A wake-up call for Europe
With US$2.5 trillion wiped off the value of stocks in the past week alone, it feels almost like a replay of 2008. During that time, the turmoil in the markets - which intensified after the collapse of Lehman Brothers on Sept 15 that year - was triggered by the US sub-prime mortgage crisis. This time, the turmoil is driven by the eurozone sovereign debt crisis - with a little help from the United States, which has just condemned itself to a decade of fiscal austerity. Just how bad the repercussions of this will be are still uncertain, but we know they will be bad.
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By VIKRAM KHANNA
06 August 2011
With US$2.5 trillion wiped off the value of stocks in the past week alone, it feels almost like a replay of 2008. During that time, the turmoil in the markets - which intensified after the collapse of Lehman Brothers on Sept 15 that year - was triggered by the US sub-prime mortgage crisis. This time, the turmoil is driven by the eurozone sovereign debt crisis - with a little help from the United States, which has just condemned itself to a decade of fiscal austerity. Just how bad the repercussions of this will be are still uncertain, but we know they will be bad.
Why has the slow-burning European crisis, which has been on our radar screens for more than a year, suddenly flared up again?
One reason is that until last month, it was presumed that the crisis would remain confined to the relatively small countries on the so-called periphery of the eurozone, namely Greece, Ireland and Portugal.
It is now clear that this was wishful thinking. The crisis is threatening to engulf the larger economies of Spain and Italy as well. Two-year sovereign bond yields for Italy have soared from about 3 per cent in early July to 4.5 per cent at present; Spanish government bond yields have jumped from 3.3 per cent to 4.3 per cent over the same one- month period.
The prospect of contagion, while worrying, would be less panic-inducing if the eurozone had the mechanisms and resources in place to deal with it; but it doesn’t. Which brings us to the second reason why hell is breaking loose. The possibility of defaults by large countries was never explicitly acknowledged by eurozone officials, and there are no known contingency plans to deal with it.
Now that possibility is no longer negligible. Part of the reason for this is the precedent set by Greece. The restructuring of Greek sovereign debt last month involved private sector holders taking a 20 per cent haircut. With private sector burden sharing perceived as the norm, investors are naturally demanding higher risk premiums on the sovereign paper of other troubled debtors, like Spain and Italy. Higher borrowing costs for these countries in turn make them more vulnerable to default risk.
While Spain and Italy are gamely trying (along with Greece, Ireland and Portugal) to push through multi-year fiscal austerity programmes to put their finances in order, market vigilantes such as hedge funds doubt whether austerity alone will be enough, even if it proves politically sustainable - which is a big ‘if’; everybody knows there is a limit to fiscal austerity.
The prospect of the restructuring of Spanish and Italian sovereign debt - even though still loudly denied by the authorities of those countries and the eurozone - is being viewed by markets as increasingly probable. This would impose huge losses on banks, insurance companies and pension funds. In the absence of corrective action, it could also threaten another round of credit seizure where banks again cease to trust each other (just like in 2008) and lose access to interbank funding.
If their borrowing capacity seriously dwindles - although this has not yet happened - Spain and Italy would also need additional funding, just like Greece and Ireland did. But from where? The International Monetary Fund (IMF) will no doubt help, but it does not have sufficient resources to alone provide rescue credits, which could run into hundreds of billions of euros. The eurozone’s hastily-created temporary bailout vehicle, the European Financial Stability Facility (EFSF), is also woefully underfunded for the task. The eurozone authorities have said they plan to strengthen the EFSF to deal with contagion, but they haven’t done it yet.
It continues to see its central mission as fighting inflation. Thus, even as some eurozone countries were deep in recession, reeling from high borrowing costs and property price collapses, the ECB (citing inflation risks) raised interest rates, first in April to 1.25 per cent and then again in July to 1.5 per cent. This has only made matters worse.
Early this year, in a break with tradition, the ECB reluctantly bought bonds of distressed eurozone governments, such as Greece and Portugal - essentially because nobody else would buy them and it had no choice but to support these countries’ banks which would lose their lifeline. But it later abandoned this practice. It also announced that it would not accept bonds issued by a country in default and consistently opposed debt restructuring - partly because it would itself have to take a haircut on its holdings of distressed sovereign debt.
But this position is becoming increasingly untenable: the eurozone needs a buyer of last resort for sovereign debt and there is no institution capable of playing that role other than the ECB. Debt restructuring is also already a reality in the eurozone. The threat of bank insolvencies in Europe could also be a reality, and if they happen, the ECB would be forced to help recapitalise the banks, just as the Federal Reserve was forced to do in the United States.
Europe’s debt crisis can be brought under control. But that will require European authorities to explicitly acknowledge its real scope - which goes far beyond the peripheral countries. It would also need the ECB to wake up to the fact that it must widen its mandate and, for now, get over its obsession with fighting inflation. Until that happens, the crisis will go on.