February 10, 2011

Hopes raised, punches pulled

European leaders look set to fudge the latest test of their resolve.

EVER since the sovereign-debt crisis erupted a year ago bond markets have repeatedly tested the resolve of European leaders to avoid government defaults. On each occasion euro-zone members have done something—but not quite enough to quell the crisis. This year looks like following the same pattern.

In early January investors sold off bonds issued by vulnerable euro-zone countries like Portugal, on the region’s periphery, and Belgium, closer to the core. In response Germany, the euro area’s reluctant paymaster, put its weight behind another initiative. A “grand bargain”, which is due to be struck at a summit in March, is supposed to bolster the support available for rescues. In return the euro zone will embrace more Germanic discipline.

Hopes had been rising that the grand bargain would live up to its name. Spreads of Portuguese and Spanish ten-year government bonds over German benchmark bunds dropped appreciably from their spikes in January. But an inconclusive meeting of European leaders on February 4th has darkened the mood again.

The one concrete reform that looks likely is an increase in the effective size of the rescue funds available to struggling euro-zone states. When these were first unveiled last May, they were said to total €750 billion ($1 trillion), of which the biggest component was €440 billion from a new entity, the European Financial Stability Facility (EFSF), whose borrowing is backed by guarantees from euro-area members. The rest would come from the European Union and the IMF.

But once the EFSF was set up it became clear that its effective lending capacity was only around €250 billion. The shortfall arises mainly because only six of the euro-area states have a AAA credit rating. This means that the facility has to retain big cash reserves in order to achieve the same rating for itself. The EFSF raised €5 billion in the markets in late January to fund loans to Ireland, for instance, but of this only €3.6 billion has found its way to the Irish. The March summit will almost certainly increase the bail-out facility to match the original promise of €440 billion. This could be done by raising the guarantees that back the facility and getting less creditworthy states to pay in capital.

The trouble is that investors increasingly fear the original bail-out sum of €750 billion will not be enough to douse the fire should it spread from smaller peripheral countries to larger ones like Spain. These fears were fuelled by Ireland’s bail-out late last year, which was sparked by the rising cost of recapitalising a bust banking system. Analysts worry that more banking bills may surface elsewhere, straining rescue funds. Willem Buiter, chief economist at Citigroup, has argued that up to €2 trillion of liquidity support may be needed.

Another disappointment of the February 4th summit was the perception that European leaders seem to be backtracking on plans to enhance the clout of the EFSF. Until now the European Central Bank (ECB) has reluctantly shouldered the job of intervening in markets by buying the bonds of troubled countries. But the summit communiqué did not include the expected diplomatic codeword (“flexibility”) for enabling the EFSF to do more. A less supple EFSF will be less effective. It may also heighten tensions within the ECB: rumours flew this week that Axel Weber, head of the Bundesbank and a critic of the ECB’s foray into bond-buying, no longer wants to be a candidate to succeed Jean-Claude Trichet as its president.

Speculation that the EFSF could facilitate a reduction in the debt of countries like Greece through buy-backs has also faded. Under such a scheme the facility would lend funds to the Greek government, which would then purchase its own debt at supposedly bargain-basement prices. Since these transactions would be voluntary there would be no default and they would be a cheap way of reducing the nominal value of the debt. It is not clear how well the idea would work in practice. Without a big discount to bonds’ par value, buy-backs may have only a limited effect on countries’ debt burdens. And using scarce EFSF resources for this purpose would reduce the ammunition for dealing with another emergency.

Rather than deal with these tricky issues, European leaders concentrated at the summit on the other side of their grand bargain, the reforms Germany wants to prevent future crises. Under a “competitiveness pact”, weaker countries will have to overhaul their economies so that they can cope with the rigours of being in the single currency. That will involve reforms in sensitive areas such as retirement ages, corporate tax and wage-indexation. Germany is also keen for countries to forswear budgetary profligacy (for example, by putting “debt brakes” into their constitutions).

Some of these ideas make sense, others less so. Delinking wages from prices would be a good idea. But aligning corporate-tax rates at a high level would make the euro area as a whole less attractive for foreign investors as well as clobbering countries like Ireland that have especially low rates. It is hard to avoid the impression that the desire to remould the euro area in Germany’s image is designed above all to mollify German voters.

The bigger flaw in the plan is that it seeks to muddle through the sovereign-debt crisis rather than get on top of it. The unpalatable truth is that government debt in Greece, and probably in Ireland and Portugal too, will have to be restructured. European leaders may yet pull a rabbit out of the hat. But this month’s meeting has many worrying that next month’s reform package will be woefully inadequate.

Source: http://www.economist.com

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