Open Europe 24 October 2011
The window of opportunity for stabilising, or even saving, the eurozone is closing quickly. As EU leaders gear up for a series of key meetings this week, Open Europe has published a new briefing looking at the short-term options available to the eurozone for tackling the most immediate crisis.
Open Europe argues that Greece should default on 60% of its debt through a managed restructuring, and that the planned second Greek bailout should be scrapped altogether, replaced by a limited transition fund designed to control the default. This would radically reduce the burden on taxpayers. Portugal should simultaneously take a 25% write-down on its debt.
Alarmingly, however, Open Europe estimates that 65 banks across the EU would fail serious stress tests, falling below an 8% tier one capital ratio, meaning they require a substantial recapitalisation. To withstand a Greek and Portuguese default, combined with marking Irish, Italian and Spanish debt to market prices, the EU banking system would need to be recapitalised by between 260bn and 372bn. The briefing sets out a three-pronged strategy for how this can be achieved, including a role for the eurozone bailout fund, the EFSF, but with strong conditionality attached.
However, using the EFSF to insure a percentage of Spanish and Italian debt against default a proposal which is currently being discussed would merely create a new set of unfunded liabilities, which markets are likely to question sooner or later.
The briefing also concludes that EU leaders should rule out forcing the ECB to act as the eurozones lender of last resort by buying hundreds of billions of government bonds an option favoured by many. The ECB is already taking on risky assets at a worrying rate, and now has an exposure of around 590bn to PIIGS, up from 444bn only this summer, in turn undermining its independence and credibility.
Open Europes Head of Economic Research Raoul Ruparel said,
"The recently mooted plan to use the EFSF to insure eurozone sovereign debt looks to be misguided. Using a fund backed by eurozone countries to insure against a default of some of the very same economies creates a circular problem the guarantees could never be called upon at the time when they would be most needed, for example if Spain or Italy face a serious threat of default. It was financial instruments with huge leverage and unfunded liabilities that largely created this financial mess in the first place. Replicating such a structure at the heart of the eurozone could potentially create an even worse crisis down the road.
"The EUs banking system needs to be fundamentally recapitalised. But this must come with strong conditions attached, with banks being allowed to fail in an orderly manner. A proper recapitalisation is still far cheaper than allowing many banks to continue to hide behind government and central bank bailouts, which only increases the ultimate cost of this crisis.
"Restructuring and recapitalisation could allow the eurozone to muddle through longer than many expect, but the eurozones deep rooted structural flaws will remain, meaning that another crisis could well be just around the corner. In order to survive long-term, fiscal union or revised membership remains the stark choice facing the eurozone.
To read the full briefing, click here: http://www.openeurope.org.uk/research/enp2011.pdf
The most feasible option for tackling the immediate and medium term crisis remains a restructuring of Greek, Portuguese and possibly Irish debt, combined with a full, but staggered recapitalisation of European banks. Such a combination will not deal with the eurozones long-term structural flaws, such as the massive gaps in international competitiveness between member states, but merely serve as a temporary firebreak.
However, at this stage, establishing even an effective temporary solution remains a huge challenge. We propose the following steps:
Restructure: EU leaders current attempts to manage a write-down of Greeces debt under the umbrella of the second bailout package, worth 109bn, will merely waste more valuable time the bailouts complexity and limited impact on bondholders will reduce the countrys overall debt by a very small amount. Instead, as priced in by the markets, Greece should undergo a 60% write-down on its debt. The second bailout should be scrapped and replaced with a transition fund, split 50-50 between eurozone countries and the IMF, giving the latter a greater say in a managed default.
We estimate that such a fund could be limited to around 45bn, meaning that a significantly smaller share of the risk will fall on European taxpayers than under a full bailout. This could also further limit the UKs share in the rescue package as the absolute amount of IMF contributions would decrease. In parallel, and under existing bailouts, Portugal should take a 25% write-down on its debt, while a 15% haircut for Ireland should be considered but could potentially be avoided.
Recapitalise eurozone banks: Alarmingly, we estimate that 65 banks across the EU would fail serious stress tests, falling below an 8% tier one capital threshold. This stands in stark contrast to the European Banking Authoritys most recent tests where a mere eight banks failed. We estimate that in order to withstand the above restructuring plan, the EU banking system would need to be recapitalised by between 260bn and 372bn, depending on an 8% or 9% threshold, in conjunction with sovereign defaults. This should happen in three stages:
- First, an effective stress test, which takes account of the suggested debt restructurings and marks Italian and Spanish debt to market prices (writing down holdings of Italian and Spanish bonds by around 20%), should be followed by a six month period, in which banks with a particularly low capital ratio following the stress tests (under 5%), should be pushed to recapitalise immediately. Other vulnerable banks should be given an extended period to raise funds and meet the 8% threshold, possibly 12 to 18 months, in order to avoid inadvertently pushing some healthy banks into the red by drastically and suddenly increasing their costs.
