(Recent Graham Bishop papers on this subject:)

The Heads of Government went away content that they had dealt with the immediate problem of Greece but the positive reaction from the financial markets was short-lived. The eurozone’s governance mechanisms seem to be only capable of achieving the barest minimum necessary to prevent an immediate melt-down. In the longer term, that is unlikely to be sufficient. As is now usual, the Heads stated: “We reaffirm our commitment to the euro and to do whatever is needed to ensure the financial stability of the euro area as a whole… All euro area Member States will adhere strictly to the agreed fiscal targets… 16. We invite the President of the European Council, in close consultation with the President of the Commission and the President of the Eurogroup, to make concrete proposals by October on how to improve working methods and enhance crisis management in the euro area”.

At his press conference afterwards, French President Sarkozy was much bolder: "We [he and Chancellor Merkel] agreed on the need for extremely ambitious and proactive advances in economic governance over the coming weeks … by the end of August, the Chancellor and I will present concrete proposals and the European Council President will in turn table measures in October".

Using the favourite press cliché of the moment, “the can has now been kicked down the road” to October to do “whatever is needed”.  If that decision turns out to be another damp squib that again appears to be the barest minimum, then financial market participants are reasonably entitled to conclude that the Heads of Government do not understand what is needed or, as a matter of political reality, are unwilling to do it.

An unexpected surge in global economic activity may float the good ship eurozone away from the looming rocks. But there is also a rising chance that the trans-Atlantic ship may decide to sink itself – with incalculable ripples (or a tsunami?) over here. The eurozone continues to sail in extremely perilous waters.

What was decided?

1. Greece was “bailed out” again. This term continues to be used emotively by the media to suggest that a “transfer union” has come into existence, whereas the assistance is in the form of highly-conditional loans designed to be repaid in due course. Restoration of the competitiveness of the Greek economy will be a lengthy process, so there was a sensible decision to avoid the obvious roll-over risks of short maturity bonds and extend bond maturities to those enjoyed by most other eurozone states. Correspondingly, interest rates were reduced from usurious levels that simply exacerbated the risk of eventual default to rates close to the cost of EFSF funding. This single step greatly increased debt sustainability as it should move debt interest back to about 5.5 per cent of GDP - the levels enjoyed by Greece when the benefits of euro membership flowed in. So Greece has been given a serious, second chance.

However, this good news was obscured by a lack of clarity about how much was new money and exactly how much was to come from the private sector. The IIF put forward an interesting proposal, but the actual participation will only be evident in the years to come and the savings for Greece are based on a discount rate of 9 per cent. Moreover, the opportunity was missed to set out the exposures of the supporting financial institutions so that the real significance of their contribution could be assessed, rather than the heroic assumption of a 90 per cent participation rate.

2. Private sector involvement

The Heads of Government stated:

“6. As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

7. All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms…”

It is quite laughable to attach any significance to this statement by the Heads of Government. Indeed, it would be interesting to sound out legal opinions on the liability of investment managers who invested client funds on the strength of such statements. The years of re-assurances by political leaders that no eurozone member would be allowed to default were exploded after Chancellor Merkel and President Sarkozy went for a walk on the beach at Deauville in October 2010 and then announced “The amendment of the Treaties will be restricted to the following issues: … providing the necessary arrangements for an adequate participation of private creditors”.

 

The Treaty change is underway at this very moment and eurozone governments committed themselves (Eurogroup, 28 Nov 2010) to inserting “collective action clauses” into their bonds after 2013 to facilitate “private sector involvement”. This was designed explicitly “to send a clear signal to the private sector that their claims are subordinated to those of the official sector”. In just 18 months, investors will be obliged by the terms of the prospectus to price in default risk where any eurozone government shows any sign of financial difficulty. Such concerns would quickly spiral into a full-blown crisis of confidence in debt sustainability of that government.

 

So the laughter may turn to tears all too quickly, as it becomes ever more apparent that the Heads of Government simply do not understand the natural, logical consequences of their actions. Until the hard evidence shows that they have come to terms with these consequences, increasingly flowery and grandiose gestures are only likely to fuel scepticism that they can realistically deal with the problems posed by 40 years of ever-rising public debt. For the eurozone in aggregate, these debts may now be teetering on the brink of sustainability. If the grand solution turns out to involve bitterly contested Treaty changes that will take years to be ratified, then an effective EU may already be history by the time of ratification.

 

According to the European Commission’s forecasts for 2011, the eurozone pubic debt is around 88 per cent of GDP and the average interest rate is 3.4 per cent. In recent weeks, financial markets have shown that any crisis of confidence will quickly push the marginal interest rate on new debt above 6 per cebt. If such an increase flowed into the debts of an ever-more cross-guaranteed eurozone, then other public spending would have to be cut by 5 per cent or more in cash terms. The Heads of Government need to show they have grasped the full implications of this basic arithmetic, and will take the necessary, simple steps to avoid it.

 

3. Stabilisation tools

A welcome commitment to extend the remit of the EFSF/ESM to allow them to act early; give loans to re-finance banks – including in non-programme countries; make secondary market purchases - but effectively subject to a veto by the ECB or any EFSF/ESM Member State. Collateral may be required from the borrower – a clear nod to Finland (but with profound political implications for borrower States).

