Welcome to Phase 2 of the Eurozone Crisis – What are the Risks?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The Eurozone crisis moved into phase 2 when the contagion spread to Italy, Spain and European banks.  ECB purchases of government debt have provided a temporary solution, but may have political problems and legal implications that make them unsustainable and may include the need for time-consuming changes in the underlying treaties. 

 

Baldwin notes that phase 2 bank problems are entwined with government debt concerns.  The line separating illiquidity and insolvency for nations and banks was crossed last month.  The ECB provided a temporary solution, but the financing facility (EFSF) itself remains insufficient to cover government debt service and banking system assistance/recapitalization.  The estimated facility could need funding well above $1 trillion. The only policy combination that policymakers may agree on, and implemented in a timely manner, involves political cover for ECB bond buying in exchange for credible national fiscal reforms.  The ECB’s actions are unsustainable politically (acting for politicians) and illegal without changes in the underlying treaties. 

 

The near-term need is for ECB to backstop the debt of solvent European countries that would help temporarily stabilize financial markets.  There are two options: either the ECB continues to backstop European bonds with political coverage or leaders create a Eurobond scheme for government debt.  These are short-term solutions, both requiring credible control of new debt issuance.  This can be accomplished if national governments adopt credible fiscal policy (Germany) and/or it is shifted to a supranational level.  The best policy option in terms of timing is ECB backstopping of government debt with political support and domestic fiscal reforms.  But the implementation of fiscal union or Eurobond issuance would take too long. 

 

Given the magnitude of the problem, the current EFSF will not work since it is capped at €440 billion.  The risk is that policy paralysis and contagion may require a more radical solution if prompt action is not taken.  The more likely scenario is for a restructuring of the eurozone and increasing chances of reduced membership until countries get their fiscal house in order. 

 

For more on Welcome to Phase 2 of the Eurozone (EZ) Crisis (VOXEU, Richard Baldwin, Sept. 5^th), follow the link: http://www.voxeu.org/index.php?q=node/6942

Who’s Came First?

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

Pete Townshend (of the band The Who fame) has done well out of the TV show CSI’s title songs.  He could carry on in that vein with theme tunes for sovereign debt crises.  Who’s Next, Who Came First, Who’s Last, …. and some others.

 

Seems that Greece is everyone’s favourite (sic) Who Came First candidate.  When will a Greek default become official?  Or how long can a fudge be maintained so that politicians can fool themselves into believing there will be no default?  The market sees default with Greek debt yields climbing towards 20%.  Nobody with some form of conventional content inside his or her head really believes that Greece will ever be able to repay its current debt load and most believe that some sort of restructuring is inevitable.  The only question is when.

 

It seems that here will certainly be another bail out and possibly one after that.  However, sooner or later reality must and will be faced.

 

And if Greece defaults, who'a next?  Portugal?  Ireland?  Spain?  Italy?  And if Greek debt gets restructured and partly forgiven, will there be a line of countries wanting the same treatment?

 

And what does this mean for the Euro and how isolated would the effect be?

Unforeseen Risk - The ECB’s Stealth Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The ECB, through its payment mechanism - European System of Central Banks (ESCB), acts as a de facto lender of last resort for troubled banks and member-country central banks across Europe.  The troubled banks, largely from deficit countries, obtain funding through the ESCB and indirectly finance the deficits, by central banks lending money against discounted public debt.  

 

The funds flow through the ESCB’s settlement system (real-time) called “target”.  Since 2007, when private capital flows dried up, large asset and liability positions emerged on the balance sheet of central banks.  The Bundesbank is the dominant creditor and dominant debtor central banks are those of Greece, Ireland, Portugal and Spain (GIPS).  The imbalances correspond to the cumulative current account deficits of those countries. 

 

A problem will emerge if these countries become insolvent and it impacts the solvency of the debtor country central banks.  This imposes large losses on the creditor central banks that are under pressure to aid domestic banks.  Taxpayers of the creditor country would have to bailout the central bank and recapitalize the banking system.  This mechanism serves as an indirect fiscal transfer.

 

This backdoor financing scheme shifts credit away from the surplus countries stifling growth.  This process can only be stopped, barring a major crisis, by a government takeover and adding central bank debt to government debt, already at alarmingly high levels.  This makes debt restructuring inevitable, increases the chances for a banking crisis and redenominating debt in a new, weaker currency.  The Eurozone has two choices, according to Sinn: a default/restructuring or open-ended support.

 

For more on the ECB’s stealth bailout click on the link to VoxEU, a policy portal set up by the Centre for Economic Policy Research:  http://www.voxeu.org/index.php?q=node/6599