Bank-friendly strategy imposed by ECB on State is unique and perhaps even outside its power, writes Colm McCarthy
The slow-motion train-wreck of the eurozone crisis left the station in Brussels on May 2, 2010, when European leaders decided that there should be no sovereign default in Greece, but rather an emergency official lending programme to the Greek government totalling €110bn. They also decided that senior unsecured bondholders in eurozone banks would be paid in full, at the expense of the sovereign states in which bust banks were domiciled.
This policy has been maintained in the case of bank creditors (no senior unsecured bank bondholder has lost) but Greece defaulted in March to the tune of €100bn , all paid by private sector holders of Greek sovereign debt. This was the second Greek bailout and was also inadequate. The preference for bank over sovereign creditors has also failed, since European banks remain under-capitalised and unable to recover the confidence of lenders and investors.
Events on the Spanish and Italian government bond markets will have a greater impact on the eurozone endgame than anything that happens in Greece. The formation of a new Greek government will likely see some relaxation of the second bailout, possibly even a further formal write-down of Greece's unsustainable debts. Greece will limp along for now and a disorderly exit from the euro has been averted. In any event Greece is an SETF country, Small Enough to Fail.
The bond yields faced by Spain and Italy have reached levels which are too high for comfort and neither country is small enough to fail. If Spain needs a full financial rescue and must exit the bond market, the same fate likely awaits Italy, the largest regular borrower in Europe. Italy needs to borrow over €20bn every month through the remainder of 2012, Spain about half that amount. Most of this borrowing is undertaken to re-finance maturing debt, the rest is new borrowing to bridge the ongoing budget gap. Neither country can afford to lock-in current high interest rates for long. But neither can they be removed from the markets, with their borrowing needs met by the EU and the IMF. These two official lenders simply do not have the resources to fund Spain and Italy for any length of time.
If Spain and Italy are to be kept in the markets there will need to be a sharp reduction in the interest rates they face. Eurobonds, which would mutualise the credit risk, are one option but have been opposed by Germany. It is a myth that pledging German credit in support of Spain and Italy is an easy option: Germany too has substantial, if less threatening, debt levels, and an open guarantee of Spain and Italy could undermine even German solvency. Yields on German bonds have been creeping up from the very low levels of a few months back and it cannot be assumed that even Germany's AAA rating would long survive exposure to open-ended liability for Spanish and Italian bail-outs.
Exit from the markets for Spain and Italy over any extended period would be difficult to square with survival of the currency union, so a formula will have to be found which caps Spanish and Italian debt service costs without exposing the dwindling number of eurozone AAA countries to downgrades. Italy, a founder member of the EU's precursor, the Common Market, back in 1958, cannot be sacrificed, is not fundamentally insolvent at reasonable interest rates and does not have a big overhang of private debt.
The immediate domino is Spain rather than Italy. Spain has had a banking bubble and many Spanish banks are under-capitalised or bust. The stress tests just released confirm this. Spain also has substantial external private and public debt. Europe's leaders are contemplating early measures to keep Spain in the bond market regarded as unthinkable for Ireland or Portugal. One option is direct European investment in Spanish banks, a move supported by Commission president Jose Manuel Barroso, in remarks made on Monday at the G20 meeting in Mexico.
No such offer was made to Ireland in October 2010, when the penny had finally dropped and the Irish government sought to haircut bondholders in zombie banks. But the ECB chose to exacerbate Ireland's problems through insisting on 100 per cent payouts, at the cost of the already-bankrupt Exchequer. These payments, from money borrowed from official lenders, went to unguaranteed and unsecured bondholders in bust banks already closed down. Further payments to these fortunate investors, at 100 per cent of face value, continue to be made by the Irish Government, in effect with funds borrowed from official lenders. No such discretionary action by the ECB was taken against any other eurozone member and in this sense the Irish situation is unique. It looks as if the attempt to impose the Irish formula on Spain has been recognised as a blunder too far and would be abandoned but for German opposition.
Spain's accumulated debt is lower than Ireland's and the Spanish banking collapse was less severe. If Spain cannot be burdened with onerous banking debt, it is time for the ECB to acknowledge that what they chose to do in Ireland was a mistake. While not apparently prominent considerations in Frankfurt, it was also arbitrary and unfair to Irish taxpayers and to blameless holders of Irish sovereign debt. The fact that this policy has failed, and was a mistake, needs to be acknowledged by the ECB and the EU Commission, whose preferred bank-friendly strategy in Ireland was imposed despite the reservations of the troika's third member, the IMF.
Under pressure of events in Spain, the EU Commission appears to have learned that the approach adopted in Ireland was a mistake, as evidenced by Mr Barroso's comments. As for the ECB, the acknowledgement of mistakes does not seem to be part of the communications strategy. Better to blame governments, or to blame the markets.
The Irish Government's negotiating position has been strengthened by the misfortunes of Spain and Italy in the bond market, since the pretence that the banking crisis can be resolved through fiscal cutbacks alone is no longer credible, even in Frankfurt.
Passage of the fiscal treaty referendum also strengthens the Government's hand and it has received further support from the IMF's recent (sixth review) report, which argues that market re-entry for Ireland is unlikely without further help from our European partners. The IMF notes that the extra debt burden was imposed on the Irish State balance sheet "to repay holders of unguaranteed senior bank bonds as considered appropriate by the ECB due to concerns about pan-European financial stability. This lack of burden-sharing on senior bank debt as part of the resolution process added to government debt, exacerbating the political difficulties with the annual payments of €3.1bn due on the notes until 2023".
The IMF clearly disapproves of this arrangement and more importantly has attributed the imposition of these costs unambiguously to the ECB. This statement from the IMF is significant since their officials were closely involved in the negotiations at the time.
They are in a position to know what actually happened. They attribute responsibility to the ECB, not to the troika collectively and not to the EU Commission, although it appeared at the time that the EU Commission took its lead from the ECB.
In summary, the IMF is saying that the debt burden on the Irish State is too high, and re-entry to the bond market on schedule is unlikely. They are also saying that the cost of repaying in full unguaranteed bank debt was imposed on the Irish Exchequer in October 2010 by the ECB, in pursuit of pan-European financial stability.
The ECB is entitled to pursue financial stability in Europe, through paying off unsecured bondholders in bust banks or otherwise.
But placing the burden on the balance sheet of a small distressed sovereign is hardly a proper exercise of the ECB's powers. It is not clear that coercing a government in this way is even within those powers. Article 35 of the ECB's statute provides as follows: "The acts or omissions of the ECB shall be open to review or interpretation by the Court of Justice of the European Union in the cases and under the conditions laid down in the Treaty on the Functioning of the European Union."
It would be a pity if the actions of the ECB had to be referred to the European Court by a member government.