Photo: AP/Nikolas Glakoumidis
Although markets have been kind to Italy and Spain recently, most economists agree the crisis is far from over.Greek politicians are still trying to hammer out a deal without jeopardizing their popular support, economy, and bailout funds. Yet troika officials are still vehemently supporting austerity, regardless of signs that more spending cuts are unsustainable.
And despite tentative agreement to move up implementation of a new, permanent eurozone bailout fund and institute a fiscal compact, rough waters are still ahead for the crisis effort.
We’ve compiled a list of all the issues still threatening to derail the monetary union. Read and weep, folks.
Since this crisis seems to be exacerbated by a lack of market confidence, EU leaders need to act in a way that will restore faith in sovereign borrowing. Doing this is difficult when EU leaders also want creditors to take 70% haircuts on their holdings of Greek debt (since it turned out to be a poor investment choice).
EU leaders want Greece's creditors to participate voluntarily so as to avoid provoking a credit event, which would result in payouts of credit default swaps--insurance contracts on purchases of sovereign debt. However, there's little chance they'll get a sufficient number of bondholders to go all in.
If EU leaders pull a high-handed manoeuvre to to avoid a credit event, then this would undermine the entire CDS industry and make it incredibly difficult for financial institutions to make a certain hedge against sovereign debt. On the other hand, the effects of a credit event are uncertain--Citi's Willem Buiter estimated late last year that exposure to contagion would be minimal ($74bn gross, less than $4bn net) in the event of CDS payouts, but the problem is that no one really knows.
The most recent terms of the deal between Greece's creditors and its government reportedly hinge on whether or not the European Central Bank will take cuts as part of the debt restructuring. The ECB holds €50 billion ($65.7 billion) in Greek bonds that it bought at a discounted €38 billion ($49.9 billion)--a full 15% of the country's debt obligations.
Involvement of the ECB in the bailout would assure investors that European leaders are willing to do what's necessary in order to save the euro, even if it involves essentially monetizing debt.
Even with the prospect of huge haircuts for the private sector, there is little hope that the country will be able to return to the markets for funding in the foreseeable future. In fact, Greece will probably have difficulty bringing its public debt-to-GDP ratio under 120% for the next decade or so.
Drastic austerity measures have taken an axe to growth and have caused massive strikes and riots in Athens. Now EU leaders want Greece to impose a new round of still deeper spending cuts, and Germany has even threatened a proposal that would take away the Greek government's power to control the budget and place it in an EU budget commissioner.
The ECB is not like the Federal Reserve or most normal central banks. It only has a single mandate--the commitment to ensuring price stability--and cannot purchase bank debt or sovereign debt on the primary markets.
Investors have been hopeful that the ECB will ultimately step in and stand behind the sovereign debts of Italy and Spain. It could do this through financing the ESM, EFSF, or IMF in lending directly to sovereigns or by buying up vast quantities of their debt in a bid to cap or stem rising bond yields.
It doesn't yet look like EU leaders are willing to step up to the plate and ask the ECB to step in, and even if they did treaty change to change the ECB's mandate that would be time-consuming.
Yields on Italian and Spanish sovereign bonds have fallen sharply since the European Central Bank proposed liquidity measures to address what was turning into an all out banking crisis in Europe. It appears that domestic banks have snatched up those bonds like mad, seeking to do a 'carry trade'--reaping profits from the difference between elevated sovereign yields (particularly on short-term bonds) and the 1% cost of borrowing money from the European Central Bank.
However, after the second three-year funding operation in late February, yields could turn around sharply, particularly if the ECB refrains from announcing more measures like this. Yields on Italian sovereign bonds rocketed to record--and arguably unsustainable--yields in November, with 10-year bonds topping 7.3%.
Borrowing costs had also been rising sharply in France, Belgium, Austria, and even Germany at that time, suggesting that no country is safe from the effects of the crisis.
Portugal is at the centre of new worries about the eurozone, as its economy contracts and borrowing costs soar.
