Europe

European finance ministers meet Wednesday to try and agree on common rules for resolving a failed bank, after failing to do so this past weekend.  If agreement is reached, and it appears far from certain that will happen, it’s likely to involve only limited flexibility for a country to bailout the bank without imposing losses on creditors.  Following on last week’s decision allowing the European Stability Mechanism (ESM) to directly recap banks, we are seeing the outlines of banking union.  That’s progress, but is it likely to draw a line under the financial crisis? It’s looking less and less likely. A Disappointing Agreement Last week’s agreement on terms under which the ESM could directly recapitalize banks was in line with expectations.  Up to 60 billion euros can be used for direct recap; countries must first ensure the bank is brought to minimum core capital levels. The host country must share in the cost of the rescue.  The rest of the money must come from bail-ins of investors and/or depositors. Guntram Wolff points out that this deal isn’t closed until governments have approved, and for Germany this means changing the law implementing the ESM. To defuse opposition at the time, the German law allowing the ESM explicitly excluded direct recap. Wolff suggests it’s unlikely that the changes will be approved ahead of German elections, meaning further delay and uncertainty. The size of the recap fund, like the overall ESM, is woefully inadequate for the scale of the banking system hole.  Looking at the countries that have already restructured their banking system, losses of 10 percent or more are common; apply that to Europe’s roughly 27 trillion euro balance sheet, as others have, and it’s easy to be pessimistic in the downside scenario.  Not all countries will have a crisis, but all are exposed heavily to the periphery.  This probably overstates the losses, but how will we know? The European Banking Authority (EBA) lacks the authority to make the upcoming stress test credible and broad regulatory forbearance masks losses. To be optimistic, therefore, is to conclude that European leaders understand the math, and in order to protect the euro would expand the fund when (and only when) needed--an unwritten commitment to do whatever it takes. But the desire of Germany and others to put off that day as long as possible, to exhaust all the other options, hardens their line when it comes to bail-ins. That makes this week’s showdown important. Allocating Losses in Failing Banks:  Rules Versus Discretion The core of the bail-in dispute is the degree of discretion national authorities should have when dealing with a failed bank. According to reports, one faction, led by Germany, want bail-in rules to provide national authorities little discretion when it comes to forcing losses on owners and creditors after a bank collapses, as well as limited room to choose the kinds of liabilities that are included.  Other countries, including periphery countries and non-euro countries, want national authorities to have more discretion.  Non-euro countries, in particular, argue that their inability to tap the European Central Bank (ECB) in times of panic requires a different set of rules.  One possible compromise (floated by the Commission) would allow flexibility once the bail-in reached eight per cent of total liabilities–after which countries would be allowed more freedom in “exceptional cases” and “subject to strict criteria”.  Of course, most periphery countries would have little fiscal space to finance any such exception. The likely outcome is a further move towards a bankruptcy-like resolution mechanism in which bank owners, creditors and potentially deposit holders are bailed-in.  From this perspective, Greece and Cyprus restructurings, notwithstanding idiosyncratic features, have become powerful precedents for the broader reform.  Wealthier, non-credit rationed countries will have some capacity to use public money for bailouts.  Periphery countries, absent the fiscal space or debt capacity to do so, will have an incentive to practice forbearance to delay failure, but when that day comes they will have little alternative but to follow the new rules.     

