A concerted effort this week by EU member states focused on how to stem the tide of recession. The negotiated solution seems to be in three parts: first, there is a 50 per cent haircut on the part of banks, then there is leverage of the European Financial Stability Facility (EFSF) to reach €1 trillion and finally there is to be an aggressive evaluation of banks’ immediate recapitalisation to meet any future shocks.
One may well ask if the medicine will cure the patient. It will not be so easy, says head of currency management at Insight Investment Management in London Dale Thomas: “The recession in Europe is going to happen, and if the European Central Bank (ECB) does what it should and aggressively eases policy, there should be a weaker euro next year.” But can anyone be complacent when considering Greece’s deteriorating finances, which economists fear reduced Europe’s room for manoeuvre in wrestling the contagion, which threatens to pitch the country into default, shake its banking system, infect Spain and Italy and tip the world economy into recession?
Equally cautious was Prime Minister Dr Gonzi on his return from an urgent meeting of heads of government in Brussels .He underlined the seriousness of the current situation in the eurozone when he addressed journalists in Brussels, saying that, so far, it does not appear that Maltese banks need any injection of fresh capital. He added that the country’s banking system is considered “very robust’ with exemplary strong balance sheets.
Not so lucky is Dexia, a Belgian bank that last month faced severe difficulties and had to be bailed out by its sovereign shareholders. Does this volatility bode well for medium-term growth prospects? The answer given by European Commission president José Manuel Barroso is that together we swim, divided we sink, and he warned the heads of government to toe the line. With courage and determination, the troika (the ECB, IMF and ESEF) is expected to reach agreement on boosting long-term growth. The recipe for growth includes enhancing measures: exploiting the single market, reducing the administrative burden and reducing the overall regulatory burden, among others.
Is this wishful thinking? How many times have we heard the mantra of killing bureaucracy (when Brussels itself wallows in it)? How can the group of 17 euro members, with disparate economic performances and varying rates of taxation, ever converge to prescribed Maastricht criteria? Studies reveal that a serious lack of central monitoring in Brussels has resulted in some countries straying from the requirements of the Stability and Growth Pact, thus undermining their own position and that of the eurozone. Now that the crisis is eating into the credibility and survival chances of the single currency, everyone concurs that it is opportune to improve the monitoring of the pact. Again, Brussels wants to approve annual budgets before they are presented in respective parliaments. Sceptics feel that this is another example of shutting the stable door after the horse has bolted.
The situation at present is that laggards such as Greece and Ireland, etc., are being rescued from bankruptcy by other members – who took their obligations more seriously – digging deep into their pockets. The latter concurred that the Stability Pact should be effectively enforced because it was beneficial to everyone that deficits stay below three per cent of GDP or, better still, are in surplus. During a recession, it is pointless chastising rebel countries that have strayed from the agreed norms or to plead for a stronger mechanism by which the European Commission can impose job cuts. History shows us that when Germany and France exceeded official limits, the goal posts were conveniently moved and they were not expected to pay any fines or launch any austerity measures.
Purists want to see a stronger European Union, politically and economically, while respecting the individual country’s sovereignty, but nobody wants austerity measures in their own back yard. Typically, all countries scrupulously defend their right to determine their own domestic fiscal policies. Some (like Malta, the UK and Ireland) are against fiscal federalism, and rejected the introduction of a common consolidating tax base (CCCTB). But in the absence of a homogenous union of countries with compatible economic growth, one is forced to the unpalatable alternative of creating a huge EFSF mechanism that will cushion all potential bailouts in a recession. At the July meeting, members only agreed to a €400 billion EFSF, which is hopelessly inadequate. Perhaps a risky solution is to lever the funds via IMF resources. Now we are told that, subject to ratification, the EFSF rescue fund be increased to more than €1 trillion – a move that is not popular with the EU paymaster, ie Germany, which faces internal problems with its electorate.
Kathleen Brooks, research director with Forex.Com in London, said: “The biggest challenge for the German Chancellor is to persuade the German Bundestag to agree to the changes to the EFSF.” Merkel is once again in the limelight regarding deliberations on how best to deal with the crisis that came to light two years ago in Greece. Under the terms of an agreement struck with her coalition, she must seek parliamentary backing for any changes to the rescue fund that carry budget implications for Germany. As stated earlier, at their recent summit leaders insisted that banks undergo substantial recapitalisation to cushion any toxic debts in their balance sheets. So apart from the leverage of EFSF, there is the cost of new capital amounting to €100 billion to prop up banks and help them get rid of potentially impaired Greek bonds. This is no walk in the park, especially with governments now urging financial institutions to write off losses of 50 per cent on their Greek debt. And yet markets are still sceptical, saying that such measures are purely cosmetic.
But why are the markets so jittery when the patient in the sick bay (Greece) is getting the best medical attention? Because the real problem is not Greece, which only constitutes a small part of the European markets. Ironically, the big fear is “contagion” – that a Greek default could trigger a financial catastrophe for other, much bigger economies such as Italy or Spain. Quoting Angela Merkel: “Italy has great economic strength, but it also has a very high level of debt and that has to be reduced in a credible way in the years ahead.”
As with Greece, eurozone leaders believe the solution is more government austerity – spending cuts and tax rises – on the part of Rome. It is no surprise that the Italian government’s debt, at 118 per cent of GDP, is certainly high, even by European standards. What’s more, these large debts are nothing new. Italy has got by just fine with a debt ratio of over 100 per cent of its GDP ever since 1991, as government spends less on providing public services and benefits to its people than it earns in taxes, and has been doing so every year since 1992, except for the recession year of 2009. But the problem is the heavy yoke required to meet the principal and interest payments on its existing debts. To rub salt in the wound, the Italian economy is not growing. It is common knowledge that its bureaucracy is rampant and it is plagued by poor regulation, vested business interests, an ageing population and weak investment, all of which have conspired to limit the country’s ability to increase production. In short, the outlook is grim.
Italy is not competitive, which has resulted in years of even weaker growth, as Italian workers find their pay is frozen, or even cut, until they regain a price advantage over other EU workers. Under Berlusconi’s government, more austerity means more public spending cuts, which hurt the economy even more. It is a vicious circle and means the market’s loss of confidence in Italy and its recent downgrading by credit-rating agencies could well end up becoming a self-fulfilling prophecy. If markets panic, and switch their money out of Italian debt into “safe” German debt, Italy will need an enormous bailout that would over run the eurozone’s current EFSF.
To conclude, there is no ignoring the warning issued by Italian Central Banker Mario Draghi, who is taking over as ECB president. He said during a speech in Frankfurt that there can be no economic growth or financial stability in Europe without “fiscal discipline”. Coming from an experienced banker, this is a stark reality check when one recalls how, in September, the ECB cut its growth forecasts for 2011 from 1.9 per cent to 1.6 per cent and from 1.7 per cent to 1.3 per cent for 2012. The economic barometer is pointing to a harsh winter ahead of us. Pessimists say that it will be extremely difficult to avoid recession in the eurozone. Perhaps next month’s meeting of the G20 will see a consensus among the leaders to avoid internal bickering and come up with a plan to boost growth, which is the only way to end the turmoil. Does this sound too much like a case of a déjà vu? Let us pray that the Greeks will give us a true gift of stability by preventing any contagion spreading across the eurozone.
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The writer is a partner in PKF Malta, an audit and business advisory firm.