Bridging the Divide in Europe

By Simon Smith, Chief Economist - FxPro

One thing Europe has not been short of over the past few years is analogies to describe its current predicament, generally involving patients, burning buildings and pretty much every apocoltyptic symbology you can think of. It’s worth throwing one more into the pot, because right now the sense I get is that the eurozone is sat atop a melting iceberg, slowly drifting away from the mainland.

For the past two years, the gap between the mainland has been growing, but rather than work on narrowing that gap (such as all paddling towards it), European leaders have mostly been concerned with stopping the iceberg melting.  All well and good, but melt it will. Furthermore, even though there is a life-boat, it looks to be holed below the water line.

Reaching the mainland again means getting to a stage where the single currency can survive in a viable form for the future. These are the long-term institutional reforms that are needed, rather than the firefighting measures required just to stop the situation getting worse.

To many, myself included, this has always meant either reducing the eurozone to a more closely-knit group of core countries, or moving decisively down the road of political and fiscal integration.

On the latter, we’re not talking full union – nor an arrangement without any conditions – but building a form of financing (i.e. a bond market) that can act as a liquid, international market for euro-denominated debt.

But to achieve this, there are two hurdles to be overcome. The first is political. Leaders don’t tend to climb the political ladder only to give power away once they are there, and so long as they are voted in by domestic electorates, this is not going to change. The latest EU summit of leaders was notable for just how little was said on the subject of further integration.

The second is the financial divide. Implementing a system of common bonds, one that avoids the issue of less credit-worthy countries ‘free-riding’ on the strong credit rating, could be done, but how do we get from where we are now to such a stage? Germany fears that it will involve the mutualisation of currently unsustainable debt levels and, quite rightly, it questions why it should pay for the past mistakes of others.

In which case, there are only four other ways of dealing with these past mistakes: either refuse to pay back creditors (default); lend them more money (which would lead to the same thing, only bigger); inflate them away (difficult in a monetary union); or combine both with a currency depreciation (euro exit).

This sort of reform would have been hard to implement at the best of times (i.e. when borrowing rates were far cheaper and debt much lower), but you can see just how much bigger the divide is now is. Since 2007 eurozone public debt has increased by 37%, or EUR 2.3trln. At the same time, the (GDP-weighted) average of peripheral bond spreads has increased by 6%, or by 4.8% from when Greece was first bailed out in 2010. It’s not an absolutely true comparison, but to a fair degree that 4.8% represents the cost of not making a concerted effort to paddle back to the mainland.

Equally worrying are the holes in the ESM lifeboat (the European Stability Mechanism). The trouble is that the ESM was conceived (late in 2010) when European leaders believed that at the time of its launch (originally scheduled for 2014) the worst of the sovereign crisis would be behind them.

The EU’s piecemeal approach means that the supposedly new and improved lifeboat is set to be launched in the midst of a storm that was expected to have passed when the plan was first mooted.

Unfortunately, there is a real danger that, rather than serving to save the eurozone, it may hasten its demise. At present, there are four countries signed up for financial assistance from the troika (EU, ECB and IMF) in various forms, including Spain’s bank loan-program. Spain itself will struggle to survive at current market rates, especially given the rising debt burden from the bank deal. All these countries must still contribute to the capital of the ESM. The only provision allowing for leniency relates to those with per capita GDP 75% or less of the European Union average, but only applicable to new ESM members (i.e. accession countries).

If Spain were to be formally ‘bailed out’ however (i.e. sovereign, not just the banks), then there would be four countries whose capital contributions to the ESM (payable by instalment over the next five years) would still have to be paid. Without direct market access, these would be indirectly paid by the ESM, unless the IMF was to take a greater role. In other words, the contributions would feature in their funding requirements and (ESM) loan calculations for the coming years. The lifeboat is holed below the waterline, even before launch. I still fear the eurozone’s ‘Lehman moment’ is still ahead of us.