In a widely trailed move, the European Central Bank (ECB) last week cut the two-week refinancing rate by 0.5% to 1.5%, but that was the bare minimum in the face of a marked deterioration in economic conditions around the region. We believe that the argument for cutting by 1.0% point, down to 1.0% is strong and would have provided a ceiling of 1% for overnight rates - although in practice the overnight rate would be effectively zero.
Over the past few months the ECB has provided substantial excess liquidity to the money markets in order to push the overnight rate below the official interest rate and has expanded its balance sheet by an estimated €600bn in the process. It is expected that the ECB will pursue this overly timid approach which has, historically, resulted in a monthly pause between each phase in monetary easing. On that schedule the ECB will reach its inevitable destination in May. Once that happens, the ECB will embark upon the same quantitative easing as is now happening in the UK and is being shuffled towards in the USA.
The problem is that the Central Bank's Charter expressly forbids quantitative easing because it would violate the no bail-out provision, although it is possible for the Bank to purchase government bonds in proportion to the Gross Domestic Product (GDP) of member countries. Inevitably, this would be of next to no help to the embattled smaller nations within the European Union.
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It is estimated that the cost of bailing out Greece, Portugal and Ireland will not be significant in the context of overall eurozone GDP. Those with long memories and an eye for detail might recall that the Bundesbank reduced Ireland's contribution to regional GDP to a mere rounding error prior to the introduction of the single currency. However, these costs will inevitably increase if the funding umbrella is extended to Italy and Spain. Proposals to issue a combined euro government bond have gained considerable support from within the Commission.
The proposal, whilst attractive in its simplicity, has several operational difficulties in practice. Supporters argue that the issuance of such a bond will improve liquidity in smaller European countries and in the context of the markets the breakdown between inter-governmental bond spreads versus Germany and each member country's debt / GDP ratio. The problem is that earlier debt estimates were based on unsustainable government revenues which were severely weakened by the credit crisis. Investors now expect a sharp increase in debt/GDP ratios across this fiscally compromised region over the next decade.
In addition to the above, prospective debt issuance over the next few years has resulted in the inevitable widening of bond spreads between the region's more peripheral countries, a move reinforced by downgraded sovereign credit ratings and exaggerated further by a high level of overseas participation in the markets of, say, Ireland and Spain, or through big redemption schedules in countries such as Greece, Italy and Portugal. However, the additional interest burden is likely to be substantial and in the context of additional fiscal packages, banking support measures and automatic fiscal stimulus stabilisers, embarrassing for local governments.
Farewell Maastricht
The obvious disadvantage of a common euro government bond is that countries may be able to borrow under this programme with impunity. It might be possible to control issuance, but the Maastricht rules relating to 3% budget deficits and 60% debt / GDP ratios have been routinely ignored. The Commission estimates that the average deficit across the region will be 4.0% this year, rising to 4.4% in 2010. The actual total will almost certainly be higher than this.
Perhaps the most significant disadvantage is that a bail-out package confined to those countries participating in the single currency will inevitably exclude, and not impose additional costs on, Britain. European governments are already deeply concerned that this country has achieved a significant competitive advantage as a result of sterling's weakness over the past nine months. These governments already desire Britain to share the burden associated with bailing out weaker economies around the region and the crisis probably presents an ideal opportunity to put an end to Britain's budget rebate.
The Fatherland
The Bundesbank president and ECB council member Axel Weber has pointedly added his country's seal of disapproval by stating that "A euro bond would be exactly the wrong road. Common liability for national state finances is not desirable and would not be in agreement with the constitutional framework of the EU the so-called no bail-out clause. It must be clear that individual nations take responsibility for their fiscal policy".
That said, Mr Weber has accepted the need for a common responsibility on the part of eurozone member countries to solve the crisis. "If, in an escalation of the situation, targeted aid for individual member states were unavoidable in the light of the extraordinary emergency situation, then this would have to be tied to strict demands and conditions". Moreover, the size of any bail-out package would "Depend on the concrete situation. It must be clear to any member government and population asking for help that any possible aid must be linked to strict conditions. There must be a guarantee that this will be kept to and that the country finds its way back to the right path. Their concrete form and conditions would then have the character of the IMF".
Germany accepts that it will have to fund the majority of any prospective bail-out, but acceptance is one thing and action is quite another. The forthcoming election schedule is expected to delay any bail-out for eurozone members. The existing coalition is already a lame duck and this political paralysis is expected to intensify after Easter as the warring parties focus on the upcoming European Parliamentary elections (7th June). These elections should represent an interesting test of regional electorates' willingness to pay for the profligacy of other eurozone nations. At present we work on the assumption that these electorates will, grudgingly, accept the principal lying behind these bail-outs. Thereafter, the next stage in the political process will involve just what and how significant any constraints might be in return for this funding. This issue is likely to dominate the Federal Elections scheduled for September 27th. Victory for the CDU / CSU, and likely coalition partner the Free Democrats, is likely to result in rapid fiscal consolidation and binding agreements to limit fiscal deficits in the future, effectively casting the Maastricht criteria in stone.
As an interesting footnote to the German political situation, an alternative to the above scenario involves the possibility of a "red / green coalition" between the Social Democrats and the Green Party. The main item on the agenda is likely to be the adoption of common European tax rates and social protection for those economies that accept the aid package. The Christian Social Union in Bavaria has suggested that major European legal decisions should be confirmed by referendum. Whilst such a policy is unlikely to appear in any German political party's manifesto it is a reflection of the very awkward political structure in Germany and that the funding for any potential bail-outs may not happen until some time after September 27th.
There is, at present, little evidence to suggest that the peripheral countries in the eurozone are in imminent danger of bankruptcy. History is littered with national bankruptcies over the years indeed Britain is the only major European economy never to have been insolvent. There is a much greater problem in Eastern Europe, particularly in the Balkan and Baltic nations where urgent action is desperately required. The IMF, the European Investment Bank and European Bank of Reconstruction and Development have announced a €25bn funding package for Eastern European banks and further measures were debated at a bad tempered summit over the weekend of 28th / 1st.
Additional funding has been promised under the IMF's lead but with significant fiscal restraints imposed as a rider sufficient to ensure that while concerns regarding the possible bankruptcy of countries such as the Ukraine and Latvia may have diminished, worsening economic conditions and social unrest remain highly likely.
This article first appeared in Week in Preview, published by Charles Stanley stockbrokers .
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