The past two months have seen a fairly typical - if dramatic - example of the European Union response to a policy dilemma. First comes an extended period of trying to avoid the problem, paying some lip-service to the issue but with each leader ultimately more focused on any domestic political dimension. Then comes a final deadline that forces the collective hand of the Union members, resulting is some last-minute deal-making to avert a (real or imagined) crisis. The result is also typical - a deal that both creates a shift in the parameters of the Union and leaves an awful lot of unfinished business swept under the carpet.
The deal struck over the weekend of May 8-9 has certainly averted a crisis. By Friday May 7 there were worrisome signs that the markets were not convinced that the earlier agreement to aid Greece would be enough to prevent Portugal and Spain also having problems with servicing their debts. The fact that these latter two countries are in nowhere near the same dire straits as Greece did not matter - contagion was about to turn the fear into a self-fulfilling prophecy as investors dumped Euro-zone assets and it began to look as if the European interbank market was about to seize up again (as happened post-Lehman). By Monday morning agreement had been reached among the Euro-zone 16 and also the wider EU-27 on a series of steps that together generated headlines about a $1 trillion package to "save" the euro. Markets heaved a sigh of relief, crisis averted. But those pesky medium-term problems about fiscal deficits and the need for economic restructuring in many countries still have to be faced. The precedent of the other members demanding that Spain make a renewed commitment to fiscal austerity raises the specter of a new level of intervention in each others' policy settings. And the big issue has been swept under the carpet - how to ensure prudent fiscal policy-making across the 16 members of a monetary alliance with strong national identities and prickly memories of past hostilities.
How did we get here?
The following summarizes the events of the past few weeks, and is based on questions we have been answering from clients and partners on how all of this happened and what might come next. The past decade was a period of easy money for Greece. Markets assumed "all Euro-zone members are really Germany" and sovereign debt spreads over bunds narrowed markedly for all issuers - in the case of Greece, from as high as 1600 bps in mid-1994 to just 20 bps in late 2007. Successive Greek governments spent this "easy" money, boosting the annual fiscal deficit - and used creative accounting to disguise the size of the shortfall in order to qualify for Euro-zone membership in 2002 (a year later than everyone else). After a general election last year, the new Greek government revealed in October that the fiscal deficit was higher than the previous government had admitted and by the end of the year the scale of the creative accounting and the size of the fiscal shortfall were leading to serious questions about the government's ability to meet its debt obligations over the coming years. The other Euro-zone members talked vaguely of the need for some form of assistance and eventually came up with a €30 billion plan involving lending from the members and the IMF. Markets became increasingly uneasy. On April 22 Moody's downgraded its Greek sovereign rating a notch to A3, then on April 27 S&P slashed its own rating three notches to BB+, i.e., junk status, sending markets into a tailspin and Greek debt spreads soaring.
Euro-zone Moves to Support Greece
Euro-zone talks over the size and parameters of an aid program finally got serious in April as it became apparent that, at these prices, Greece could not fund itself in the markets, making the €30 billion deal clearly insufficient. By May 2 a larger deal had been agreed: €110 billion in loans over a three year period, with €80 billion from fellow Euro-zone partners and the rest from the IMF. This year, Greece will get €30 billion from fellow '-zone members, the proportions reflecting each country's capital position at the ECB. In return, the Greek government has agreed to a severe fiscal austerity package that aims to get the general budget deficit down to 3.0% of GDP by 2014. The IMF will undertake quarterly reviews of Athens' adherence to its pledges.
Meanwhile, on May 3 the ECB tossed out a critical lifeline, announcing that it would suspend the minimum rating threshold for acceptance of Greek debt as collateral, so guaranteeing the Greek banks access to cheap central bank funding irrespective of the status of the sovereign rating - a sign of the severity of the funding crisis hitting the Greek banks (and potentially other European banks holding Greek debt). By May 7 the parliament in Germany - the largest participant - had approved its €22.4 billion three-year contribution, as had France (€16.8 billion). And on May 9 the IMF approved its part of the deal and announced that €5.5 billion would be made available immediately. These commitments ensure that Greece can meet its near-term funding needs. In particular, it should have no problem refinancing the €8.5 billion 10-year Euro-bond due on May 19. However, at this point the markets remained unconvinced that Greece could avoid a debt restructuring - despite repeated insistence from Euro-zone officials to the contrary.
