European politics now increasingly dominates European economics.
In Greece, the severe cutbacks in government spending have resulted in strikes and violent protests on the streets of Athens. In many countries, governments, often unstable coalitions, are struggling to pass legislation, implementing necessary spending cuts or tax increases. In Ireland, the opposition parties have promised to renegotiate the bailout package if elected at an election due early in 2011. In Germany, the paymaster and strength behind the European Union (EU), Europe’s biggest tabloid Bild asked “First the Greeks, then the Irish, then…will we end up having to pay for everyone in Europe?”
In December, at a special EU meeting, the German view, set out by Chancellor Angela Merkel, prevailed.
The meeting rejected any attempt to increase the scope and amount of the existing bailout facilities. The E-Bond proposal was quietly shelved. The EU agreed to formalize the European Stability Mechanism (ESM) through a short amendment to the Lisbon Treaty. The new facility would be inter-governmental with any euro zone member having a national right of veto. The facility was highly conditional, capable of being triggered only as a last resort.
A key element was the requirement for “collective action clauses”, effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If the solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur. In addition, new bailout funds would automatically subordinate existing debt and have to be paid back first.
Chancellor Merkel’s position reflects the views of the German constitutional court, which endorsed European economic and monetary union prescribed in the 1992 Maastricht treaty only on the basis of the treaty’s no-bailout provisions. This influences the need to impose losses on investors.
It is clear that the stronger members of the EU, led by Germany, have decided to limit future liability in bailouts. As membership of the euro prevents large devaluation of the currency, economic adjustment will require reduction of the budget deficit and deflation. As Greece and Ireland demonstrate, more rigorous deficit cutting may not return the countries to solvency. The EU proposals implicitly recognize that over-indebted countries cannot sustain currency debt levels. The reduction of the debt burden will have to come through restructuring or default, with creditors taking losses.
Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral European sovereigns may be unavoidable. Investor concerns that the Greek and Irish did not solve the fundamental problems may be confirmed. The safety nets are now seen as unlikely to be large enough to rescue larger countries, such as Spain and Italy, if they require support. Investors will need to take losses.
This month, Portugal and Spain have managed to issue debt successfully, giving investors confidence—temporarily—that the problems are manageable. However, in Portugal’s case, the debt carried a yield of 6.7%. Portugal’s 10-year bonds briefly reached 7% earlier this month—a level investors demanded from Greece and Ireland shortly before both countries finally capitulated and accepted bailout packages. These issues will do little to alleviate longer-term pressure.
Large volumes of maturing debt mean that the test is likely to come sooner than later. The heavily indebted European sovereign states face $2.85 trillion of maturing debt in the period to 2013. Portugal, Italy, Ireland, Greece and Spain have bond maturities of $502 billion this year.
European problems now threaten global recovery. China, which contributed around 80% of total global growth in 2010, has expressed growing concern about the problems in Europe. Trade between China and the EU, its largest export market, totals around $470 billion annually, contributing a trade surplus of €122 billion for China in the first nine months of 2010. Any slowdown in Europe would affect Chinese growth.
A continuation of the European debt problems, especially restructuring or default of sovereign debt, would also severely disrupt financial markets.
Events since the announcement of the bailout package in early 2010 have been reminiscent of 2008. Then, as now, the optimism following bailouts of Bear Stearns and other troubled US banks was premature. The promise of China to purchase Portuguese and Spanish bonds is similar to the ill-fated investments of Asian and West Asian sovereign wealth funds in US and European banks.
Eventually, with each successive rescue and the re-emergence of problems, the capacity and will for further support diminished. The EU rescue of Greece and Ireland is also reminiscent of US attempts to rescue its banking system, with more and more money being thrown at the problem. The strategy was defective, preventing the creative destruction required to restore the system to health. The actions may have doomed the economy into a protracted period of low growth, laying the foundations for future problems.
Satyajit Das is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
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