The Year the European Crisis Ended

E. Jones

• Publisher: Palgrave Pivot
• Year: 2017
• ISBN:
  9781137451118
• Topic: Politics & International Relations
• Subtopic: International Relations
• Index: Politics & International Relations

The author narrates the end of the European crisis from the June 2012 European Council summit through the bailout of Cyprus. Paying particular attention to political developments in Italy, the book shows the fragility of market confidence and the waving attitudes of political elites.

1

Europe Decides to Act

Abstract: The European Council moved into action in June 2012 with the decision to construct a European banking union and to allow the European Stability Mechanism to make direct capital injections into troubled banks. This failed to calm the markets sufficiently and so European Central Bank President Mario Draghi announced that he would do ‘whatever it takes’ to safeguard the euro. The ECB developed a program to buy unlimited amounts of debt in distressed markets where governments asked for assistance and accepted conditions in terms of reform. Spain looked like an obvious first case for this new program. However, the restoration of confidence in the markets was fast enough that the program never had to be used.

Keywords: banking union; euro; outright monetary transactions

Jones, Erik. The Year the European Crisis Ended. Basingstoke: Palgrave Macmillan, 2014. DOI: 10.1057/9781137451118.0006.

Game changer or sucker’s rally?

1 July 2012

The European Council summit held on 28 and 29 June delivered a surprisingly positive result for the markets – a clear commitment to Europe-wide banking supervision headed by the European Central Bank (ECB) and, following that, the possibility for European bailout funds to be invested directly by the European Stability Mechanism (ESM) into troubled banks. These factors should relieve some of the concern in the markets about the counterparty risk attached to doing business with banks in the distressed countries on Europe’s periphery. The leadership of the euro-area countries also agreed to use the resources available in the European Financial Stability Facility (EFSF) and the ESM ‘in a flexible and efficient manner to stabilize markets’ in those countries that have aggressively undertaken reform measures, such as Italy and Spain. This should help to put a floor under sovereign debt markets. Italian and Spanish bond prices rallied almost immediately after the announcement as a result.

The agreement offers room for optimism, particularly when compared to the dire consequences that might have resulted from a failed summit. Italy’s technocratic prime minister, Mario Monti, earned renewed support from both sides of his awkward coalition of centre-left and centre-right adversaries. Where before the summit there was talk about the possibility of early elections to be held in Italy next autumn, this now seems like a more remote prospect. The fact that Monti can turn his attention to growth rather than continued austerity is another positive sign for his coalition. No one really wanted to reap the whirlwind that would follow another Italian political crisis and now they can start planning in earnest for elections to be held in Spring 2013.

Spain and Ireland got bonuses as well. Spain received a commitment that any bailout for its banks would come from the EFSF on a pari passu basis and that it would be continued to be managed by the ESM without gaining seniority over other creditors. This eliminates an important source of uncertainty surrounding the Spanish package. Now we only need to wait for the details of the Memorandum of Understanding to assess what conditions European support will bring. For their part, the Irish received indication that their European partners would reconsider the long-term sustainability of their own bailout arrangements. This is not a clear commitment to lighten the burden on Irish taxpayers, but it is better than the steadfast opposition that the Irish government had faced on the issue to date.

Angela Merkel’s government won important concessions as well. Although the post-summit reporting tends to view the negotiations as a victory of Italy and Spain over Germany, the reality is much more subtle than a Euro 2012 football match. Both European deposit insurance and Eurobonds appear to have fallen off the agenda. No doubt they will resurface soon, but not with the same sense of urgency as in the past. Any respite in the markets cuts both ways – favouring Germany as well as the more distressed countries – in this sense.

Despite the potential for optimism, however, significant uncertainties remain. The most important is the political reaction in Germany. The Bundestag ratified the ESM treaty and the ‘fiscal compact’ soon after Merkel returned from the summit. The vote was decisive, yet still close in many respects. The German people and their representatives remain apprehensive about the prospect that they will end up financing banks and governments on Europe’s periphery. Recent controversies around highly technical issues related to financial imbalances between central banks in the Target2 system, or collateral rules applied in central banking transactions, reflect a much-heightened sense of risk awareness on the part of the German public. Should the ESM wind up making significant purchases of Spanish and Italian sovereign debt (using the ECB as its agent), the German public might turn quickly against the agreement.

Other uncertainties lie in the details of the agreement and the order of operations. The European Commission will have to draft legislation for centralized banking supervision led by the ECB under the existing provision (Article 127, paragraph 6) of the treaty on the functioning of the European Union. The basic elements of that arrangement – covering everything from how widely it will apply to how specifically it will be implemented – need to be worked out within the Council of the European Union in consultation with the European Parliament and the ECB. There are simply too many stakeholders in this legislative process to make clear predictions on what will emerge and when. The Eurogroup leaders would like this mechanism to be in place by December; that timetable could easily slip.

