Worst of the Eurozone Crisis Is Not Over Yet

All is relatively quiet in the eurozone these days – or at least that is what you might think, speaking to portfolio managers over the past few months. German chancellor Angela Merkel has visited Greece, Ireland has re-entered the bond markets and the ECB’s balance sheet is in play for Spain and Italy, so what is there to worry about?

Plenty. While the most disastrous possible risk – a complete, disorderly disintegration of the eurozone – has been greatly reduced by the ECB’s new bond-buying programme, Outright Monetary Transactions (OMT), the worst of the eurozone crisis is by no means behind us.

Greek exit delayed

While, just a few months ago, businesses and analysts were preparing for an imminent exit of Greece from the eurozone, there has been a widespread lowering of probabilities for that scenario. The main reason for this seems to be that the German administration has entered its campaign period in the run-up to general elections in September 2013. Merkel would rather not accept responsibility for whatever is unleashed when Greece leaves the eurozone, in case it derails her re-election.

If Germany wants to keep Greece in the euro, the logic goes, then Greece will stay in the common currency area. This logic is flawed for a few reasons.

First, even if Merkel wants to keep Greece on life support for now, Greece needs more time to make the fiscal adjustment being demanded of it, and more time will require more money. There is no way Merkel will succeed in coaxing more cash for Greece out of the Bundestag.

Second, even if Germany manages to cough up more funding for Greece, its other troika partners may not be keen on doing so.

Greece released its 2013 budget last week, indicating that public debt will surge to 189 per cent of GDP by the end of next year. If Greece’s debt burden cannot be deemed to be on a sustainable path, the IMF cannot release more money.

The only way to reduce Greece’s debt burden effectively and sufficiently is to write down some of its debt. So far, Germany, the ECB and the IMF have all indicated they would refuse to take a hit on their Greek government bond holdings.

Third, even if Germany wants to give Greece more time and money to achieve a swingeing fiscal adjustment, Greece might not have any interest in doing so, particularly not after five years of economic recession.

The current plan of undergoing an internal devaluation is not politically or socially tenable. Public support for eurozone membership in Greece has fallen significantly since mid-2012, and will continue to do so when the government sucks another €9 billion out of the economy next year, as demanded by the troika.

Sharp divisions are emerging within the Greek coalition, and the government will do very well to survive the rest of 2012 intact. I expect the coalition will collapse over the next few months, and new elections will place a Syriza-led government in power.

Syriza is likely to stick to its promises of no more austerity and a debt moratorium, in which case the Greek government and the troika are likely to negotiate Greece’s exit from the euro, with the troika providing bridge financing to mitigate the blow for Greece. This could happen as early as the first half of next year.

A model student

In contrast to Greece, Ireland has been identified by creditor countries as a shining example of how Europe will emerge from the crisis.

It is true that Ireland has stood apart from the other bailout countries in a few important ways. For starters, Ireland has dipped a toe back in the bond markets, despite being in a bailout programme. Investors also seem relatively confident that Ireland will not default, as exhibited by lower, long-term Irish bond yields than its Greek, Portuguese, Spanish and Italian counterparts.

According to the Purchasing Manager’s Index (PMI), Ireland has seen its manufacturing activity expand over the past eight months. This is in sharp contrast with the eurozone, which has, on average, seen manufacturing activity contract for 15 consecutive months.

Ireland’s PMI data is encouraging, with new foreign orders particularly buoyant in recent months. This is a positive indicator for Ireland’s export sector, which should keep expanding.

But here’s the big problem in Ireland: there is no economic growth. While exports have remained buoyant, domestic demand continues to provide a drag on economic performance. Unemployment has stabilised at very high levels (around 14.7 per cent) and, as the government works out the details of yet another austerity budget, there are increasing signs of austerity fatigue.

I expect the Irish economy to contract by around 0.5 per cent this year, and stagnate next year. This is much more pessimistic than the government’s forecasts. Without growth, Ireland’s debt burden – quickly approaching 120 per cent of GDP – is clearly on an unsustainable path. While Ireland will have access to credit lines from the EU bailout funds, it will eventually have to write down its debt.

