What would work for Euroland?
0The European situation deteriorated steadily and seriously through the course of 2011. The failure of policymakers to stem contagion effectively from haircuts on Greek government debt, as well as the possibility that a country could leave the euro, has put Euroland in a grave situation as we go into 2012. Government bond markets are increasingly illiquid. Bank funding markets are closed. And Euroland is in recession. In the absence of effective and decisive action, the continued existence of the euro looks increasingly finite.
Our view remains that the political will is there. Several times this year, European politicians were faced with the option of choosing either closer fiscal integration or financial disintegration. Each time, they chose the former. Their failure has largely been one of effective, competent, and timely implementation. But it has also reflected political disagreements that are not yet resolved. The growing – but imperfect – willingness to share financial risk at the sovereign level has been matched by much greater enforcement of fiscal restraint and a transfer of national sovereignty over fiscal policy.
Political will shall be severely tested in early 2012. The circumstances are likely to require a significant innovation in policy if the euro is to survive. Those political disagreements over the methods to solve the crisis will need to be resolved. At present, Euroland is tipping into a self-reinforcing downturn. The shocks to confidence and the financial sector have been severe and persistent enough to push Euroland into a recession that is likely to be exacerbated by further pro-cyclical fiscal tightening, as governments attempt to maintain their 2012 deficit targets. Cyclical indicators are already consistent with falling output. We expect them to weaken further.
Although fiscal policy is being tightened further, the risk is that Euroland recession will lead to fiscal slippage, in turn provoking a further loss of market confidence in euro area sovereigns. With financing needs still extremely high in many euro area countries, especially Italy, such an additional loss of confidence could be extremely disruptive.
The banking sector also has considerable funding needs in early 2012. The ECB’s provision of liquidity to the banking sector should prevent a full-scale crisis, but continued liquidity flight out toward the core euro area countries is likely to mean that banks’ marginal funding costs will remain prohibitively high and that credit availability will continue to tighten.
There are areas of potential resilience, which would support Euroland recovery if financial conditions were to stabilize and confidence improve. For example, the global economy has remained surprisingly firm in the face of the Euroland crisis, so a solid external backdrop could support recovery. Also, Euroland has many strong fundamentals – healthy corporate cash flows, a nascent consumer spending recovery in Germany, and in aggregate, better fiscal metrics than the US or UK. And on a consolidated basis, Euroland has a balanced international trade position, which means that the region does not rely on external capital flows from the rest of the world. Relying on the uncertain kindness of strangers is demonstrably a problem for some of the constituent countries but not for the region as a whole. But Euroland will only be able to benefit from those if policymakers to take bold, rapid, and decisive action to address its financial problems. Otherwise, this self-reinforcing downturn is only likely to lead to a further intensification of the crisis and, quite possibly, bring about a disintegration of Euroland. A policy framework that creates and exacerbates depressions is unlikely to be permanent. In reality, then, the pressure on policymakers is likely to be at its most acute in the new year if financial conditions remain deeply challenging and Euroland is clearly in recession.
So what can be done? It should be increasingly clear to policymakers that without ample liquidity, there can be no solvency in Euroland’s public finances. The recent political changes in Italy, for example, should have been profound enough to have had a palpable impact on the market’s perceptions of its government’s solvency. Not so. And the innovation since then has been growing pressure on other, core governments’ spreads.
To the extent that the immediate problem is liquidity, we see two potentially complementary policy options. The first is that the ECB injects substantial liquidity into euro area bond markets through large scale asset purchases (or QE). We do not think that the treaty prohibits the ECB from doing so, as long as it is explicitly for monetary policy purposes. That may mean that the ECB will need to cut rates to 0.75% or 0.5% to demonstrate that its ability to ease policy further through rate cuts is exhausted and that asset purchases – similar to those conducted by other central banks – are the only option. It would also suggest that the ECB needs to buy a representative basket of euro area government bonds, rather than just those in the most distress.
All the same, we think that a program on such a scale similar to that conducted by the Fed and Bank of England – that is, about 10% of their economies’ GDP (so close to €1tn for the euro area) – would have a significant effect on restoring confidence and liquidity to euro area government bond markets. The fact that QE has now become a standard part of monetary policy implementation in developed economies should give the ECB some comfort in that regard. At present, it is the exception.
The ECB could borrow other tools pioneered by other developed economy central banks. For example, the Fed developed the Treasury Securities Lending Facility (TSLF), which permitted banks to lend their hard-to-fund mortgages to the Fed (with appropriate haircuts for credit and liquidity risks) in exchange for borrowing some of the Fed’s portfolio of Treasuries, which the banks would find easy to fund. This relieved some of the strains on bank funding and had a calming influence. The Bank of England did much the same with its Special Liquidity Scheme (SLS).
Analogously, some banks in Europe now find themselves holding dollar-denominated assets that are difficult for them to fund comfortably on acceptable commercial terms; meanwhile, euro area central banks hold large amounts of US Treasuries as part of their foreign exchange reserves. One could imagine a program under which euro area central banks allow banks to swap some of the difficult-to-fund dollar assets (with appropriate haircuts for credit and liquidity risk) for US Treasuries currently held by the central banks that would be easy to fund. This would help to relieve some of the strains in European bank funding.
Of course, to the extent that this support cannot be unlimited, even if it is substantial, means that there needs to be further progress in allowing governments to finance themselves in instruments that the market will regard as liquid. That implies a further move toward Eurobonds. The European Commission plans to produce proposals for Eurobonds by the end of this year. But, even if euro area governments were to decide to move toward common debt issuance in some form, the political processes by which they could be effectively introduced would take some time. They would require the negotiation and ratification of an EU Treaty change, a process that could last well beyond 2012. Political risk related to such implementation could be considerable. An implication of this is that the ECB would need to keep its enlarged balance sheet in place for several years, as other central banks have already illustrated.
Of course, both of these policy measures – large-scale ECB asset purchases and a Eurobond – are currently opposed by the relevant authorities, especially those in Germany. So a solution involves some policymakers doing something they have told markets they are not prepared to do. In reality, that means the economic and financial crisis in Europe will need to worsen significantly further before, or if, they are accepted. In our view, the crunch point is very soon.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
