by Don Alexander, MBA
Associate, RSD Solutions Inc.
There’s trouble in paradise
And Heaven’s not the same,
These are lyrics from a doo-wop song by the Crests that can be applied to risk management and stop-gap measures proposed by Eurozone officials to stabilize financial markets. This can describe the Brussels deal last week that attempts to reformulate the underlying rules for the euro zone. The problem is that the full details were not disclosed and already it is falling short of market expectations.
There are a number of unresolved issues from the meeting: there are no details on how much money will be needed to protect the market from further speculative attacks and prevent contagion, how will the banks be recapitalized to cover losses on their sovereign debt holdings, there is limited information on what measures will be implemented to reduce the borrowing costs and does the cure proposed in Brussels actually work?
The amount of European debt that needs to rollover in the next 12-24 months is staggering compared to the amounts discussed for a temporary financing facility. The outstanding sovereign debt of Italy is nearly $3 trillion that would dwarf any temporary financing facility being considered. A rating down-grade could spark another speculative attack.
The recent stress tests for the European banks suggest a further need for $150 - $200 billion in new capital. This does not take into account any further write-offs of existing debt. In addition, the banks are often under intense pressure in their country of domicile to take on additional sovereign debt after poor auctions. If the sovereign debt crisis moves into a full blown banking crisis, the speed of contagion will increase rapidly.
The borrowing costs of a number of countries have increased to near-record levels in recent auctions. The issue of borrowings costs has not been adequately addressed and may not be reduced until financial markets are stabilized. Details of how this is being implemented are lacking.
There have been a number of measures proposed to promote fiscal discipline, central oversight by Eurozone authorities and rules to discipline countries that break the debt limits. The idea is that once these rules are in place, the ECB and Eurozone officials could do more to resolve the underlying problems. However, this is rehashing old issues that were in the earlier treaty and raise issues about national sovereignty. There is some doubt that all countries will accept the proposed changes.
There is another issue not addressed by authorities and that is the persistence of imbalances and the lack of economic growth. A number of countries are experiencing problems from lack of growth and not budget management. There is concern that fiscal austerity will blunt growth and actually worsen the debt problem. Eurozone officials need to consider lessons from the 1930s and not just the 1990s.
The ECB needs to take a more active role in ring-fencing the crisis and act as a lender of last-resort (such as debt purchases in the secondary market). Officials need to provide a larger financing facility to deal with the crisis. Otherwise, there will be further trouble in paradise.
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