- The European Central Bank, Bank of England, Swiss National Bank, and Bank of Japan had reactivated USD swap facilities with the U.S. Federal Reserve and could thus offer unlimited USD funding to their domestic banks. French and German banks hold some €900bn of 'peripheral' E.U. debt, nearly equal to their own capital. Responding to signs of similar stress rising in Europe now, the E.C.B. and the central banks of Britain, Japan and Switzerland agreed to reintroduce three-month dollar liquidity operations in the fourth quarter.
- Now it is clear that Sovereign default and spillover contagion would amount to an end of the eurozone and the euro as we know it now.
- The situation as we described it in the first part of this piece, has led to counterparty trust fading heavily, with many E.U. banks unable to service global clients needing USD. The actions by these leading central banks have ensured that the E.C.B. can access whatever dollar liquidity is required.
- Bank of France Governor, Christian Noyer, said all European banks (not just French ones) would have to adjust their business models and shrink their balance sheets because U.S. money market funds were "withdrawing from Europe".
- The need to recapitalize E.U. banks has been emphasized by the I.M.F.
Yes, this is reminiscent of the TALP (Term Asset-Backed Securities Loan Facility) facilities that the U.S. government established to replace toxic assets and increase liquidity among U.S. banks. The U.S. emergency fund served to support U.S. lenders in the 2007-2009 crises.
The European government's 'lifeboat', the E.F.S.F., which used to deliver E.U. members themselves in a similar way, is being called on to take over the role of the E.C.B. in buying member government debt in the secondary market. But in Europe the democratic process works slowly. The lifeboat's extended size and job description needs to be approved first by 17 Parliaments, something that may take till mid-October (if it doesn't get derailed by willful parties along the way). Until then it is up to the E.C.B. to keep sovereign markets alive while propping up banks with unlimited liquidity. In the process, the E.C.B. itself is steadily getting thoroughly contaminated. There is good reason for the German exodus from its ranks.
If the Balance Sheet of the E.C.B. is called into question, then the entire structure of the E.U. is vulnerable.
With six member nations having had their debt downgraded, we doubt whether the increase in political, fiscal and financial integration is possible in the E.U. Just as Germany is refusing to support the concept of the 'eurobond' (which will lead to Germany giving a blank check to these weaker nations) so such reformations will have a deep structural impact on member nations that it will be similar to a conquest of those nations in all but cultural terms, but without a shot being fired.
The integration of the individual States into a centralized federal system in the United States gives us a pattern of what is needed to resolve the problems of Europe, but the loss of sovereignty would just be unacceptable to most members.
The crises highlighting these structural weaknesses can drag on for quite some time still before they bring the Eurozone down. In the process, EU banks are grinding their credit extension to a standstill (as in the U.S. if for different reasons) making the mood somber and anxious, with business inclined to be more risk averse and unemployment topping 10% with no hint of a reversal soon. Core Europe is cyclically slowing down, while peripheral Europe is structurally sinking under its fiscal austerity and lack of growth engines. More reform and fearful political shifts are needed, with the E.C.B. keeping markets on board. The worst still lies ahead.
Referendum to Exit?
Greek Prime Minister, George Papandreou, is considering calling a referendum on euro zone membership as a ways to strengthen the government's hand in dealing with the debt crisis as pressure mounts from all sides. A bill to be submitted in parliament, paving the way for such a vote, is to be discussed in coming days.
Without its next loan tranche, Athens says it will run out of cash in mid-October. A default would threaten contagion to larger euro zone economies such as Italy and hammer European banks with heavy exposure to Greece. Asked whether Greece would get the next loan tranche, finance minister Venizelos said, "Yes, of course." Even if it does, many economists and investors believe Athens will default on its debt mountain, more than 150% of Gross National Product, within months. Then its 111 tons of gold will be used to retain access to international markets.
With a cut in its credit rating from A+ to A and being placed on a negative watch we saw the rise in the costs of financing the government rise. Yields on Italian and Spanish bonds rose above 5% despite six weeks of European Central Bank buying to stabilize them. The cost of insuring peripheral debt against default also rose.
Under mounting pressure to cut its €1.9 trillion debt pile, the government pushed a €59.8 billion austerity plan through parliament last week, pledging a balanced budget by 2013.
But there has been little confidence that the much-revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of persistent stagnant growth. [Since 2001, Italy has averaged a growth rate of 0.2% per annum]
S & P darkened the picture further by saying, "We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve. Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges. Budgetary savings may not be possible because the government is relying heavily on revenue increases in a country that already has a high tax burden and is facing weakening economic growth prospects. In addition, market interest rates are expected to rise."
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