Tackling Eurozone crisis

By Padhraic Garvey

The Eurozone crisis has gripped world attention in the past couple of years, and inability to address the problems in a convincing manner has seen manageable issues within the Economic and Monetary Union (EMU) become problems that have grown so large that they could pull the system apart.

As it is the breakup risk remains elevated, and that risk has continued to increase since the crisis erupted in early 2008. Since then three small issuers (Greece, Ireland and Portugal) have gone cap-in-hand to its EU partners and the IMF, and more recently two large issuers (Italy and Spain) have had to ask for European Central Bank (ECB) support through purchases of their government bonds.

Every time the Eurozone politicians have cobbled together a solution it has been too little too late, and frustratingly has pushed the EMU system further into crisis. A number of things have been agreed. EU loans to Greece were a first important step. Then the European Financial Stability Facility (EFSF) was set up to help fund stressed issuers. However, in both cases the initial packages have had to be subsequently doubled in size in order to appease market demand for a more credible solution.

In the meantime the ECB has been reluctantly buying paper of the aforementioned issuers, acting like a massive band-aid over the problem. This so-called Security Market Purchase (SPM) program was resurrected recently as Italian bonds came under severe pressure. The ECB’s decision to buy Italian bonds was a huge one, as this sees the ECB attempting to support the largest bond market in the Eurozone, and the third largest bond market in the world.

Moreover, at the pace that the ECB is currently buying, they could own the entire Italian BTP market in a little over two years! The ECB finds itself in this uncomfortable position as European politicians consistently struggle to find a solution to the debt crisis.

Such a solution is premised on four key elements. First, there needs to be a hard haircut for Greek government bonds of at least 50 percent. Second, the banking system needs to be ready for this and the risk of more, and therefore needs a core capital adequacy ratio in the region of 9 percent. Third, the EFSF needs to be leveraged so that it has much greater firepower than it currently has. Fourth, the ECB’s SMP program needs to remain in place and ready to buy Eurozone government bonds when necessary. If we get these four elements in place we could see a turning point towards better times.

However, that would not be an end to the crisis. There are two additional elements that need to be addressed, more structural elements that need more time get up and running. The first element is to do with competitiveness. Surviving in a single currency regime requires an ability to compete. Greek unit labor costs have increase by some 65 percent since they joined EMU while German unit labor costs are slightly down. Greece needs to contain/reduce wages and/or grow productivity in order to be a more credible EMU member; else we face into the same problems again in a decade.

The second medium-term requirement is a more credible fiscal union, ideally backed by a common issuance policy for government bonds. This will be an equally tough one to pull off. It requires that the Germans take more responsibility for Greek debt and in effect are jointly liable for Greek debt. This is a big task, but something along these lines is required in order to ensure that we do not see a crisis like this one again. Importantly this crisis can happen once only. The core countries would not tolerate this happening again in a decade, which is why addressing Greek competitiveness issues is a key necessary condition before any semblance of fiscal transfer union is seriously considered.

So where does this leave us? Eurozone politicians have promised to deliver a big solution. With the markets in a state of crisis fatigue, there is hope that this will ease some tensions. Yet, if it is not credible enough this crisis will roll on into 2012 and risks only getting worse. That said, it remains unlikely that Greece will leave the EMU. The political momentum behind preventing this from happening is very strong, both from the core EMU members and from Greece itself. For as long as this remains the case EMU remains intact and a solution to the debt crisis happens along the lines as described above.

To the extent that Eurozone politicians eventually appease the markets the consequences for global markets and for Asia are positive. The risks to the system are reduced and recession risk is eased in Europe. This would not be enough to directly impact Asian growth in a positive fashion, but it would certainly minimize the negative impulses that have been coming from the Eurozone debt crisis. Some smaller EMU members would remain in recession as they deal with austerity measures, but the larger EMU members would have a platform from which to grow from, and in particular German growth could re-ignite.

Even in a relatively positive environment where the EMU survives there remain some significant residual risks. The most important of these is the contingent liability that falls back on the AAA-rated EMU members coming from the payout of EFSF loans to the stressed periphery. Importantly these loans add directly to the debt/GDP ratios of the supporting issuers, which thus deteriorate their credit metrics. The biggest risk here centers on France, which is the weakest of the AAA-rated issuers. Use of the EFSF could push the French debt/GDP ratio to the mid-90’s, threatening its AAA rating.

This would be better than the alternative scenario where Greece leaves the EMU. If this happened the Drachma would likely collapse in value by some 65 percent versus the Euro, seriously undermining net investments in Greece held by overseas players. Banking assets and liabilities and Greek government bonds would be re-denominated back into Drachma, hurting overseas holdings in particular. In addition, a haircut on Greek government bonds would likely be delivered on top of that, worsening the pain.

This would only be the beginning as the Greek banking system would likely implode, likely requiring nationalization and/or re-capitalization. The Greek economy would likely shrink by some 10 percent in the first year, and by another 10 percent thereafter. And then there is the contagion to the rest of the Eurozone to consider. The shock to the system would likely see European bourses crumble, and may well necessitate the closure of exchanges for a few days in order to stabilize things.

The shock wave across the global financial system would likely be severe with Asian equity markets also seeing significant downward pressure. A risk-off mode would likely persist for a number of weeks at the very least as the Eurozone comes to terms with the first loss of one of their members. The worry would be that if Greece can leave, then perhaps Portugal or Ireland could also leave. And in the worst case the likes of Italy could come under pressure as a potential exit candidate, which would basically mean the end of EMU.

The loss of even one EMU member would be a nightmare. The consequence are unbounded, and we would venture into the absolute unknown which would see financial markets trade worst case fears, potentially bringing down the global financial system for a period. This in turn is why we think it will not happen. The only risk to our view is that Greece itself decides to leave. If that happens there is nothing that could be done to prevent this, and we would have to manage the consequences.

The writer is the Global Head of Developed Debt and Rates Strategy at ING Bank.