposely built to be passed in order to engender market confidence. It didn’t.

The EBA has stated that this devaluation of sovereign debt should apply to loans held in trading and banking books. In other words, banks cannot ignore the losses on loans to Greece by simply parking them where market prices are not typically used for valuations. Logically, a consistent policy of pricing to market, irrespective of where the sovereign debt is held, would force banks to raise significantly more capital as protection against potential losses than the previous approach of ignoring the banking-book holdings. Overall, the EBA calculated that its proposal would require European banks to raise nearly €200 billion in additional capital, not the €108 billion that seems to be on the table.

Though the proposals are still not entirely clear, recapitalisation is expected to be met by the banks themselves where possible, with governments and the EFSF only stepping in as a last resort - or that is how the theory goes. Similarly, the plan (or hope) is that French and German capital deficit will be remediable through selling bonds to investors or selling non-core assets, without recourse to yet more taxpayers’ money. Well, the best laid plans …

However, there is an obvious pitfall. Many of the banks may well decide that the only way to comply with the new requirements - and plug any possible gaps in their capital holdings - is just to lend less and sell off more assets, which in turn could starve households and businesses of vital credit - thereby killing off growth and sending the entire euro zone into recession. The return of the credit crunch.

Inevitably, particularly acute divisions have opened up between France and Germany , as the crisis rumbles on and as the meetings become more numerous and longer. The most serious disagreement is over the role and function of the EFSF mechanism, its current €440 billion bailout fund looking less impressive with almost each day that passes: trillions are obviously required.

Essentially, France wants the EFSF to become a bank in all but name and borrow money from the European Central Bank - therefore providing access to potentially limitless funds (or as good as) with which the EFSF can directly lend to states, if necessary. Like France? President Nicolas Sarkozy is, of course, terrified by the prospect of the country losing its triple-A status - and for good reason, considering Moody’s October 17 warning that within the next few months it might deliver a “negative” verdict on France’s credit rating. But the dark reality is that the French economy is in trouble and its banks have a dangerously high exposure to Greek debt - let alone Italian or Spanish debt. In which case, a ‘super-EFSF’ could be France’s saviour.

Germany , however, is vehemently opposed - along with the Dutch and Finnish - to the very notion of the ESFS effectively becoming a bank, believing that it would undermine the ECB’s traditional ‘impartiality’. In the intransigent words of Wolfgang Schauble, the German finance minister, “we will stick to the agreed guarantees … we will stick to the situation, as it is in the treaty, that the central bank is not available for state financing”. Everything so far indicates that Germany has won the day on this issue and that EU leaders appear to have discounted the possibility of the ECB boosting the EFSF’s firepower.

Instead, Germany has endorsed an option for the EFSF to have the power to guarantee new loans - government bond sales - to countries such as Spain and Italy that are struggling to borrow; the EFSF (ie, the euro zone taxpayer) would be in line for the first 20% of losses on these loans, so commercial investors could lend to Spain and Italy with greater confidence that they would get their money back. This could either be achieved by offering straightforward insurance or, in an alternative apparently gathering more support, using insurance to attract or lever up bigger amounts of private and public investment. ‘Sovereign wealth’ funds from Asia and the Gulf, including China , could possibly be tapped, along with the IMF. The statement issued by the EU-27 after the Brussels summit certainly indicates such a line of thought, asserting that the G20 “should ensure that the IMF has adequate resources to fulfil its systemic responsibilities” and “should explore possible contributions to the IMF from countries with large external surpluses”.

Naturally, the German government is ever mindful of domestic politics - unwilling to increase either the potential liabilities of the German taxpayer or its own contribution to the EFSF (€211 billion). Try selling that in a general election - getting hard-working and upright Germans to subside ‘lazy’, ‘work-shy’ Greeks or Portuguese. But with the above ‘insurance’ scheme in the pipeline, Germany will consent to raising the EFSF’s fund to €1 trillion-plus - even if it is a purely hypothetical increase at the moment, given that the ECB is out of the picture. Reinforcing the German stance, Angela Merkel had to briefly fly back to Berlin on October 26 to face a vote in the Bundestag on this very issue of increasing the leveraging power of the EFSF. She comfortably won, once the opposition and her own critics within the Christian Democratic Union were reassured that there would be no increased German contribution to the EFSF fund. This enabled Merkel to return to Brussels and say - perhaps conveniently - to her fellow EU leaders that her hands are tied. No new German money for the EFSF.

Or, to put it another way, the German administration wants to extinguish the fire - but does not want to pay for the firefighters. Unsurprisingly, the markets began to fall by late afternoon on October 26, as the realisation dawned that the German-backed plan to save the euro zone was based more on financial jiggery-pokery - or ‘creative accounting’ - than real, hard cash. A distraught investor told BBC News 24 that the only solution to the crisis was in fact a “blank cheque” from the ECB or some other major financial institution. Anything else was just pissing in the wind.