A debt restructuring in Ireland could come in many different forms. Merkel has singled Ireland out as a “special case” in the eurozone, and has suggested the country may receive a deal on retroactive direct bank recapitalisations from the European Stability Mechanism (ESM), one of the EU bailout funds.

This has always been a red herring. By now, Irish sovereign and bank debt are so intertwined that parsing them out retroactively will be like trying to unscramble an egg. The debt relief from retroactive bank recapitalisations is unlikely to be a game-changer for Ireland.

Another way to reduce Ireland’s debt burden is if Ireland wins a deal on restructuring its promissory notes.

The ECB remains opposed to this, preferring instead that any debt relief come from the EU bailout funds with strict conditionality attached.

Ireland could also undergo a debt restructuring that resembles the Greek private sector involvement deal, with a haircut imposed on those holding Irish sovereign debt. There is absolutely no appetite for this at present.

Whatever the form of debt relief, it is clear that, despite low government bond yields, Ireland is not out of the woods yet.

A silver bullet

The ECB’s OMT has been a key cause for market calm in the eurozone. While the OMT will continue to fuel a market rally once it is finally activated by Spain, the euphoria surrounding the ECB’s programme is unlikely to last.

A number of triggers could undermine investor confidence in the OMT. A Greek exit from the euro or Italian political parties campaigning on an anti-euro platform could worry investors.

More importantly, the OMT only really addresses the fiscal side of this crisis. All of the bond-buying done by the EU bailout funds and the ECB will take place against a backdrop of awful economic indicators, as Spain and Italy continue to retrench and implement structural reforms.

Finally, the EU bailout funds and the ECB are a double act, with the latter only buying bonds for countries that have submitted to the conditionality attached to the former. The EU bailout funds have a very clear lending ceiling of €500 billion and, as that ceiling is approached, investors will worry that, with no more bailout cash and therefore no more conditionality, the ECB will turn off the taps to troubled countries as well.

Once investor sentiment shifts and bond yields creep upwards, Spain will probably be pushed into a full troika programme. When the bailout cash runs out, we could see Spain unable to regain market access and pushed into a debt restructuring.

The euro crisis is currently in a lull that could present a big opportunity for eurozone policymakers. If leaders used the market calm to make swift progress on establishing a political, banking and fiscal union, many of the forecasts outlined here could be avoided. Sadly, market pressure has often been the driver of change in the eurozone. It is much more likely that this opportunity will be squandered and that there will be plenty of drama in store for the region over the next few years.

This piece is cross-posted from Business Post with permission.

6 Responses to "Worst of the Eurozone Crisis Is Not Over Yet"

  1. steve from virginia   November 7, 2012 at 1:47 am

    I come away from articles like these perplexed. What are the Irish or the Portuguese supposed to do over the longer term … like 1000 years or so? How about 100 years? How about 10 years? Where is the 'reality plan'?

    There is the usual 'growth' mantra but what is supposed to grow? More auto sales? More vacation 'villas' around more miles of Mediterranean coast? More McDonald's and Tescos? Right now the European auto industry is collapsing. Real estate is a bust. Retail margins are narrowing or gone. The European fuel consumption is almost 15 million barrels per day … most of this is imported from Africa and the Middle East. It is paid for with massive and unaffordable borrowing. This process has been stumbling since 2008, the complete breakdown is heaving into view.

    From whom are the Europeans borrowing? Ireland and the rest cannot borrow against their own accounts — they are shackled to the euro — they must borrow from financiers in City of London and Wall Street. Currently, credit terms are onerous … what comes next? If Europe cannot pay its bills its fuel consumption is exportable to the United States which can borrow against its own account at all levels. No wonder the US president is claiming the country is 'energy independent'.

    How is Ireland supposed to cope with the current state of affairs for more than a few months? Ireland has no domestic fuel production to speak of. It MUST borrow or go onto a severe — and permanent — energy diet. Can Ireland borrow for another year? It must, obviously. How deep a the hole will creditors allow Ireland to dig? The Irish corporate tax shelter is not very useful to corporations that aren't earning much. Eire can be the gateway for flight capital to exit Europe but that lasts only until the euro is done away with. At that point Ireland becomes something like Serbia … or Yemen.