 

In recent papers, this author has argued that the EFSF’s terms of reference should be changed to enable borrowing on demand by any State whose economic policies have been approved by the Eurogroup during the “European Semester”. Empowering the EFSF’s facilities to be used on the basis of a “precautionary programme” would seem to go a long way towards this goal.

 

• Could this new tool open the way to a transfer of the ECB’s bond holdings to the EFSF to restore purity to the levers of policy? The Eurosystem already has the dealing desks that could enable it to act as the EFSF’s agent immediately. How quickly will the ECB be empowered to act in the secondary market against a future purchase obligation by the EFSF?

• Though the EFSF has a ceiling, earlier ministerial statements appear to have left open the possibility of increases in the size. The new functions could easily exhaust the existing capacity – but markets might have reacted much more favourably if the statement had underlined again the willingness to expand as necessary, rather than always lag behind needs and perceptions?

 

4. Fiscal consolidation and growth

All eurozone States will adhere strictly to their agreed plans to improve competitiveness and remove macro-economic imbalances. As these plans are agreed by all eurozone members, they should indeed open the way to borrowing from the EFSF by any state faced by “exceptional financial market circumstances” which cause an unreasonable challenge to its debt sustainability. This would be a critical step on the way to an effective political union.

 

• Pro-growth aspects of this were not spelt out sufficiently to catch market attention. The idea of increasing the co-financing rates for structural funds and raising the capacity to absorb EU funds are deeply EU technocratic terms that mean little to the average market participant. Why not spell this out as a per cent of Greek GDP? The number could well look significant.

 

5. Economic governance

“13. We call for the rapid finalisation of the legislative package on the strengthening of the Stability and Growth Pact and the new macro-economic surveillance. Euro area members will fully support the Polish Presidency in order to reach agreement with the European Parliament on voting rules in the preventive arm of the Pact.”

 

• Why could they not simply agree at the Council meeting to the final element of Parliament’s proposal on the six-pack? This would enable a courageous European Commission to propose prompt corrective measures to any State which is losing competitiveness due to unsound overall economic policies. The Member States could only override such proposals by Qualified Majority Vote (QMV) – a tough requirement that would probably only be met in the event of manifest error by the Commission. These policies would underpin a strong probability of good economic behaviour into the foreseeable future. That would be a huge confidence-boosting measure.

It is widely reported that France is the main obstacle to this agreement. How does this opposition square with President Sarkozy’s plans for “extremely ambitious and proactive advances in economic governance”? How is this refusal consistent with the statement that “All euro area Member States will adhere strictly to the agreed fiscal targets”? It seems intensely illogical to make commitments that are intended to convince – yet refuse the step of binding one’s hands to ensure the commitment is fulfilled. Market participants are baffled, and can be forgiven for doubting the true commitment. It would be simple to put these doubts to rest.

What remains to be done?

1. The absence of technical details and widespread reports of confusion about exactly what was agreed are dispiriting, as they provide ammunition to bears of the euro. Reading between the lines, it is possible that an agreement was made that will have far-reaching consequences. The details need to be fleshed out, especially when many of them exist already but are spread around many dense, technical working documents that non-specialist journalists reporting within a few hours will have no opportunity to research.

2. The depth and scale of the eurozone leaders’ commitment can be spelt out readily by the simple process of laying out the timetable of bond maturities for the programme countries say to the end of 2011. The schedule could include the timing of the corresponding inspection visits by the EU/ECB/IMF and subsequent reporting to Eurogroup meetings for approval. The final step would then be the provisional calendar of issuance by the EFSF/ESM to fund these entirely foreseeable borrowing requests.

Such a schedule would demonstrate the scale of future borrowings and it would have to be integrated into the programme of eurozone government borrowing. It would soon be clear that a major, top quality borrower had emerged on a scale that would rival many EU governments. Colloquially, its issues might soon be termed “Eurobonds” even though they stopped distinctly short of the thorny obligation of assuming the debts/liabilities of other Member States” – the act forbidden by Article 125 (popularly known as the no-bail out rule). Any change to that Article is likely to be a long-drawn out and acrimonious battle that could easily divide the eurozone, rather than unite it.

3. Take proper account of the potential credit risk that is being built in explicitly to eurozone government bonds. The European Commission has just published “CRD IV” - a mammoth set of documents that runs to nearly 700 pages. This proposal would implement Basel III into EU law. However, the Commission has not received any political guidance on the need to deal with the new risks that EU governments are about to introduce.

The proposal maintains the now self-evident fiction that eurozone government bonds are risk-free, and so should be given a zero risk weighting. Moreover, the most basic measure of risk management rules - prohibiting “large exposures” to any group of connected borrowers - are explicitly dis-applied (Article 389) to sovereign governments. This is precisely the mechanism to spread contagion from the State to its implicitly–guaranteed banks, and then on to their counter-parties in other States.

It would be utterly irresponsible for the Heads of Government to permit such a contagion-spreading mechanism to continue.

 

Recent Graham Bishop papers on this subject:

Responding to the bank stress tests: Eurozone’s leadership – not the bankers - on trial 17 July
Either political union of the eurozone OR disaster is at hand: a 7-point plan 11 July
Graham Bishop: Three Proposals to ensure Fiscal Sustainability in the Eurozone  27 January
Graham Bishop's book: The EU Fiscal Crisis: Forcing Eurozone Political Union in 2011? 20 January