Sunday, July 24, 2011

EU Steps Forward, Still Much More Needed

As the debt ceiling debate continues on this side of the Atlantic, over in Europe the EU and ECB have apparently agreed upon a plan to end Europe’s sovereign debt crisis. Since early 2010, each bailout of Greece (we’re now on number 3), Ireland and Portugal has witnessed enthusiasm in financial markets through a stronger Euro and massive stock rallies. Needless to say, had any of the previous plans been successful, the current conversation would not be taking place.

Several highly regarded Economist's responded to Economix’s questions on recent efforts to save the euro. Simon Johnson, Carmen Reinhart and Laura Tyson each offer insightful thoughts, but Tyson’s responses appear most spot on. Overall the answers display much less enthusiasm than financial markets have for the likely outcome. I certainly recommend reading the entire article (Economist Q. & A. on Europe’s Debt Accord) but wanted to offer my own responses to several of the posed questions.

“Q. What effect is the European accord, including “selective default,” likely to have on Greece’s economy as it tries to recover?”

Tyson offers the most comprehensive answer, highlighting similar themes being argued by proponents of MMT and Keynes. Up until now, Greece’s presumed liquidity crisis has been treated with bailouts providing temporary loans at below market rates. Although these loans reduce the present value of Greece’s debt burden, the actual amount of outstanding debt remains unaffected. In reality, Greece represents a solvency crisis with minuscule hope of ever repaying existing debt in full. The decision to include “selective default” portrays acceptance of a solvency crisis, marking a significant step forward toward an actual solution.

“Selective default” involves restructuring Greek debt to actually reduce the total amount outstanding. Two primary options will likely be available to creditors for restructuring current holdings. One option offers creditors new 15 or 30 year bonds at par (face value) with interest rates around 4-5%. The other option provides new 15 year bonds with slightly higher interest rates but requires a principal reduction of 15-20%. It’s clear that Greece's existing debt is only reduced by creditors selecting the second option.

A significant portion of outstanding Greek debt is held by the ECB and European banks, whom are not bound by mark-to-market accounting standards. As noted in Avoiding Default Protects Phony Asset Valuations, these creditors are largely valuing current holdings at par despite market prices. Choosing an option that includes principal reduction will therefore force banks to realize losses on current holdings. Potential for large realized losses and previous reluctance to dispose of current holdings probably removes any consideration of voluntary options involving principal reduction for these creditors. Regardless of the options selected by remaining creditors, the actual reduction in outstanding Greek debt will be minimal.

Apart from including "selective default," the European accord requires Greece to enact even greater austerity measures. Similar to previous measures, these requirements will reduce the chances of an economic recovery already being hindered by a strong Euro. Further economic contraction combined with a reduced willingness to pay taxes will continue undermining efforts to meaningfully reduce the deficit and debt burden. Despite taking a step in the right direction, the European accord appears severely inadequate to aid Greece's economic recovery or reduce the likelihood of future default.

“Q. What are likely to be the challenges in carrying out the European plan?”

The European plan was made especially urgent by recent rises in yields of Spanish and Italian sovereign debt. Greece, Portugal and Ireland have already been effectively locked out from issuing new debt. An initial resolution to these countries losing access to credit markets involved creation of the European Financial Stability Facility (EFSF). The EFSF issues triple-A (AAA) rated debt guaranteed by financially stronger euro zone countries and uses those funds to provide loans well below market rates. To maintain its AAA rating, only about 270 billion euros of the 440 billion guaranteed are currently available for loans. The new accord expands the EFSF’s abilities to include purchasing bonds on the secondary market, providing loans supporting European banks and backing losses by the ECB. Although these are meaningful steps, the EFSF is vastly underfunded for its expanded role.

An Alliance Bernstein report (provided by Zero Hedge) discusses the inadequacy of the EFSF going forward.
Apart from minor measures related to Greece, the European accord fails to reduce existing debt burdens for any other overly indebted nation. After a brief calm, markets are likely to once again test the resolve of politicians and central bankers. Since the EFSF was not granted the breadth necessary for funding Spain and Italy, it becomes all the more probable that EU/ECB commitments will be tested.

Under the EFSF guidelines, countries requiring loans from the facility are unable to guarantee the facility’s debt. Given the sheer size of Spain and Italy, if both countries become locked out of credit markets, the EFSF’s lending capacity will need to be expanded from 440 billion to nearly 2.5 trillion euros. Without debt guarantees from Spain and Italy, the responsibility will fall primarily on Germany, and to a lesser degree France. Based on Alliance Bernstein’s estimates, Germany will need to guarantee 790 billion euros, which equals 32% of Germany’s current GDP.

Maintaining the EFSF’s AAA rating is imperative for ensuring loans are provided at the greatest discount. Expanding the EFSF becomes further complicated by France’s significant amount of existing debt. If France’s credit rating were downgraded due to extra debt guarantees, Germany’s share could conceivably become nearly 1.4 trillion euros. Whether or not Germany could retain its AAA rating while providing such a massive guarantee remains an open question. Even before that question needs addressing, Germany and France will probably face the tougher challenge of selling the new proposal to their citizens. Despite all the hype, significant challenges remain in approving and implementing the European plan.

“Q. What does this move portend for the euro zone?”

Probably the most certain effect of the European accord is that it buys more time. The euro zone is suffering from over-indebtedness that has rendered several nations and banks insolvent. While prospects for growing out of debt remain a pipe dream, reality almost always involves either restructuring existing debt, devaluing currency or generating inflation. Recently the ECB has been vigilant in maintaining its mandate for stable money by raising interest rates to quell inflation. This policy has also encouraged a stronger Euro. With currency devaluation and inflation off the table, restructuring debt becomes the only feasible option.

This move represents the first step toward allowing restructuring of existing debt. However, the current scheme only applies to Greece and is doubtful to make a significant impact. Any considerations of allowing or forcing more significant restructuring are probably defeated by fears of a modern day bank run (think Lehman 2.0). Within a short time, interest rates on Spanish and Italian debt will likely start pushing through recent highs. At that point, the insufficiency of the EFSF will become widely apparent.

Although politicians may wish to kick the can down the road forever, each countries’ citizens remain a wild card concerning their patience. Greece is effectively experiencing a depression at this moment, yet being asked to sacrifice more. Ireland’s citizens are enduring a recession in return for bailing out banks. Germans' have benefited enormously from creation of the EU, but may be asked to accept enormous risks to maintain the current alignment. One can only imagine the fallout if France and Germany guarantee loans for Spain and Italy, only to watch those nations willingly default on their obligations.

As described in Time is Running Out on the EU, the true conclusion to the euro zone crisis still lies in either greater fiscal unity or some number of defections. While the current accord provides measures for increased fiscal unity, the troubled nations remain stripped of means for recovery. Potential resolutions still remain numerous, but time for implementation is ticking down. If the Middle East uprising last year taught us anything, the whims of desperate people can change in an instant. Allowing a euro zone resolution to be ultimately dictated by public uprisings will certainly bring about a more chaotic end. The European accord is certainly a step forward, but much more will be necessary to ensure a peaceful and prosperous outcome.   

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