Background

The European Union (EU) summit June 28-29, and, perhaps more than the market appreciates, the European Central Bank (ECB) meeting on July 5^th, will be crucial to the future of the eurozone. At present, peripheral countries are stuck in a negative feedback loop, where capital outflows lead to deleveraging, which pushes down growth, leading to deteriorating fiscal fundamentals, resulting in calls for austerity, which in turn worsens the growth outlook and encourages further capital outflows. Policymakers need to act to break this feedback loop. Otherwise peripheral countries, including Spain and Italy, will be forced to consider default and withdrawal from the monetary union.

 

What do policymakers need to do?

• Fiscal Union:
• Debt mutualisation to guarantee market access for all sovereigns at reasonable rates
• Symmetrical fiscal adjustment, where austerity in the periphery is off-set by stimulus in the core and increased transfers to weaker nations
• Eurozone-level budget control
• Banking Union:
• Eurozone-level bank supervision for all banks
• Eurozone-level bank resolution: bank recapitalisation direct from the European Stability Mechanism (ESM), not via the sovereign
• Eurozone-level deposit insurance: deposits guaranteed jointly and severally with the implicit or explicit backing of the ECB
• Central Bank:
• ECB states explicitly that it is the lender of last resort to sovereigns and will ensure reasonable interest rates with unlimited support

 

It is worth noting that the above solutions are becoming widely accepted even by eurozone policymakers. Much of the argument now is about sequencing and governance. The solution might well be at hand; the real question is whether political constraints prevent policymakers from grasping it.

 

What is likely in the near future?

No eurobond in the near term: Germany will not countenance any moves to debt mutualisation without a move to eurozone-level budget controls, enshrined in a new treaty. The German constitutional court would not allow the government to assume an open-ended liability without a constitutional change and probably a referendum. Furthermore, Germany will want to exert significant budgetary control, otherwise it will be writing a blank cheque to the periphery. German Chancellor Angela Merkel’s comments June 22, reflect these fears: “If I give money to Spanish banks, I am the German chancellor but I can’t say what these banks do.”

 

France, on the other hand, is demanding mutualisation as a prerequisite for a loss of sovereignty. Francois Hollande, President of France, has asserted that, “There can be no transfer of sovereignty if there is not an improvement in solidarity.” Unless France is forced by market pressure to give up sovereignty, it is unlikely it will agree to the type of eurozone-level governance structure which will be acceptable to Germany. As a result, little movement is likely on eurobonds in the near term.

 

A eurozone redemption fund and euro bills are more likely, but also not very soon: A eurozone redemption fund, where debt greater than 60% of gross domestic product (GDP) is pooled and then funded by joint and severally guaranteed debt, and euro bills, issued on a joint and several basis, would get around the German constitutional constraints, as they at least theoretically would have a limited size and time horizon. However, it is hard to see these policies being implemented without parliamentary ratification and even referenda. The implementation of a redemption fund and/or euro bills would therefore take a long time. Furthermore, as Germany might see these measures as a stalking horse for eventual eurozone bills, it would probably still demand greater eurozone-level budget control. They would therefore face similar political constraints to eurobonds.

 

Growth initiative: The mini-summit on June 22, confirmed that some sort of growth initiative, via additional European Investment Bank (EIB) lending, streamlining the dispersal of EU structural funds and project bonds, will be announced. The size has not been confirmed, although numbers of between €80 billion and €140 billion have been quoted. Unfortunately, this amounts to less than 1% of eurozone annual GDP, and given the time lags in implementing infrastructure programmes it is unlikely to cover a single year. With even Germany’s debt to GDP at 81.5%, there is little room for core to periphery transfers without the institution of some sort of eurozone-level tax, which of course comes up against the same political obstacles as eurobonds.

 

Banking Union: It is likely that eurozone leaders will agree to cede responsibility for supervision of large, systemically important banks to the ECB. Unfortunately, as many of the problematic banks are small, for example the Spanish cajas or German landesbanks, it is unlikely this will provide much additional transparency. It will be difficult to agree a eurozone-level resolution authority quickly, given differing bankruptcy laws. Direct lending to banks from the ESM would also probably require re-ratification. At present not even the original ESM treaty has been ratified by all countries. Perhaps the most positive outcome could be the ESM losing its senior lending status; however, whether the ESM board alone can agree to this is legally unclear. Lastly, eurozone-level deposit insurance is very unlikely, due to the massive liabilities involved (peripheral deposits are approximately €3 trillion). Jointly guaranteed deposits would be much the same as eurobonds in terms of sharing credit risk. It is therefore unlikely Germany will agree to it without the prerequisite of eurozone-level budget control.

 

Central Bank: The ECB has already moved to ease liquidity constraints by loosening its rating requirement for collateral. Interviews with a number of Governing Council members suggest growing support for a deposit rate cut. We might also get a new 3-year longer term refinancing operation (LTRO), although funding markets have been relatively well behaved of late, with Euribor continuing to trend downward, and bank credit spreads, outside Spain and Italy, tighter than last November. Outright Quantitative Easing (QE) seems extremely unlikely at present. It might be more acceptable to restart the covered bond programme, as this would not be constrained by the ECB’s Articles, which prohibit monetary financing of governments. ECB President Mario Draghi has commented on the need for a long-term vision of the eurozone, so it’s possible that a successful summit will embolden him to more drastic action. However, much like France in the debate about ceding sovereignty, it would require additional market pressure for the Bundesbank and others to agree to support outright buying of government debt in unlimited amounts.

 

(1) The interest rate at which participant banks within the European Union will lend to another participant bank in the EU. This rate has become the short-term interest rate.

 

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