The Euro-zone Responds to Wider Pressures
Last weekend's Euro-zone agreement was designed to ease market fears and prevent contagion from spreading. Headlines have trumpeted the "$1 trillion shock-and-awe" response. The details are more complex, with the €750 billion actually spread among three separate measures:
1) A €60 billion rapid reaction stabilization fund, controlled by the European Commission, ready to send money to a Euro-zone country facing a financing crunch. (Based on Article 122 of the Lisbon Treaty that allows the Commission to rush aid to a country in crisis, although 122 was envisaged as covering natural disasters.) Modeled on the existing balance of payments facility that has aided non-zone EU members such as Hungary. Funds are borrowed by the Commission on the markets, using the EU budget as collateral. Theoretically, all 27 EU members are on the hook if any money from the €60 billion pot is disbursed and not paid back.
2) A "special purpose vehicle" is being created by an intergovernmental agreement among the 16 zone members, which will raise up to €440 billion on the markets using a mix of loans and guarantees. This will be the hardest of the various steps to implement. The German cabinet yesterday backed plans for Germany to provide up to €123 billion in loan guarantees, which suggests the plan is moving along smartly. However, any actual loans approvals would be contingent on the recipient country meeting fiscal deficit targets agreed with the IMF and the EU.
3) The IMF will add up to €250 billion of "matching funds". No specifics have been provided by the Fund except the amount and a statement that any IMF action "would be on a country-by-country basis."
In addition to the above, the ECB finally took the step it had been trying to avoid - buying up government bonds in the market (albeit indirectly, via its member central banks making purchases in the secondary market). Trichet announced this step would be done to "ensure depth and liquidity in those market segments that are dysfunctional" - in other words, this is not part of a monetary bid to reflate the economy but is a means of countering a short-term market crisis. The ECB said the scope of the purchases has yet to be determined but would be offset by liquidity-absorbing operations so that the stance of monetary policy is not affected (i.e., for every €-worth of debt bought, the ECB would sell other securities back into the secondary market). A number of central banks have begun making purchases (including Greek and Portuguese debt).
The ECB also announced it will resume some of the emergency liquidity measures it had put in place post-Lehman, measures the ECB was starting to scale back. Specifically, it will resume fixed-rate 3- and 6-month liquidity operations (rather than competitive tenders) and did not say how long it anticipates keeping these operations in place. Meanwhile, the Fed reopened currency swap lines with several central banks in a bid to ease fears of a US$ shortage as investors dump riskier assets and move back into the greenback. Finally, the ministers reportedly put strong pressure on Spain to take more concerted steps to cut its fiscal deficit in order to reassure the markets. Spain said on Monday it will not draw on any of the emergency funds and today outlined a new round of spending cuts.
Why Spain and Portugal are not the same as Greece
Before getting to the longer-term issues raised by all of this, it is worth taking a moment to outline our oft-repeated argument that Spain and Portugal are not Greece. Both did see their sovereign ratings downgraded by S&P last month, but to far-from-junk levels of AA and A-, respectively, and not because of concerns about solvency but as a reflection that both are in for a prolonged period of subdued growth. Neither sovereign faces the high short- or medium-term funding needs of Greece, and both have been able to finance their debts in recent weeks, albeit at higher prices. Both should also be able to borrow at these higher rates this year, without seriously undermining their ability to finance their debts.
Portugal's fiscal deficit last year hit 9.3% GDP and it is running an annual current account deficit over 8% of GDP, implying serious concerns about its medium-term competitiveness. The government may struggle to reduce the fiscal deficit to 8.3% this year as pledged. However, public sector debt stands at about 77% of GDP, far below others in the 'zone. And, Portugal's gross financing needs are only about a third of those of Greece this year, giving the government more breathing room to establish fiscal credibility.
