“This is ‘shock and awe’… in 3-D,” says Marco Annunziata of Unicredit. Indeed, the sheer scale of the euro stabilisation package that the EU announced late last weekend (up to €750bn, including a top-up of as much as €250bn from the International Monetary Fund, IMF) took markets by surprise on Monday. It “far exceeded what was expected from a Europe that has produced too little, too late” since the single currency zone’s debt crisis began last October, says the FT. For the first time, Europe’s leaders moved “one step ahead” of the markets.
What the measures involve
The measures include a rapid-reaction stabilisation fund of €60bn controlled by the European Commission – the money is available to countries facing a financing crunch. All EU members would participate in this. Eurozone members will also raise €440bn from the markets via a ‘special purpose vehicle’, which would guarantee loans for members in trouble. The IMF has agreed to match every two euros of rescue money with one of its own. No funds will be made available, however, unless the overborrowed states pursue stringent, IMF-monitored debt reduction plans and structural reforms.
In addition, the European Central Bank has bowed to calls for it to begin buying up government bonds issued by troubled peripheral states to help bring down their borrowing costs. It is also reactivating the direct lending programme to banks, a liquidity-boosting measure seen during the worst of the credit crunch.
What’s more, in conjunction with other central banks, it will restore currency swap agreements. Following a sharp rise in dollar interbank interest rates as demand for dollars jumped amid the global flight to safety last week, central banks will lend dollars obtained by swapping their currencies with the Fed to ease dollar liquidity shortages. This is “all in”, says Andrew Bosomworth of Pacific Investment Management. “What more could they have done?”
A response to a near-meltdown
All this firefighting had become increasingly urgent by last weekend. There was a danger of “complete meltdown” in the markets last week, says Gary Jenkins of Evolution. Spreads on Portuguese and Spanish debt had shot up with those countries on the verge of joining Greece “in the unable to borrow from the markets club”. Fears of defaults in the European periphery hit the banking sector due to European banks’ large exposure to sovereign – and private – debt in these economies. Credit Suisse reckons European banks have around $75bn of Greek, $46bn of Portuguese, and $85bn of Spanish government debt alone.
“A collapse” of the peripheral countries would “detonate like a nuclear bomb over the financial sector”, making Lehman “look like a firecracker”, says Walter Molano of BCP Securities. Banks became increasingly reluctant to lend to each other: the three-month interbank dollar rate hit an eight-month peak. There was a danger of a “fresh seizure” of the banking system, says Dave Shellock in the FT.
Enter the support package, which prompted a massive relief rally. After plummeting last week, pan-European stocks rose by more than 7% on Monday, their biggest one-day jump in 17 months. The FTSE 100 gained 5%. Bonds of heavily indebted counties had their best daily rally since the eurozone’s inception. But by Tuesday the euphoria was already wearing off. The euro slid back below last Friday’s level of $1.27 against the dollar.
Will the bail-out work?
The package still leaves “i’s undotted and t’s uncrossed”, says Hugo Dixon on Breakingviews. It’s not clear how this bail-out mechanism would be activated – does it require a consensus or a majority of eurozone states? A legal challenge by German eurosceptics appears a distinct possibility, while parts of the package will still have to pass through national parliaments. That could prove difficult.
Meanwhile, much of the eurozone has its own debt problems. All the AAA-rated nations in Europe already have public- debt-to-GDP ratios of 70%-80%. So it’s hard to be confident that countries can raise the amount required. “The volume of aid is likely to be much smaller than the official figures suggest,” says Ulrich Leuchtmann of Commerzbank.
And while €750bn is a big sum, it covers just over a year’s new borrowing by eurozone members, says Robert Peston on BBC.co.uk. That’s not enough “if investors were to start to lose confidence in the ability of some big countries – such as Spain or Italy – to honour their debts”.
The fundamental problem remains
Beyond the practical difficulties, there’s another long-term problem. “You cannot resolve the debt crisis by issuing more debt or putting up guarantees,” says Christian Blaabjerg of Saxo Bank. Like using more alcohol to stave off a hangover, this is storing up further potential trouble for the future. But the crucial issue for now is that while the package will stop the immediate liquidity crisis, it cannot do anything for the troubled eurozone members’ longer-term solvency.
The southern states are trapped. The fiscal tightening necessary to rein in debt risks making their downturns worse. That further undermines their budgets, exacerbating the debt problem. This “vicious circle” continues, says Juergen Michels of Citigroup. With no prospect of a sustainable improvement, the risk of debt restructurings in the periphery – a default, in other words – remains “high”. Social unrest in Greece shows “how hard it will be for states to push through the deficit-busting reforms necessary”, says David Prosser in The Independent.
Just look at Portugal, adds Simon Johnson in the FT. Simply to keep its debt pile constant and maintain interest payments of 5%, it will have to tighten fiscal policy by 10% of GDP in two years. With interest-rate cuts and devaluation ruled out by euro membership, that implies “massive unemployment”. The rescue package is simply a “giant sticking plaster” rather than a solution to the sovereign debt crisis, says Prosser.
So the worries over a southern state defaulting, and even the eurozone breaking up, are not going to go away. Nor will it help matters that eurozone interest rates are set to stay low for the foreseeable future, given the lousy growth prospects in the periphery. Elsewhere, the US recovery (for now, at least), looks more solid, raising the prospect of higher rates there soon. Both Capital Economics and Barclays Capital still expect the euro to fall to $1.20 this year.