A Firewall With Some Loose Bricks

Efforts to isolate the contagion are not reassuring investors | “Adding more credit in the system is merely papering over the cracks”

Matthew Philips


As Europe veers from one crisis to another, financial authorities led by European Central Bank President Mario Draghi have reassured the rest of the world that they have the firepower in place to keep the euro intact. Bond traders aren’t buying it.

Investors have shrugged off the Continent’s latest efforts to increase the bailout capacity of various lending programs, including new International Monetary Fund commitments, to €859 billion ($1.09 trillion). Already, we’re seeing diminishing returns to Europe’s piecemeal bailouts. On June 9, Spain received a €100 billion loan courtesy of the European Financial Stability Facility, a bailout fund created in 2010. By June 18, yields on the country’s 10-year government bonds were up more than one percentage point to 7.2 percent, the highest ever for Spain since it joined the euro. Italian borrowing costs have also surged since March, crossing 6 percent on June 13.

At the recent Group of Twenty meeting in Los Cabos, Mexico, European leaders made soothing pronouncements in support of the single currency. The IMF announced it would nearly double its own lending capacity to $456 billion, thanks to increased commitments from emerging countries such as China, Brazil, and India. Next month, Europe is set to unveil its permanent €500 billion bailout fund. All of this still falls short of what would be needed for a wholesale rescue of Spain and Italy, Europe’s third- and fourth-largest economies. Spain has €345 billion of principal and interest due through 2014; Italy faces €704 billion.

Yet at this point, the size of the financial firewall to contain the crisis is less important to investors than progress on creating some sort of enforceable fiscal discipline on EU member states. “There’s no magic number out there,” says Simon Johnson, an MIT professor and former chief economist at the IMF. Increased ECB lending will eventually lower the borrowing costs of countries such as Spain and Italy. “The question is by how much and for how long,” says Johnson. “Adding more credit in the system is merely papering over the cracks.”

One big reason Europe’s crisis has continued to unnerve the bond market is the circuitous way rescue funds have been distributed since the crisis began in 2010. The ECB is prohibited from lending directly to governments: Instead the central bank made funds available to banks, which in turn often used the money to buy their own governments’ debt.

This approach has created a negative feedback loop in which the contagion spreads back and forth between banks and governments. For example, Spain’s banking crisis morphed into a sovereign debt crisis as the realization took hold that the cost of saving the banking system would end up bankrupting the Spanish government. In Greece and Italy, the problem started with overindebted governments and spread to their countries’ banks, which are loaded down with deteriorating government bonds. “Markets are much more focused on crisis mechanics being developed that break the contagion cycle between sovereigns and banks,” than on the firewall, says Guillaume Menuet, a euro-zone senior economist at Citigroup Global Markets.

Investors might be reassured if Europe’s leaders moved to create a more unified banking system, one with a cross-border deposit insurance system and a stronger, pan-European bank regulator to replace the ineffective European Banking Authority. Officials have said they’re working on a proposal along those lines.

An even more ambitious goal is for Europe to craft a tighter fiscal union where sovereign spending levels are subject to enforceable controls. That may pave the way for the creation of Eurobonds, where countries collectively pool their debt.

All this would take months, if not years, of negotiations. Europe may not have that much time, especially if Italy and Spain get into serious trouble. The ultimate fear is that demand for Italian and Spanish debt dries up. “We’re talking more than a trillion dollars to cover the financing needs of those two countries if they were shut out of the markets,” says Paul Ashworth, chief economist at Capital Economics.

That’s the apocalyptic scenario. If Spain and Italy can hang on and Europe’s leaders demonstrate progress toward more fiscal and bank regulatory unity, then the firewall becomes relevant again. The bulwark at least will buy policy makers time as they work to address long-term issues.

The bottom line European efforts to build a $1.09 trillion firewall to keep the debt crisis from spreading aren’t reassuring bond investors.


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