If the banking supervision does not come into place quickly, neither will the possibility for the ESM to inject capital straight into the banks. The agreement makes it clear that the supervision arrangements are a precondition for the bailouts. Paradoxically, such a delay is more likely if the markets remain calm (or even buoyant) during the rest of the summer. The longer the negotiation of the details drags out, the easier it will be for different stakeholders in the process to shrug off their willingness to compromise and to harden their negotiating positions. It will be important to keep a close eye on how those negotiations progress to make sure that what looks like Europe’s first major effort to turn the corner on this crisis does not turn into a sucker’s rally by autumn.

Implementation risk

8 July 2012

The market rally that followed the June European Council summit evaporated as quickly as it started. By the close of last week, the yield differential between Italian and German ten-year sovereign bonds stood at 470 basis points; the differential between Spanish and German bonds was almost a full percentage point (or 100 basis points) higher.

These spreads are well beyond what either the Italian or the Spanish governments believe to be sustainable in the medium to long term. They are at, or above, the level that precipitated the political crisis that drove Italy’s centre-right Prime Minister Silvio Berlusconi from power. And they show no evidence of coming down in the near future.

The explanation for this rapid reversal of market sentiment is easy to piece together. Almost as soon as the crisis measures were announced, European leaders began to back away from different parts of the agreement. The Finnish and the Dutch governments did not want European bailout funds to buy government bonds in secondary markets. The Finnish government was not too keen on seeing the bailout funds take an unsecured equity position in distressed banks either, and so asked for collateral. For its part, the German government understood Finnish and Dutch concerns – facing, as it does, similar objections from within Chancellor Angela Merkel’s own centre-right coalition.

Then unidentified spokesmen for European institutions made it known that national governments would be responsible for any equity stake in distressed banks taken by European bailout funds; European-sponsored bank recapitalization would be an implicit contingent liability for national finances if not an outright obligation to be added to public debt.

Of course, that direct financing of distressed banks will only come into play once the European Commission finishes drafting legislation for the ECB to take charge of European banking supervision. The Eurogroup statement made it clear that the legislation should be done in time for the Council of the European Union to approve it before the end of the calendar year; what the statement failed to point out is that implementation would probably drag on until the second half of 2013 – which is far too late for Spain.

The idea that money given to Spanish banks would be on the same level with other creditors in the market also came into question. As numerous commentators pointed out – and no official sources negated – public sector creditors always find a way to assert seniority. Witness the second Greek bailout.

What this all adds up to is a classic case of implementation risk. The Finns, the Dutch, the Germans, and the bureaucrats working for European institutions are doing precisely the same thing that they complain about in Greece. They offer a strong statement filled with good intentions and pointing to significant changes in policy that then comes apart once the negotiators leave the room and the bureaucrats find loopholes through which they can allow the most vocal critics to extract new concessions.

Everything is couched in the rhetoric of democratic legitimacy. The governments cannot ask their people to bear any greater burdens for other countries – particularly when they have given so much already. They have a point.

The problem is that their point is much the same as that made by representatives of trade unions, public sector workers, pensioners, school age children, university students, or, in France, the very rich. How can they possibly go back and ask their people for more when they have given up so much already? They have a point as well.

The people making strategic portfolio allocation decisions in large international investment houses are no doubt experiencing déjà vu at the moment. More likely than not, these investors cut their teeth at the time of (or soon after) the conservative revolution under Margaret Thatcher and Ronald Reagan. They are likely to be convinced that Europe is re-entering a period of what the Swedish economist Anders Aslund called ‘eurosclerosis’ – a kind of arterial sclerosis of economic institutions. And they will be looking to move their money elsewhere as a consequence.

The recent decision by the ECB to lower its policy rates will only reinforce that inclination by making the euro more attractive as a funding currency to finance the global carry trade. Hence it is well past time for Europe’s heads of state and government to show that they are ready to carry through with their agreements. Otherwise, like Greece, they must be prepared to suffer the consequences.

Event risk

15 July 2012

Moody’s downgraded the Italian state by two notches from A3 to Baa2 on Friday, 13 July 2012. The Italian political class immediately cried ‘foul’. The ratings agency announced its decision shortly before the market opened and on a day when the Italian government was planning to auction a mix of three-year and longer-dated bonds. The auction was scheduled well in advance and so the ratings agency’s timing seemed inappropriate (to say the least).

Given that the main thrust of Moody’s complaint centres on the fragility of Italian sovereign debt markets in the face of sudden shocks, it is easy to see why an Italian political class well-tuned to look for conspiracies would be suspicious. As it turned out, they should not have worried; the announcement had little immediate impact. Italy placed the €3.5 billion maximum allotment of three-year bonds at gross yields only slightly above coupon – 4.65 per cent versus 4.5 per cent – and well below yields that have prevailed since last May.

