Monday 20 May 2019

Europe playing Russian Roulette

The EU should have long ago isolated the fiscal crisis to Greece, Ireland and Portugal, says Colm McCarthy

A convenient narrative for European political leaders is that Greece has brought the current crisis on itself, through failing to deliver on the programme agreed with the troika in May 2010.

While there has certainly been foot-dragging in Greece over the last 12 months, the Greek government has made a reasonable effort, in dreadful circumstances, to stick to the programme. The budget deficit has been cut sharply and a further austerity package is likely to be accepted.

The true source of Greece's latest crisis cannot be acknowledged, namely the inadequacy of the May 2010 deal framed by the troika and accepted by a Greek government which had no alternative. The European political leadership decided, in May 2010, not to face the music and continues to deny the inevitability of a Greek sovereign default, which can be deferred, but not avoided, through the extension of additional funds.

There will be no orderly writedown of Greek debt for now and the pretence will be maintained that default can be avoided through sufficient austerity and reform in Greece.

This is wishful thinking on a heroic scale and risks a disorderly outcome. It is no longer worth insuring Greek bonds against default -- the premium to insure €10m worth of five-year bonds has reached €2m per annum, so the premiums would cost as much as the payout.

Had the May 2010 deal provided for debt writedown, the Greek crisis would be over by now. The crises in Ireland and Portugal would probably have happened anyway but would have been easier to handle and the European sovereign debt market would surely be less fragile.

Greece, Ireland and Portugal are small countries and a major disaster can be averted if the debt market meltdown can be confined to these three. But if Spain goes under, threatening next-in-line Italy, the world financial crisis will enter a new and potentially disastrous phase.

On Friday, the yield on Irish 10-year bonds reached 12 per cent, the highest level yet seen, with Portugal not far behind. But more ominously, yields on Spanish 10-year bonds have been creeping up and reached 5.7 per cent on Friday, double the rate for Germany.

When Irish yields went into this territory last summer, the writing was on the wall with the country heading for an EU/IMF rescue. This need not happen for Spain, but current European policy is placing Spain in jeopardy.

Ten-year yields for Italy, Europe's largest bond market, have shot back up towards five per cent, close to the danger zone, and one of the ratings agencies (Moody's) has threatened a downgrade. The prevarication over Greece is responsible and has resulted in uncertainty about whether the proposed 'voluntary' participation by investors will constitute a default triggering payouts to those who have insured their Greek bonds.

The result is that no one knows where they stand, the lawyers are hovering and the credit insurance market is beginning to freeze. This may seem a technical point but it is important: investors will be reluctant to hold uninsurable risks, including Spanish bonds, if the lack of clarity continues.

In summary the insistence that there be no Greek default is destabilising the prospects for larger countries where there may be no need for one. So, in order to avoid, for a while longer, a small default which is inevitable, European policy is sharply increasing the risk of a really big one that could be avoided. This is a game of Russian roulette, to be repeated at six-monthly intervals it would appear.

There is a high risk of accident in the Spanish or Italian bond markets, or of an unexpected bank failure or a government collapsing somewhere. On Friday, Bank of England governor Mervyn King put it succinctly: "Providing liquidity can only be used to buy time. Right through this crisis, from the very beginning, an awful lot of people wanted to believe that it was a crisis of liquidity. It wasn't, and it isn't."

If Europe had political leadership, it would long since have taken the necessary steps to isolate the sovereign debt problem to Greece, Ireland and Portugal, with individual tailor-made solutions. In the case of Greece, this requires a reduction of about €150bn in the country's debt, with considerably smaller figures adequate to exit the crises in Ireland and Portugal.

The overall cost of a decisive resolution need not be greater than €250bn and could be less.

This sounds a lot, but it amounts to less than two per cent (once-off) of the EU's GDP for a year. The financing cost on a long-dated bond would cost as little as one-tenth of one per cent of Europe's annual output. Some of this burden needs to be borne by private creditors and some by taxpayers. One reason this has not been done is that European political leaders are reluctant to admit to their electorates that the euro system was poorly designed from the outset, that some countries should perhaps not have been admitted at all and that there have been massive failures of bank supervision. French banks apparently hold €56bn in Greek bonds, German banks €30bn. Why were they allowed to acquire these huge exposures?

A further reason is unwillingness to face the political task of dividing up the losses. The 'solution' to date has been to allocate these losses to the taxpayers of the three debtor countries while providing (repayable) loans in the absence of market access.

But it is now clear that Greece, for one, will never be able to regain market entry on this basis. The same may well prove to be the case for Ireland and Portugal. The allocation of the losses to the taxpayers of Greece has already proven to be infeasible so they must be borne elsewhere. If this reality is not faced now, it will be faced eventually, and the costs will rise in the interim.

Some commentators in Ireland have been suggesting that the Greek crisis is no bad thing from an Irish standpoint, since it brings matters to a head and improves the prospect of a definitive resolution. But nothing like this is happening. The European leadership has decided that Greece should have additional (repayable) funds and a fig-leaf voluntary writeoff by private creditors which everyone expects to yield very little. Greece will limp on for a while, insolvent beyond reasonable doubt. The destabilisation of sovereign bond markets elsewhere, including those of countries with a reasonable chance of solving their problems, is the price for purely domestic political manoeuvrings in France and Germany.

In Ireland's case, the likelihood of regaining market access through 'sticking to the programme' has been diminished further by the failure of European leadership over Greece. The deferral of the Greek solvency crisis means there will be another one in due course and Irish market re-entry is to be achieved against the background of a European sovereign credit market in further disarray.

The agenda for the Irish Government is not altered by the Greek crisis. It remains (i) the reduction in the interest rate on EU loans to a level consistent with debt sustainability; (ii) the provision of medium-term ECB financing to the Irish banks; and (iii) an end to payouts to unguaranteed bondholders in failed Irish banks.

Concessions on these three critical issues will not be enough to make the situation manageable without the elimination of the budget deficit in the shortest possible time span. If that is not enough, some additional debt relief may also be necessary.

The refusal to contemplate a Greek default is touted as a defence against contagion and spillover effects on other troubled eurozone members. It is having precisely the opposite impact.

The continuing deluge of destabilisation chatter from Frankfurt reached a new level in last week's Irish edition of The Sunday Times, which quoted an unnamed ECB official in the following terms: "In the meantime, we may have to come to the conclusion that it doesn't really make sense for the ECB to keep putting €100bn into Irish banks. What we are doing is actually illegal, but we have being doing it because we want to help Ireland. Maybe we might come to the conclusion that we should stop."

If offering this kind of commentary to newspapers is a component of 'helping Ireland', they should indeed stop.

Colm McCarthy lectures in economics at UCD. He headed an expert group examining state assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua. He is also the author of the report into the semi-state sector from the Review Group on State Assets and Liabilities.

Sunday Independent

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