by Mark Blyth and Stephen Kinsella
The latest Euro crisis summit was different from the 19 others that preceded it in one
very important respect: The PR department of the EU played this one very well. Rather
than hopes being raised only to be dashed, this time they were dashed before the
summit only to be raised after it ended.
And yet hopes are now slowly deflating once again, even as the Eurogroup works out
the final details.
The idea behind the latest maneuver is that recapitalizing European banks will reduce
the correlation between the creditworthiness of a state's banking system and the
creditworthiness of a State itself. If a state's banks are highly levered and filled with
rapidly devaluing government debt (as they are in Europe), then the risks borne by the
banks becomes risks to the state, and vice versa, as Greece, Ireland, Portugal, and now
Spain are learning. This occurred thanks to the flawed design of the Eurosystem. Being
deprived of a currency printing press, Euro-bound states cannot credibly commit to
bailing out their banks, so when their banks inevitably get themselves into trouble, this
shows up in their sovereign's yield.
The creditor countries hence decided to allow the use of the European Stability
Mechanism (ESM) to directly recapitalize the damaged balance sheets of Europe's
banks, specifically the Spanish banks. And market participants were initially thrilled.
Yields on sovereign bonds fell immediately following the deal's announcement. For
example, the generic yield on Ireland's nine year sovereign bonds fell from 7.1 to 6.4%
in one day, an unprecedented drop. Similar drops took place in Spain and Italy.
Everyone hoped that this time it was different; that Friday's initial euphoria would not
melt away by lunchtime on Monday — and once again this time it was not different.
Yields are now beginning to climb for Irish, Spanish, and Italian debt as the markets
realize three important details of what was agreed.
First, the ESM, the bail-out fund, still isn't big enough to deal with the problems in
the PIIGS collectively. The ESM cannot be a true lender of last resort since its
disbursements are subject to veto by the contributing states. The real lender of last
resort should be the ECB, but it is constitutionally impaired from doing so, while there
is no buyer of last resort for the weaker sovereign bonds in the Eurozone. The
unwillingness of the ECB to fulfill these roles telegraphs that Spain and Italy can
indeed be forced out of the market once the perception returns that the sovereign cannot
effectively guarantee its banking system regardless of any short term recapitalization.
The total bond stock of Spain and Italy is approaching 3 trillion-with-a-T Euros. The
ESM is 750 billion-with-a-B Euros.
So what does this much-heralded recapitalization actually mean? A bunch of
sovereigns, including some under a lot of yield stress themselves such as Italy and
France, have promised to put money that they don't have into a big bag and use that to
buy stock in a bunch of insolvent, if not thoroughly bankrupt, Spanish banks, so that
they can write off colossal real estate loan losses. Even if that works...what's next?
Once the deal has been done, let's say that the ESM now owns stock in a bunch of
banks with no upside assets to speak of in an economy (Spain) with 25 percent
unemployment and collapsing GDP growth. Is that a sound investment? And for the
EU's next trick, where do they get the money to do the same for Italy if it comes to that?
Couple this maneuver with weak growth within the Eurozone as a whole and the
existing liquidity position of many of many of their banks (many of whom are already
on life support from the ECB), and you still have a multifaceted crisis looking for an
effective solution.
Second, even if any of this is economically plausible, exactly how the ESM will go
about recapitalizing these "already dead" banks is not clear. Many countries have
taken large equity stakes in their banks. Would the ESM buy the stakes off these
countries? And if so, at what price?
Take Ireland for example. The Irish government, with a GDP in 2011 of close to 160
billion euros, has committed at least 64 billion euros to its banks. Just over 25 billion
euros worth of the recapitalization is held as bank equity. Now, let's that say the ESM
buys this equity - think about it as buying shares in a company. What price does the
ESM pay? The banks are not worth 25 billion anymore, probably closer to 15 or 20.
Does the ESM pay 25 and make a loss? Or does the Irish state sell the shares at a loss?
In either case, who pays?
Third, the debt-to-GDP ratios of the major countries within the Eurozone are
looking increasingly fragile — even if the ESM succeeds brilliantly, and all of the
details of the plan are worked out at the Eurogroup meeting today. As German imposed
austerity continues to bite and the Eurozone as a whole slumps into a new ERM (the
new Eternal Recession Mechanism) where downward wage and price adjustments are
the only game in town, debt to GDP will continue to increase, not decrease. In turn,
more austerity will be imposed and the Euro economies will contract further, which will
once again impair the balance sheets of the sovereign and their banks, still tied together
via the Euro.
So we end up back where we started, at 20 Euro Summits and counting.
Harvard Business Revie
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