- The changes to the modus operandi of the ESM agreed at the latest summit appear significant at first (sovereign bond purchase, non-preferred creditor status, direct lending to banks plus the quid pro quo of ECB-led banking supervision) and can help sever the vicious sovereign-banking nexus to some extent. But the ESM’s limited firepower keeps the economic logic of currency-or bank runs in place. Until much more is done, don’t expect a lasting recovery of asset prices.
Macro At Hart (MaH) haven’t been counting diligently, but a rough approximation suggests that the end-June summit of European leaders was the 12th such jamboree since the first agreement to support Greece was reached in March 2010. Yet, despite the many attempts to find a solution to the crisis, the notion of true European solidarity seems as elusive as that of the selfless New (Soviet) Man. Some important steps have been taken though and it is worth reviewing the five key elements agreed on:
- Allow EFSF/ESM to purchase sovereign bonds in the secondary market: While this is the point markets take the most interest in, it is in fact not a new provision as it is already allowed under current EFSF rules. But it can be done only at the request of the country concerned and has not been used so far.
- Allow ESM to lend directly to banks, not only sovereigns: A positive in that it will limit a further increase in public debt in places where the banking system is viewed as a contingent liability of the government, a time-bomb just waiting to go off. As such, it helps break the vicious sovereign-banking nexus to some extent: it limits the feedback from the banking system to the sovereign, though not the transmission of sovereign risk to the banks. Any request for capitalization will still require the adherence to the conditionality of a Troika program, a positive for those concerned about transparency and accountability.
- Establish EZ-wide banking supervision under ECB: An important step that represents the quid pro quo for allowing the ESM to recapitalize banks directly.
- ESM not to have “preferred creditor” status: Another positive in two respects: 1) it signals a degree of willingness to participate in and share losses should a debtor default, and 2) it lessens the degree of private sector haircut that would otherwise be required if there is a debt restructuring in a program country.
- Agreement on €120 bn package to boost growth: a snow job and political hoodwink to the new political consensus emerging around President Hollande, but not worth further discussion.
Against so many positives does this make the summit a success? What overall score does it deserve? The answer depends on the benchmark used: is it a success in terms of fundamentals and what is required, or with respect to expectations and the market reaction or simply in terms of what is politically feasible?
- From the normative perspective, the answer is simple: if this was the summit to end all summits, it has failed spectacularly and deserves an F. There was no agreement on a full banking union (including an EZ-wide deposit insurance and resolution regime), no augmentation of the ESM’s €500 bn funds, no agreement on the proposal to set the ESM up as a bank and allow it to borrow from the ECB and certainly no change in the operations of the ECB itself.While Italy’s almost €2.0 trn and Spain’s €800 mn public debt need not all be refinanced in one year, Italy has €242 bn coming due in 2012 and €271 bn next year, with the equivalent figures at €112 bn and €186 bn for Spain in 2012 and 2013 respectively (for a grand total of €811 bn including banks, according to JP Morgan). It is thus clear that the ESM’s closed-end resources are inadequate should there be increased selling pressure on these countries, be it because of mere contagion or because solvency deteriorates further as the local economies experience a deepening downturn. Just like in the case of a currency- or a bank run, it is thus rational for investors to continue to sell these sovereign bonds in the absence of other improvements. The only option to stop such a run would be through an open-ended commitment to deploy the ECB’s unlimited resources. And this is aside from the question of whether such a course of action is even desirable. MaH have argued elsewhere that a preferable solution would be to devise and operationalize a Sovereign Debt Reduction Mechanism, in conjunction with increased support for the banking system.
- Given the record of previous summits, market expectations were perhaps not set too high all the more so given the well-understood differences in the points of view France/Spain/Italy and that of Germany. Against this backdrop, markets reacted positively to the summit outcome at first: Spanish 10yr spreads to Bunds fell 85 bps between June 29th and July 2nd, the European stock market rose 8% to a local peak on July 5th and EURUSD bounced from 1.24 to almost 1.27 (close to 2%) within a day. But this success was a qualified one: a few days and one disappointing ECB meeting later, Spanish spreads had more than reversed the previous drop and climbed to 5.63%. European stocks held up better but then dropped over 4% in the wake of the ECB’s relative inaction. And EURUSD soon began to slide to 1.25 before dropping to 1.23 on the ECB meeting. With many market values at the same or a worse level than prior to the summit, this suggests another fail. Only because of the initial short term impact do we generously award a D on this count.
- It is perhaps in terms of political feasibility that the agreement scores highest. Given the obduracy of Germany and other creditor countries, some concessions carry a material political cost and will have to overcome significant domestic resistance: witness for example the open letter written by Ifo-President Hans-Werner Sinn and signed by 160 professors (even though it has immediately ignited a stormy debate about such populist attacks). Still, politics is the art of the possible and even a B- feels generous on this criterion.