Last week, European Central Bank President Mario Draghi laid out the framework for the next developments he wants to see in Europe.Considering how important the ECB has been in slowing the crisis, it is likely that the ECB will get what most of what it wants.
Draghi’s demands are just a few of the many steps European leaders will need to take in the medium-term in order to keep the monetary union afloat.
Depending on the time frame for these developments, we could see more sovereign debt restructurings and bailouts.
Here are the next steps to look for:
1. EU leaders need to sort out seniority problems in holdings of distressed sovereign debt.
Official European institutions (for example: the ECB) have bought up sovereign bonds of troubled countries like Greece, Portugal, Ireland, and even Spain and Italy in an attempt to keep their borrowing costs down. However, the fact that these official creditors did not take losses when Greece restructured its debts in March signaled to investors that official creditors had become de facto senior bondholders while private investors had become subordinated.
This subordination discourages private investors from buying more sovereign debt from countries they believe could default. One of the major ways that the ECB and EU bailout funds can mitigate financial tensions is by purchasing sovereign bonds, but Draghi is refusing to do more of this before these seniority problems are resolved.
“I think they have to take losses in Greece to get real trust in Spain,” Lawrence MacDonald, bond trader and author of “A Colossal Failure of Common Sense,” told Business Insider Friday. Greece still has too much debt, and a new plan will likely include another debt restructuring, which the official sector could take part in. More on this in step three.
2. finalise plans to use European bailout funds, the EFSF and ESM, to purchase sovereign debt.
The ECB does not want to be the only institutions purchasing sovereign debt, and expects EU countries to join in the effort. Both bailout funds are authorised to purchase bonds, but Northern European countries have resisted such calls to bail out Southern Europe. In part, their aversion to such plans stems from continuing problems with seniority (addressed above), but mostly EU leaders face political resistance to continued bailouts of Southern Europe.
Such a development is most important for addressing concerns about purchases of Italian and Spanish sovereign bond purchases. Most analysts consulted by Business Insider believe that these countries will have to submit to certain conditions in order for the European bailout funds to be used for this purpose.
It’s also important that EU leaders approve the ESM—the future European bailout fund—in the first place. Right now, it still faces opposition, particularly from the German Constitutional Court, and though it’s likely to be approved it will be important to see whether the Court imposes any conditionality on the fund.
3. Decide on a new Greek bailout.
Greece became the first developed economy to default in more than 60 years when it restructured its debt in March. However, high public debt and demanding payments debt payments have exacerbated continued investor angst about the state of the Greek government.
Thus another restructuring, likely one in which Greece’s official creditors take losses, appears almost inevitable at this point. As we discussed in the first step, this would also send a positive signal to private purchasers of sovereign debt, because it would signal that investors wouldn’t suffer disproportionate losses in the event of a restructuring in another country.
4. The ECB will restart purchases of sovereign bonds.
As we explained earlier, ECB bond-buying has the effect of raising demand for sovereign bonds and pushing down yields.
Unlike last time, the central bank has now explicitly remarked on its inability to use monetary policy effectively in the midst of high sovereign borrowing costs. That means this time the ECB will act with an eye towards keeping yields on sovereign bonds low, restoring faith in European sovereigns.
That said, Draghi has used high borrowing costs as a means of putting pressure on European leaders to act, and so is unlikely to completely alleviate concerns about high bond yields so long as more economic reforms are needed. We explained last week that this is likely to spell continued volatility in financial markets.
5. Create a European banking authority.
In June, European leaders decided to create a European banking authority to govern bank recapitalizations and cleanse financial institutions with unsustainable investments. If strong enough, the creation of this institution could mark the first step towards divorcing sovereigns from their banking systems and creating a centralized European government.
That said, investors are concerned that this entity will neither have the strength nor the transparency to create a viable banking authority. EU leaders want the ECB to lead the charge in creating this institution, however the ECB itself remains unreliable (at least in comparison to the Federal Reserve), as it is far more likely to pull strings behind the scene and cover up the details of its operations.
Moreover, Europe’s current banking regulator—the European Banking Authority—wields little power over European banks to institute uniform financial policies or break up banks with unwieldy finances.
Finally, EU leaders are likely to resist attempts by any institution to wrest control of domestic financial systems away from national leadership.
6. Institute a deposit guarantee system.
The next step for this nascent European banking authority would be a deposit guarantee scheme that would pledge centralized European support for deposits in troubled banks. This is the next step towards separating the banking systems from national governments, and would likely restore foreign investors’ willingness to lend money to Europe. This is an important step for stimulating currently fading growth in European economies.
7. The ECB will announce plans to target sovereign yields.
When it feels that EU leaders have made sufficient progress in economic reforms, the ECB is likely to announce plans to restrict the spread between borrowing costs for peripheral Europe (i.e. Italy and Spain) and core Europe (Germany, France, etc.). This would go a long way towards tying these regions together economically. Click here for our full explanation on how this would work >
8. Introduce some form of joint eurobonds.
The implementation of eurobonds remains a controversial plan that is likely years away. That said, an ECB plan to keep bond yields similar for different countries will remove much of Northern Europe’s aversion to debt mutualization, since it would no longer be able to borrow at record low rates. The rational next step would be the explicit mutualization of at least some sovereign debt, providing the implicit promise that a strong country like Germany would stand by a weaker country like Portugal in the event of financial troubles.
9. Political union.
The final piece of the European puzzle is political union, complete with fiscal transfers that would allow the eurozone to function as a federal whole (much like in the United States). In this case, European countries would have to give up some sovereignty, and thus this is likely to remain a distant development.
Today, it remains unclear exactly how deeper political union would come about. Lorcan Roche Kelly, European Strategist at Trend Macrolytics, told Business Insider last week that France is most likely to resist calls to cede sovereignty to the European whole. However, the fact that Northern Europe will be pressured to stand behind its Southern European counterparts may mean that the former will demand concessions in the form of political power.
The United States of Europe remains a far-off prospect.