It was a grave error for Germany's Angela Merkel and France's Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder 'haircuts' at this delicate juncture Photo: EPA
By Ambrose Evans-Pritchard, Telegraph.co.uk | 16 November 2010
Unless the ECB takes fast and dramatic action, it risks destroying the currency it is paid to manage, and allowing a political catastrophe to unfold in Europe. If mishandled, Ireland could all too easily become a sovereign version of Credit Anstalt— the Austrian bank that brought down the central European financial system in 1931, sent tremors through London and New York, and set off the second deeper phase of the Great Depression, the phase when politics turned ugly.
"Does the ECB understand the concept of contagion"? asked Jacques Cailloux, chief Europe economist at RBS. Three EMU countries have already been shut out of the capital markets, and footloose foreign creditors hold €2 trillion of debt securities issued by Spain, Portugal, Ireland and Greece. "If that is not enough to worry about financial contagion, what is? The ECB's lack of action begs the question as to whether it is fulfilling its financial stability mandate," he said. That is a polite way of putting it.
The eurozone's fiscal fund (European Financial Stability Facility) is fatally flawed. Like Alpinistas roped together, an ever-reduced core of solvent states are supposed to carry the weight on an ever-widening group of insolvent states dangling beneath them. This lacks political credibility and may be tested to destruction if— as seems likely— Ireland is forced to ask for help. At which moment the chain-reaction begins in earnest, starting with Iberia.
It was a grave error for Germany's Angela Merkel and France's Nicolas Sarkozy to invoke the spectre of sovereign defaults and bondholder "haircuts" at this delicate juncture, ignoring warnings from ECB chief Jean-Claude Trichet that such talk would set off investor flight from high-debt states. EU leaders have since made a clumsy attempt to undo the damage, insisting that the policy shift would have "no impact whatsoever" on existing bonds. It would come into force only after mid-2013 under the new 'bail-out' mechanism. Nobody is fooled by such a distinction.
Sadly for Ireland, events have snowballed out of control. Confidence has collapsed before Irish export industries— pharma, medical devices, IT, and backroom services— have had time to pull the country out of its tailspin. Premier Brian Cowen— who presides over a budget deficit of 32% of GDP this year— still insists that 'no rescue is needed'. "We have adequate funding right up until July," he said. Mr Cowan must know this is not enough. Funding for Irish banks has evaporated, and with it funding for Irish firms.
As we learn from leaks that "technical" talks are under way on the terms of any EU bail-out, it can only be a matter of weeks, or days, before Ireland has to tap EFSF— for €80bn to €85bn, says Barclays Capital. Portugal is in worse shape than Ireland. Total debt is 330% of GDP. The current account deficit is near 12% of GDP (while Ireland is moving into surplus). Portuguese banks rely on foreign wholesale funding to cover 40% of assets.
The country has been trapped in perma-slump with an over-valued currency for almost a decade. Successive waves of austerity have failed to make a lasting dent on the fiscal deficit, yet have been enough to sap the authority of the ruling socialists and revive the far-Left. Former ministers are already talking openly of the need for an EU-IMF rescue.
It is hard to see how Portugal could avoid being sucked into the vortex alongside Ireland. Europe and the IMF would then face a cumulative bail-out bill of €200bn or so. That stretches the EFSF to its credible limits.
The focus would shift instantly to Spain, where economic growth stalled to zero in the third quarter, car sales fell 38% in October, a 5% cut in public wages has yet to bite, and roughly 1m unsold homes are still hanging over the property market. The problem is not the Spanish state as such: the Achilles Heel is corporate debt of 137% of GDP, and the sums owed to foreign creditors that must be rolled over each quarter.
The risks are obvious. Unless 'core' EMU countries [[Germany, maybe France?,: normxxx]] raise fresh funds to boost the collateral of the rescue fund, markets will not believe that the EFSF has the firepower to stand behind Spain. Will Germany's Bundestag vote more funds? Will the Dutch? Tweede Kamer, where right-wing populist Geert Wilders now holds the political balance, adamantly opposes such help, and might well use such a crisis to launch a bid for power.
Moreover, it is far from clear what would happen if Italy were forced to provide its share of a triple bail-out for Ireland, Portugal and Spain. Italy's public debt is already near the danger point at 115% of GDP. It is also the third-largest debt in the world after that of Japan and the US. French banks alone have $476bn of exposure to Italian debt (BIS data).
While Italy has kept a tight rein on spending, it is not in good health. Growth has stalled; industrial output fell 2.1% in September; and the Berlusconi government is disintegrating. Four ministers resigned on Monday.
It is clear by now that IMF-style austerity and debt-deflation is not a workable policy for the high-debt states of peripheral Europe, since it cannot be offset by the IMF 'cure' of devaluation. The collapse of tax revenues has caused fiscal deficits to remain stubbornly high. The real debt burden has risen further.
The ECB is the last line of defence. It can halt the immediate Irish crisis whenever it wishes by buying Irish bonds. Yet, instead of pulling out all the stops to save monetary union, the bank is winding down its emergency operations and draining liquidity. It is repeating the policy error it made by raising rates into the teeth of the crisis in July 2008.
Yes, the ECB is already propping up Ireland and Club Med by unlimited lending to local banks that then rotate into their own government debt in an internal "carry trade". And yes, the ECB is understandably wary of crossing the fateful line from monetary to fiscal policy by funding treasury debt. Bundesbank chief Axel Weber might fairly conclude that it is impossible at this stage to reconcile the needs of Germany and the big debtors.
If the ECB prints money on the scale required to underpin the South, it would set off German inflation, destroy German faith in monetary union, and perhaps run afoul of Germany's constitutional court. If EMU must split in two, it might as well be done on Teutonic terms. All this is understandable, but is Chancellor Merkel really going to let subordinate officials at the ECB destroy Germany's half-century investment in the post-war order of Europe— and risk Götterdämmerung?
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