Greek crisis

On October 21 EU finance ministers finally approved the next tranche of €8 billion in bailout loans to Greece - subject, that is, to IMF blessing. Athens will receive the money by mid-November and this should, all things being equal, save the country from immediate bankruptcy. But the situation is still unbelievably dire and a Greek default is virtually unavoidable, the only question being whether it will be ‘orderly’ or ‘disorderly’. The latter scenario would surely signal the death of the euro zone, with contagion spreading into Portugal , Spain and Italy - and beyond. There would be a run on the euro and banks would fall, especially French banks.

Greece could face accumulated capital requirements of €252 billion by the end of the decade and a debt-to-GDP ratio of 186% unless write-downs can be agreed this week. But there are no signs yet of a consensus emerging on Greece - quite the opposite. Differences are getting bigger. Ministers say they are working on the fine details of a second rescue package. There is vague talk of “fresh aid money” and “private sector contributions”, but nothing much more than that. What we do know is that Germany, the IMF and various EU leaders have been aggressively pushing for investors (ie, banks) to take a much bigger ‘haircut’ or write-down on Greek debt, maybe up to 60%.

But France and the ECB are fearful of such a prospect, thinking this would destabilise the banking sector and just frighten the already volatile markets. Bondholders reportedly offered on October 23 to increase their voluntary write-downs to 40%, almost double the 21% initially agreed in July - but not more. Italian, Spanish and Portuguese banks could be hardest hit by both these plans and have put up stiff resistance. Bankers have warned that anything over 40% risks setting off a ‘credit event’, triggering credit default swaps and in turn threatening economic meltdown. As for the EBA, it is thought to be preparing to publish the capital requirements in a breakdown by country, rather than individual bank, once the extent of the Greek ‘haircut’ is determined. Raising the stakes even further, the head of Germany’s second biggest bank, Commerzbank, has strongly hinted that the best course for Greece (perhaps other countries as well) is to bite the bullet and declare itself bankrupt in order to calm down the markets. There are only two options: “either they service their debt as agreed or they declare insolvency with all the tough consequences”.

Another widely circulated story is that ‘hard-line’ EU leaders, backed by the IMF, have delivered an ultimatum to the bankers - threatening to trigger a formal default on Greek debt, thus risking the aforementioned ‘credit event’, if banks refuse take at least a 50% ‘haircut’ and accept the losses on their holdings. This ultimatum would take the form of the IMF refusing to pay its share of the bailout money for Greece , a contribution worth €73 billion.

To this end, the ‘haircut hawks’ at Brussels presented a report which maintained that in a “worst-case scenario” Greece could end up needing a second bailout of €450 billion, twice the size of the current package and more than the €440 billion available to the EFSF’s rescue fund - meaning, of course, that the Greek debt crisis alone could swallow the euro zone’s entire bailout fund, leaving nothing to spare to help the affected banks of Italy, Spain, France, etc. We further read that Vittorio Grilli, a senior EU official, travelled to Rome to present the ‘take it or leave it’ deal to the Institute of International Finance , which is leading the negotiations for the banks. If the banks called the EU-ECB-IMF troika’s bluff, they would potentially face nationalisation.

Italian collapse?

Meanwhile, if possible, the euro zone crisis took a turn for the worse as the EU gathered at Brussels in the evening of October 26, with the news in the morning that Italy’s borrowing costs had nearly hit 6% - despite the fact that in August the ECB had been busily buying billions-worth of Italian and Spanish bonds, temporarily pushing the interest rate on Italian government bonds down to 5% or thereabouts. How short-lived.

This is clearly unsustainable and Italy ’s mountain of debt is set to reach somewhere in the region of €1 trillion. Without drastic action, like a write-off or bailout - something - Italy could find itself sliding into default and near bankruptcy. If that were to occur, Greece could be the least of the euro zone’s worries - a mere storm in a teacup. Italy may be too big to fail, but it is increasingly becoming too big to bail out. Not to mention Portugal , Spain , Ireland , etc - what is to be done about them if the situation spins out of control?

Panicking, EU leaders have piled the pressure on the ‘feckless’ Silvio Berlusconi over Italy’s growing debt - sternly telling the Italian premier that he must ‘stop the rot’ and take more “radical measures” to reform the country’s economy. Deepening the humiliation, Merkel and Sarkozy told Berlusconi in face-to-face discussions that he needs to provide “credible evidence” that Italy is “serious” about its programme of “structural reforms” - which is EU-speak for more austerity and attacks on the working class. At the same time, they are demanding that Italy draws up a plan for growth. An impossible squaring of the circle, given that in the real world - as opposed to the fantasies of conservative governments and mainstream anti-Keynesian economists - attempting to ‘balancing the books’ and implementing a vicious regime of cuts just sends the economy ever downwards, as consumer spending diminishes and tax receipts dry up. A negative feedback loop, to coin a phrase. Look at the disaster that is Greece. Yet, irrationally, this is the very same medicine that Merkel, Sarkozy, the IMF, etc want to impose on Italy . Disaster beckons.

The Berlusconi government now teeters on the edge of collapse, running out of support both internally and externally. The contradictions have become too much to bear. Yet the plight of Italy could easily be a presentiment of the European future to come, of failing states and failing banks - and general impoverishment for the masses