While the government has been effective in meeting spending targets to date, investors are increasingly worried about its continued success amid tightening credit conditions and the need to make difficult austerity choices ahead.
A Portuguese restructuring would have devastating effects on Spanish banks, which have $7.14 billion in exposure to Portuguese sovereign debt and $88.48 billion in total lending exposure to the country. If Spain is not properly backstopped, such a default could set off a spiral that could destroy the monetary union.
The Italian and Spanish economies are too big to fail and too big to save. Italy's 120% public debt-to-GDP ratio second in size only to Greece among euro area countries, and Spain's public debt is rapidly expanding to prop up an overly leveraged private sector.
If one country falls it affects bond yields elsewhere in Europe and lending throughout the banking system via contagion. These effects would be particularly strong if the failing country were Italy or Spain. EU leaders must find some way to reassure markets that both countries' debt issuances are truly risk-free in order to stem rising borrowing costs that could render finding funding in the open market impossible.
The European Financial Stability Fund (a temporary fund) and the European Stability Mechanism (the permanent version) are the rescue funds meant to provide funding for Greece, Portugal, and Ireland, to construct a firewall around Italy and Spain to prevent contagion from spreading, and to serve as the ultimate backstop for troubled EU banks.
The problem is that neither of these funds appear to be large enough to truly backstop Italy and Spain, particularly since the EFSF and France were downgraded. The current incarnation of the EFSF has a 440 billion euro ($590 billion) lending capacity, some of which has already been devoted to Portugal, Ireland, and Greece. The ESM has been capped at €550 billion euros, and EU leaders have agreed to institute it by July. If this preliminary agreement goes through. that would nearly double funding available to helping Europe. Germany is objecting to that plan.
Jointly issued eurobonds would allow strong EU sovereigns to back the debt of struggling sovereigns in part or in whole.
Both the Council of Economic Experts and the European Commission have been studying options for eurobonds, some of which could avoid the time-consuming treaty change likely needed for broader changes to the role of the ECB in general EU governance.
However Germany is adamant that eurobonds are only something that can be considered very far down the road, and should not be included in the current debate.
The IMF is already participating in the bailouts of Greece, Ireland, and Portugal. EU and IMF leaders have talked about expanding the fund's role in the bailout effort. It even announced a plan that would allow sovereigns to borrow up to 1000% of the quota of funds they contribute to the fund for one to two years.
However, the IMF's current lending capacity is too small to provide for the funding needs of Spain or Italy. The U.S. is highly unlikely to agree to any plans to expand the capacity of the IMF, regardless of the fact that other countries (in particular the BRICs) have said they would contribute to an IMF-led effort to bail out Europe.
And you thought the U.S. was bad.
Relations between the fiscally sound Germany, Finland, and the Netherlands and the rest of Europe led by France are heating up. Germany is objecting to many of the proposals that France and the periphery are advocating, and Finland is against giving up its right to a veto on any proposals (it is objecting to most).
These debates underscore a greater problem in the euro area. Lack of enforcement mechanisms let eurozone countries violate the Stability and Growth Pact in the first place, resulting in the excessive debts at the root of this crisis. The lack of adequate taxation and power-sharing mechanisms impedes passage of joint guarantee mechanisms, too. Finally, without a more comprehensive central government, states struggling with excessive debt will have a hard time ever returning to growth.
The European Union ties 27 countries together, only 17 of which use the euro. The divide between the euro- and non-euro countries is deepening, with only 25 of 27 EU countries tentatively approving a new treaty that would automatically impose sanctions on governments that exceed deficit and spending targets.
Of the two holdouts, the U.K has been particularly vehement in its opposition to the deal, particularly without sweeteners that would ensure London's continued preeminence as the financial services hub of Europe. The Czech Republic was the other country to reject the deal.
But regardless of whether euro and non-euro countries can work out these immediate disagreements, it is clear that euro states have less and less in common with the rest of the EU.