- Secondly, if banks fail to raise private funds under the defined timeline, national treasuries should recapitalise these banks using public funds, but in return receive preferential shares and equity warrants. Banks would also be required to sign a "living will, including a plan for how to wind up trading books within days should the crisis deteriorate. These measures impose conditionality on the funds and reduce moral hazard.
- Thirdly, if the cost of recapitalisation exceeds 4% of GDP for a national government, then the eurozone bailout fund, the EFSF, should step in, but with the same strong conditionality. Combining private funding with the remaining loan guarantees and IMF contributions, could give the EFSF enough money to backstop vulnerable banks. The decision to allow the EFSF to fund a recapitalisation would need unanimous consent from all members. If the option is declined, then winding down the bank should be considered and possibly put into motion. Therefore, in parallel, EU leaders must make it an absolute priority to establish credible wind-down mechanisms for banks, at the national as well as EU level.
Reform: Significant structural reforms in Greece and Portugal, but also Italy and Spain, will need to be stepped up, with a better balance between pro-growth measures and austerity. However, even with such reforms it may well prove impossible to close the huge gap in economic competitiveness between eurozone members, leaving break-up or a whole new level of eurozone fiscal integration as the only two options in the medium to long-term.
Unworkable or ineffective options:
ECB purchasing massive amounts of bonds: Favoured by many banks and economists, this option would involve the ECB purchasing hundreds of billions worth of government bonds, including Spanish and Italian debt, effectively becoming the eurozones lender of last resort. However, although such a move could serve to stabilise the market in the short-term, as the ECB could in theory massively expand its balance sheet very quickly, it would also mark a pyrrhic victory for the euros long-term survival. Forcing the ECB to play this role would radically undermine its credibility by removing the barrier between fiscal and monetary policy, therefore denting financial market confidence in the ECBs ability to effectively manage inflation.
The ECBs balance sheet is already in a vulnerable state, and is taking on more risky assets at a worrying rate. We estimate that the ECB now has an exposure of around 590bn to PIIGS, up from 444bn only this summer and it remains unclear how the ECB would cover any losses. If the ECB continues to compromise its independence, credibility and finances, German support for the entire euro project could evaporate.
Radical increase of the EFSF: We estimate that in order for it to act as a credible back-stop for the eurozone, the EFSF would need to be equipped with 2,000bn in effective lending capacity (underwritten by Triple-A countries), with the total size of EFSF guarantees around 3,220bn. This would require most Triple-A countries to guarantee loans amounting to more than a third of their respective GDPs, with France providing 36% and Germany 38% of their GDP. Since this would threaten the credit rating of both France, and as a consequence, the EFSF itself, this is a politically and economically impossible option.
All options for leveraging the EFSF, without increasing actual guarantees, also fall on two key hurdles: ECB and German reluctance to leverage the fund through the central banks balance sheet, as well as the huge level of correlation between the EFSF guarantees and any scenario in which they would be invoked. For example, it has recently been proposed that the EFSF be used to insure a percentage of Spanish and Italian debt against default.
However, this may prove ineffective, since these countries would essentially be partly guaranteeing themselves through their membership of the fund and unable to make good on these guarantees if under threat of default the exact time when those same guarantees would be invoked. In addition, if these two countries did face a serious default risk, the losses would be much greater than the proposed 20% insurance, potentially rendering the scheme irrelevant.
Muddle through to 2013 followed by debt restructuring and/or fiscal union: It is highly unlikely that EU leaders can postpone a comprehensive debt restructuring, at least in Greece, until 2013, when a new mechanism to deal with sovereign default comes into force - given the almost hopeless state of Greeces finances and the small chance of agreeing a bailout fund big enough to carry the eurozone over to that date. On the other hand, while fiscal union of some sort may be necessary for the eurozone to survive in the long-term, any proposals which seem economically credible look to be politically impossible at this point in time.
NOTES TO EDITORS
1) For more information, please contact the office on 0044 (0)207 197 2333, Raoul Ruparel on 0044 (0)757 696 5823 or Mats Persson on 0044 (0) 779 94606 91.
2) Open Europe is an independent think-tank calling for reform of the European Union. Its supporters include: Lord Leach of Fairford, Director, Jardine Matheson Holdings Ltd; Sir Martin Jacomb, former Chairman, Prudential plc; Sir Stuart Rose, former Chairman, Marks and Spencer plc; Sir Crispin Davis, former Chief Executive, Reed Elsevier Group plc; Sir David Lees, Chairman, Tate and Lyle plc; Sir Henry Keswick, Chairman, Jardine Matheson Holdings Ltd; Lord Sainsbury of Preston Candover KG, Life President, J Sainsbury plc; Sir John Egan, Chairman, Severn Trent plc; Lord Kalms of Edgware, President, DSG International plc; Hugh Sloane, Founder, Sloane Robinson.
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