by Don Alexander, MBA
Associate, RSD Solutions Inc.
The author, Daniel Gros, noted in a recent communique (VOXEU, August 11th) that the current euro crisis has reached the core. Investors and treasurers need to ask themselves what is their exposure in a worst case scenario?
Investors anticipate the unraveling of the 21 July 2011 “solution” and a potential Lehman type breakdown of the interbank-market and put the European economy into an “immediate recession” like the one experienced after the Lehman bankruptcy. The European Financial Stability Fund (EFSF) was designed to provide liquidity financing and not solve solvency issues. Gros argues that without quick and bold action such as giving it access to unlimited ECB re-financing there will be a generalized breakdown of confidence.
Greece is not interpreted as a special case, but viewed as the manifestation of a general problem: (1) as a sign that the Global Crisis was spreading to public debt; and (2) as a sign that capital markets would no longer refinance excessive levels of public debt, especially in the Eurozone members who could no longer rely on central bank support. The EFSF was sized to provide the financing promised to Greece, Ireland, and Portugal and provide lower rates for their long-term financing. However, if the borrowing costs of Italy and Spain stay at crisis levels, how can they be expected to provide billions in euro in aid to peripheral countries at 3.5% when they pay a much higher rate? Any decline in the core Eurozone members that remain to back the EFSF and the debt burden would become unbearable. Italian government debt alone is equivalent to the entire German GDP.
The situation is critical due to a domino effect. At this point the Eurozone needs a massive infusion of liquidity. Given that the cascade structure of the EFSF is part of the problem, the solution cannot be a massive increase in its size.
Banks are the weakest link due to European debt exposure. This increases the cost of capital for banks exposing them to a breakdown in the interbank market and credit circuit. If the EFSF was registered as a bank and given access to unlimited re-financing by the ECB, it is the only institution to provide liquidity quickly and in convincing quantity. This solution has the advantage that it leaves the management of public debt problems in the hands of the finance ministries, but provides governments with the liquidity backstop that is needed when there is a generalized breakdown of confidence and liquidity as a lender of last resort. A massive increase in the ECB’s balance sheet (which if the US experience is any guide will not lead to inflation) constitutes a lesser evil compared to a breakdown of the Eurozone financial system.
What is your exposure to European sovereigns and banks?
http://www.voxeu.org/index.php?q=node/6853
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