Spain is nowhere close to even Portugal's woes, let alone Greece's. The economy is struggling from a housing and construction market collapse, from woes in the smaller and community-based banks, and from the plunge in external demand, all of which will hold down GDP growth through 2011 and have boosted the unemployment rate to 20.5% in Q1. However, the economy did finally emerge from recession in Q1 with 0.1% quarterly growth and early indicators for Q2 show some signs of life returning. The fiscal deficit hit 11.2% of GDP last year, but the recently-announced plan of spending cuts should see it fall below 10% this year and stands a realistic chance of meeting the 3.0% target by 2013. Public sector debt will rise to a still-manageable 65% of GDP by end-2010. And finally, the amount of debt that Spain will need to raise this year is estimated at about €97 billion, well below the €140 billion issued last year, and it has already successfully issued a large proportion.
Near-term risks appear to have been ameliorated. Pressure on Euro-zone banks and counterparties should ease and there is unlikely to be a serious risk of the interbank market seizing up again. On the downside, if $1 trillion of shock-and-awe doesn't prevent serious market contagion, the Euro-zone players are out of options.
Athens is facing a mammoth headache after the decade-long party. The economy is headed for a real GDP contraction of around 4% this year. Even with the tough new austerity steps being implemented by the government, public sector debt is forecast to peak as high as 149% of GDP in 2013 before then starting to decline. According to the IMF, more than one-third of the debt stock will mature in the next three years and almost half will mature in the next five years. That maturity profile alone means that Greece will remain under the investor spotlight. More to the point, Athens' fiscal policy will be subject to quarterly reviews from the IMF. If the Fund were to judge that critical targets had been missed, aid could be withheld, sparking a new debt crisis for Greece. There is also a risk that the Greek populace will make the country ungovernable - not unthinkable given the violence of recent protests in Athens - although the headlines about a shared Euro-zone crisis and aid package may help to reduce the fury.
For now, Greece should meet its near-term funding needs without a major problem. However, its debt profile remains unsustainable. Unless the fiscal austerity plan very quickly leads to a dramatic shift in the public accounts (not unthinkable, given that Greek accounting apparently was so chaotic that no-one really knows what was going on) there is a real risk that austerity will lead to such a sharp recession that the resulting drop in GDP makes it even harder to bring down the ratio of debt-to-GDP. We believe there is a strong possibility that, once the current wave of market panic has subsided, there will be some form of Greek sovereign debt restructuring - done in a way that allows the European banks in particular to avoid massive write-downs, perhaps an "agreed" extension of terms.
There is still a fundamental need for almost all members (and others, such as the UK) to do some serious fiscal restructuring to get their deficits under control. This will be a major constraint on growth across the 'zone and wider Europe through 2011. There may also be some pressure on Germany to stimulate its own domestic demand, rather than rely on exports to generate its own growth.
Going forward, there will be less tolerance for 'zone members that do not do enough to reassure markets that they are getting their fiscal house in order (though how well the likes of France and Italy will take it if smaller countries start to castigate their fiscal policy choices remains to be seen). However, without the threat of a market panic there are no real mechanisms in place to enforce prudent fiscal policies. This issue will come back to haunt the members.
The aftermath of the crisis is likely to lead to a fundamental weakening of all euro-denominated assets over the coming year, as investors are forced to acknowledge that a monetary union of sixteen sovereigns with no clear central authority does not make for fast decision-making in a crisis - contrast the tortuous route taken to get aid to Greece with the speed of the IMF-led support given to Hungary in the fall of 2008.
Longer term, none of the measures announced over the weekend tackle the fundamental issues of uncompetitive economies across the southern part of the Euro-zone. There is a basic North-South split that has been brought under the spotlight. The days of narrow spreads over bunds will not be seen again for some time.