    The idea is that something magical will turn up in the next decade or so and 'solve all the problems' in the meantime, the entire European Enterprise hinges on whether the ECB can keep offering rear-guard actions: making loans … that are more dubious every month! At some point some sort of organic returns are needed … they never arrive. Sadly, there are no returns on consumption … simple waste for its own sake. The Europeans have nothing in the way of real goods or services to offer in exchange for the petroleum they burn up … except for petroleum burning gadgets: the most vicious of all vicious circles..

    The outcome of this dynamic is fuel poverty … something that occurring right now across the euro-zone and in the UK. What the Europeans need to do pronto is to rethink the 'business as usual' concept and ditch growth. Cheap natural resource capital does not exist any more. What remains is worth too much to waste. The economy built around monetizing waste is a loser. Europe needs to power down and figure out how to provide decent lives for citizens without consumption. Unfortunately, there is little time remaining to figure out how to do this. The ongoing Euro-calm is an eye in the hurricane, the next phase will see Europe cut off from fuel supplies and structural shortages that cannot be dealt with.

    Conservation by other means …

    • Pete   November 7, 2012 at 3:34 pm

      Right on Steve,That is exactly what I have been saying for years. We cannot grow ourselves out of debt. We need another paradigm. We can't look back at history, because the future this time is different because of declining stores of cheap resources.

  2. Aegean1972   November 8, 2012 at 8:03 am

    part 1

    Look at Greece 5 years ago and you can get an idea of where Europe is now. Look at Greece today (a nation TOTALLY ruined by austerity, with 1/3 of the people laid off) and you will get an idea of how Spain, Italy are going to look like 2 years from now.
    Even the core has a major problem. In my recent trip to holland i couldnt believe the amount of unemployed people and foreclosed houses. It will only take one domino (Greece) for Europe to start collapsing. And it seems like the troika is actually "pushing" Greece to jump. Otherwise i cant explain the tyrannical-measures that are being enforced on a nation that has lost it all. While on the other hand, Spain is being helped "under the table" by the ECB, without having to take not even 10% of the measures that Greece is forced to.

    The euro-periphery is pretty much on the same level as far as "unefficiency and disorganization. So why are they pampering Spain, while Greece is being punished? This is a recipe for disaster.

  3. Aegean1972   November 8, 2012 at 8:03 am

    Part 2

    Greece cant hold on much longer. Its a socio-economic disaster. The left and the far right have risen, the country is stuck with boat-loads of illegal immigration coming from the middle East (Turkey) and Europe isnt helping one bit the conservative coalition party to save the nation. So when Greece collapses, the boarders will open and hundreds of thousands of illegal afghanis, pakistanis (etc) who are stuck over there right now will flood europe. Just like it happened in Albania in the 90's when the nation failed and hundreds of thouands of albanians flooded Greece to find work.

    europe get ready. Its was your choice to push Greece off the boat.

    Europe should had been united 30 years ago. They failed to do so then and now they are trying (during a hard recession) to do in 5 years, things that should had happened over a 30-year period. That is not possible and someone's gotta tell them that, before they drag the worlds economy into a 1920's depression from the collapsing euro-periphery nations. Lets not forget that america is very fragile and will be very affected from all this. Fiscal cliff is right in front.

  4. Sonny Marshall   November 13, 2012 at 2:01 pm

    Hmmmmmm, looks like the fiscal cliff may be in Europe, not in Washington D.C., and it may be one, that no one can do anything about.

  5. Ken   November 24, 2012 at 7:42 pm

    You all have it wrong. The EU is here to stay and no country will part ways with the euro, not even Greece. A break up of the euro will result in an all out deprssion for the eurozone and would also put the continent at war with each other. I believe that the euro was put together because the politians saw this deleveraging coming years ago. Rather then allow it to happen as stand alone countries and risk a major war with each other, they put this thing together so that they can share in the sacrifice required to better their long term economies. We are now in a globalized economy and many of the countries in europe would not be able to compete on their own agianst the BRIC's. The Euro will hold and continue to grow.