The auction was not an unqualified success. Longer-run securities fared less well and the yield spread on ten-year benchmark bonds over Germany remained high at 480 basis points (or 4.8 per cent). Nevertheless, the overall picture was good enough for many Italian commentators to conclude that the markets shrugged off the downgrade, voting instead for the underlying strength of the Italian economy and showing confidence in the technocratic administration of Italian Prime Minister Mario Monti.

That conclusion is overly optimistic. Moody’s ratings announcement is also supportive of Monti’s government. The problem is that while Monti’s team may succeed in making reforms, some other set of Italian political actors will be responsible for implementing them after the next round of national elections which will hopefully not take place until the spring of 2013. Italy is subject to ‘implementation risk’ at least as much as any other country in Europe, if not more so given the peculiarities of the current political environment.

As for the underlying strengths of the Italian economy, the ratings agency expressed concern about the current contraction in Italian output. But it used this weakness in output performance primarily to justify the continuing negative outlook. Should growth improve, Italy’s credit rating could either stabilize or increase again. In other words, both implementation risk and macroeconomic risk are important for Moody’s analysis, but neither justifies the downgrade.

The main problem for the Italian government – so the ratings agency argues – is what Moody’s calls ‘event risk’. Event risk is the prospect that something outside the control of the Italian government will roil the markets and so cut off liquidity. The examples given in the announcement are more dramatic than a ratings change; they include a Greek exit from the eurozone or a larger-than-expected Spanish bailout. This is hardly an exhaustive list.

Moody’s is not the only organization worried that something bad could happen that would precipitate an Italian liquidity crisis – particularly this August, when the markets are likely to be thin and small movements in volume could trigger large movements in prices. The larger Italian banks are also concerned and the main newspapers have published stories about how the banks are modifying their summer vacation policies to ensure that there will be adequate coverage in treasury departments and on trading desks.

The Italian state has modified its treasury operations as well. On 10 July – three days before Moody’s ratings announcement – the Italian Treasury cancelled the bond auctions it had previously scheduled for 14 August, which is the day before Italy’s most important summer public holiday. The Treasury announcement explains the cancellation as the result of higher-than-expected tax revenues and in line with historical precedent. However, the choice of which auction to cancel – mid-August rather than, say, mid-September – is due to a combination of fragile markets and the threat of unforeseen events.

The challenge is to identify events that are large enough to move Italian markets and then to assess the conditions that might bring them about. A Greek exit and a full-scale Spanish bailout are the two most talked about in the media, but there are many other possibilities that should be considered.

Structural reform and structural damage

22 July 2012

European sovereign debt markets ended last week on another note of high tension. The yield on Spanish ten-year sovereign bonds finished at 7.27 per cent – which is not only a record high but also well beyond the 7-per cent threshold regarded as ‘sustainable’. Meanwhile, the differential between Italian and German ten-year sovereign bonds closed on Friday at 5 per cent. Spain is worsening despite efforts to agree on a bailout for the Spanish banking system; Italy appears to be next.

This continued worsening was only to be expected. The markets never held much confidence in the European agreement reached on 29 June; continued squabbling over the precise interpretation of the terms surrounding the Spanish banking bailout has made matters worse; and repeated warnings by international organizations such as, most recently, the IMF that European political leaders need to act decisively to head off disaster have reinforced the perception that decisive action is not a European forte.

The two questions to ask at this point are, first, what can politicians do to alleviate the situation and, second, what is likely to happen if this tension continues to drag on. The answers lie not in the day-to-day movements of market prices. Rather, they are found in slower moving structural concerns.

The good news is that the countries on the periphery of the euro area are undertaking significant structural reforms. Most of these measures are intended to short up government finances by rationalizing expenditures, lowering expectations, and improving efforts at revenue collection. These measures will not make the peripheral economies more competitive, but they will improve the likelihood that bond holders will be repaid.

At the same time, the peripheral countries are engaged in more wide-ranging market-structural reforms to improve the efficiency of collective bargaining and employment practices, to make it easier to open small businesses, and to consolidate domestic financial institutions. Here there is some chance that market participants in the peripheral countries will be more competitive in the leaner and aggressive sense of the word. They will learn to live not only without government handouts but also without the long-term worker-management relationships or forward-looking (‘patient’) finance-industry connections that encourage significant investment in human capital at the firm level.

The problem is that neither fiscal consolidation nor market-structural reform is going to show immediate results. As I have argued in previous notes, we first have to deal with implementation risk – the prospect that agreements will not be ...

Table of contents

• Cover
• Title
• 1  Europe Decides to Act
• 2  The Markets Respond
• 3  Risk Returns through Italy and Cyprus
• 4  The European Crisis Comes to an End
• Epilogue: Beyond the European Crisis
• Index