Probability of multiple countries in the euro area defaulting is no longer negligible, says Moody’s.
The euro zone continues to stare into the abyss, with fiscal contagion sweeping across the continent and threatening to spread to the wider global economy. Some analysts are predicting a break-up of the monetary union might only be days away, barring a last-minute extraction of a rabbit out of the hat or, in this case, a euro bond out of the Bundestag (Germany’s equivalent of the Lok Sabha).
Rating agency Moody’s issued a report on Monday, warning that the probability of multiple countries in the euro area defaulting was “no longer negligible”. And, an increase in the likelihood of one or more members “leaving the euro area”.
CONVERGING CRISES
The problem is two-fold and mutually reinforcing — a sovereign debt crisis and a simultaneous banking crisis. The investor run on Europe’s government bond market has reached epic proportions, with even Germany’s bonds failing to find buyers last week. A few days later, Italy had yet another disastrous bond sale, with six-month debt at a yield over six per cent, nearly twice the yield it got in late October. This was despite the departure of Silvio Berlusconi and his replacement by respected technocrat Mario Monti. On the same day, Belgium, one of the region’s so-called “core” nations, was downgraded by Standard and Poor’s.
It is becoming clear that investors are not only shunning government debt but also shying clear of the region’s banks, themselves large holders of sovereign debt, engendering a credit crunch that could be even more dangerous for Europe’s economy.
Billions of euros are flooding out of the continent’s banking system through the bond and money markets. According to data compiled for the Financial Times newspaper by Dealogic, European banks have sold $413 billion worth of bonds this year, equivalent to just two-thirds of the $654 bn due to be returned to investors in 2011 as the debts mature. The resulting $241-bn funding gap is the first time European lenders have collectively been unable to replace their maturing debt with new bonds for at least the past five years.
In the third quarter of this year, bond issues by European banks only reached 15 per cent of the amount they raised over the same period in the past two years, according to Citi Group. Short-term funding markets have also dried up, with American money market funds, in particular, shying clear of Europe. And, banks are also ceasing to lend to each other.
In the event of the run on banks continuing, the knock-on effects for businesses reliant on bank loans will have a devastating impact on an economy already hobbling in the shadow of a recession. Analysts say it is almost certain that European banks will be forced to deleverage , with negative implications for credit availability in Asia and the US.
STUBBORN ON REMEDIES
Meantime, Germany, the euro zone’s hegemon, continues to refuse considering either the issuance of euro bonds or quantitative easing by the European Central Bank, the only two measures left that most analysts believe might have a chance of calming markets.
Instead, Berlin is pushing with greater urgency for fiscal union as the panacea for the euro zone’s woes, saying it was the only long-term solution. The problem is that a long-term fix will take an equally long time to work out, a luxury the euro zone simply does not have.
To create a true fiscal union between the 17 countries that use the euro would require a change to the treaties that govern the 27-member European Union. This is likely to be a tortuous process, involving national referenda that could overturn any progress made by governments.
It is widely being reported that Germany and France are, instead, mulling other ways of achieving the goal, one being an agreement among just the euro zone countries. However, it is possible that some of the euro-17 would be either unable or unwilling to accept the German-dictated fiscal rules that would bind such a union. Thus, another option reportedly being explored is a separate agreement outside the EU treaties that could involve a core of eight or 10 euro zone countries of the willing.
Germany has hinted that if a fiscal union is put together, it might then consider the idea of jointly issued euro zone bonds and a more flexible role for the ECB in fighting the crisis.
FRANCO-GERMAN FOCUS
Angela Merkel and Nicolas Sarkozy, the German and French heads of government, are expected to unveil an outline of a potential agreement ahead of an EU summit on December 9. Before this, euro zone finance ministers will meet in Brussels tomorrow to discuss the progress of bailouts for Ireland, Portugal and Greece, as well as review efforts to boost the euro zone rescue fund’s firepower.
Operational rules for leveraging the fund are now reportedly ready, clearing the way for the euro 440-billion facility to attract cash from private and public investors. However, given the uncertainty in the whole euro area, the likelihood of finding keen investors is increasingly slim.
And, with the bailout fund’s own triple-A rating at potential risk of contagion, the finance ministers will be discussing measures whose relevance and impact has already been overtaken by events. Instead, it is the ongoing Franco-German machinations that are in the spotlight and will determine whether or not we might see a new fiscal union arise, phoenix-like, from the ashes of the crisis.
