Investor sentiment recently has been buoyed by signs that the European sovereign debt and banking crises appear to be under control—at least for now.That’s part of the fallout of liquidity measures led by the European Central Bank back in December, which allowed banks to access virtually unlimited financing from the central bank at incredibly low rates. This staved off the prospect of an imminent banking crisis in Europe—something we argued at the time was escalating even more quickly than worries about a PIIGS default.
With another three-year long term refinancing operation ahead, European banks will likely make big requests for more capital from the central bank, particularly since this is the last such operation the ECB is scheduled to conduct.
But let’s not get too excited here: even the best case scenario for Europe is still pretty bleak. Let’s walk through the most optimistic scenario.
Negotiations between Greek government officials and banking representatives are ongoing about how much of a haircut the latter will take voluntarily, and about whether or not the European Central Bank will take haircuts as well.
In the best case scenario, the European Central Bank steps in and agrees to stomach significant losses. In order not to monetise sovereign debt—something it’s not permitted to do under the current EU treaty—it may have to transfer these holdings to some other organisation that is allowed to take losses, but bottom line would be significant official sector participation in the bailout in addition to private sector involvement. It’s still doubtful that this would stave off a credit event, but at least it would put an eventual return to debt sustainability somewhere on the horizon.
At this point, the European Central Bank would probably have to step in with a new round of long-term refinancing or some measures to protect and recapitalize banks that would be exposed to this default.
Most important at this point would be preventing the crisis from spreading to Italy, even if it means preemptively offering it a round of cheap long-term financing, probably with support from the IMF. The ECB could also conduct another round of LTROs with relaxed collateral requirements, which would encourage Italian banks to lend the government the €131 billion ($171.5 billion) it needs in funding this year. More innovative austerity measures and attempts to rein in tax evasion would need to be pursued.
Greece stays on the euro, and austerity measures are severely curtailed to keep the population from starvation or revolt.
PortugalInvestors are already worried about the prospect of a Portuguese default, and given the current state of Portugal’s recession and its government’s shortfall in funding for the year, this contingency appears probable. Portugal has not benefitted from the LTRO, and the government will face increasing adversity in adopting any more austerity measures.
However, a quick resolution to restructure Portuguese debt and keep the country on the euro—rather than a protracted agony that inflates investor fears—could nip debt sustainability problems in the bud. Portugal’s economy is relatively small, and if a plan were agreed upon quickly to restructure some of its debts in a “selective default” this plan could work in a way that the Greek one has not. Either way, expect losses on this one.
This time, some organisation will have to step in to support Spain and France, both of which have banks with high lending exposures to Portugal—$88.48 billion and $25.66 billion, respectively. The French government might be able to take care of its problems domestically if the ECB continues to throw out money, however Spain will likely need external funding. Spain’s financial system is already balancing on the brink of collapse, and if the government shoulders the burden it could very well turn into the next Ireland.
While Spain’s government may need some cleanup—particularly at the muni and regional level—the country does not need austerity, and EU leaders should not demand it. They may indeed have to help the country meet its €165.3 billion ($216.3 billion) in funding obligations, however, as credit conditions would tighten further after a Portuguese default.
The most positive outcome is a turn away from harsh austerity towards policies that will pump cash into Spain and Italy in order to keep their governments and financial systems afloat. While Spain needs cleansing, it does not need austerity, and in fact austerity could inflame the already tense conditions caused by 48.6% youth unemployment. Italy could use some austerity, but this should be tempered by efforts to restore growth and develop the productive capacity of workers. That includes structural, political changes that will dilute the power of the government and guilds, and these measures that could be guided by the European Commission and a technocrat government like that of Mario Monti.
These plans, however, do not work without significant cash. Eurobonds and an ECB backstop would immediately calm markets and alleviate the crisis, but the current funding proposals rely on contributions from the very countries who are likely to suffer here. Let’s do the maths (and we’ll throw out some proposals for leveraging the EFSF as they seem far-fetched). [Data from EFSF website.]:
(ESM + EFSF)[1 – (Percentage of contributions from Italy & Spain)] =
(€500 billion + €440 billion)[1 – (0.179 + 0.119)] = €659.9 billion (or $868.8 billion)
This number will probably be supplemented by a maximum of €140.4 from contributions funneled through the IMF, although a likely loss of France’s AAA by a second ratings agency in the coming months will diminish the funding available that is the most highly rated.
At maxiumum, you end up with about €800.3 billion in secure funding to backstop Italian and Spanish lending for at least the next few years, to rescue Italian and Spanish (and perhaps even French) banks, and to continue to support Portugal and Greece as far as the eye can see.
That means EU leaders are going to have to raise a LOT more funding. They face significant difficulties in doing this—particularly from countries like Finland and Germany—but this is the best case scenario. And that most assuredly entails political drama ahead.