EU ministers apparently made little progress last week on terms under which the European Stability Mechanism (ESM) would recapitalize weak banks, though they still hope for an agreement by end month.  That said, if a draft plan circulated by European Commission Secretariat is a guide, we are seeing another step in the disappointing (and risky) retreat from last year’s promise to decisively break the link between troubled periphery banks and their sovereign.  This plan looks like more of a bruise, or a slight bend, rather than a break.  The good news is that events likely will force a change down the road. One notable element of the document, which reports on features agreed by Euro ministers, is to make a country whose bank was receiving aid put in its own resources alongside the ESM.  If a bank is to receive direct support, the country in question must first ensure that the bank’s capital meets the minimum level of 4.5 percent for tier 1 capital, and then must pay in 10 to 20 percent of the amount of the recapitalization. This looks steep.  Such burden sharing is justified by the need for the country to address all legacy problems (the ESM only resolving a capital shortfall that occurs once the ECB takes over supervision), but moral hazard concerns look also to be in play. Other ways in which the ESM plan will fail to address the debt sustainability question were already known--banks need to be systemically important and pose a threat to eurozone stability, as well as solvent with the injection of capital; the country needs to be able to issue in markets but at risk of fiscal unsustainability if it fully funds the rescue; and creditors and private shareholders of the bank receiving support will need to have paid up (affirming the precedent set in Cyprus). The recap program is limited to 50 to 70 billion euros from the 500 billion euro fund.  As pointed out by the FT, its unclear that many of the banks at the center of the crisis (Anglo-Irish, Bankia and Laiki for example) would have qualified for assistance under this scheme. It is not surprising that policymakers would be wary of announcing more ambitious plans while the German constitutional court is considering the legality of ECB support policies, and ahead of German elections.  But what if German elections come and go, and the policy doesn’t change?  The best that can be said is that, when faced by the risk of imminent crisis, creditor governments have done the minimum each time to avoid a country collapse. Markets remain untroubled, apparently anchored by its confidence that Europe has shown the flexibility to change in the past, and would do so again. Two problems with that: first, that diminishing popular support for European policies and the rise of non-traditional political parties may make justification of changes harder in the future than it would be now; and of course, having to go to the edge of the cliff to get the policy changed has a corrosive effect on markets. It’s hard to see how this helps.

The IMF program for Cyprus has been released (here and here).  Growth is projected to fall 13 percent over the next two years, though the discussion of risks implicitly acknowledges that a larger decline is likely (many private analysts expect a decline of 15 percent this year alone).  Given that the program contains 6.6 percent of fiscal consolidation measures during 2013-14, and a major deleveraging of the financial system is underway, skepticism is warranted.  The Fund also acknowledges that should these downside risks materialize, or program implementation slip, government debt (which is forecast to peak at 126 percent of GDP in 2015) becomes unsustainable. The programs have buffers, but financing looks inadequate.  Coming after a negotiation where the Troika publicly promoted one financing gap (17 billion euros) knowing that the actual gap was far larger (shortly after agreement on the program, the gap was revised to 23 billion euros) further undermines confidence in these projections.  The next review, slated for September 15, likely will have to confront these issues.

The most recent Pew Survey on European attitudes (summary table below) shows that support for the European integration project is dropping.  My colleagues at CFR are far more able than I am to address the broader political ramifications of this shift.  A few points though on the link between economic growth, public opinion, and support for the European reform agenda. Growth matters.  Today’s Eurozone GDP numbers remind us that Europe remains in a grinding recession; a second-half recovery now looks to be a long shot at best.  The only bright spot comes elsewhere, with news of  a German labor deal that will raise engineering wages by nearly 6 percent over the next 20 months (rebalancing European demand and stimulating German consumption needs more of this).  Some of the decline in the Pew numbers likely is cyclical, as declining confidence in their own economic prospects seems to spill over to other issues.  Notably, the need for jobs dominates other issues on the economic agenda.  The mood is particularly bleak in the periphery, reflecting those countries’ economic troubles. This is consistent with the idea the recession and diminishing expectations for the recovery are weighing materially on public opinion. A disillusioned France should matter to markets.  The sharpest decline in sentiment in the survey--both for their own economic prospects and for the EU project--is in France.  This coincides with other reporting suggesting declining confidence in the government’s ability to put the economy on the right track.  In this regard, markets could be sensitive to a rise in opposition to the European project in France.  The right-wing National Front (FN) party headed by Marine Le Pen has announced that it will run in next May’s EU parliamentary elections on a platform calling for an referendum on the euro.  How would markets react if--fueled by disillusionment with the government’s economic program--the FN was the first past the post in those elections? Will a single chart damage Europe’s efforts to resolve the crisis?  I missed this when it first came out, but it’s still worth a look.  Last month, the ECB’s Eurosystem Household Finance and Consumption Survey presented estimates, for households, of median net wealth and the median value of their main residence.  The interesting datapoint:  Germany is at the bottom.  Belgium, Spain and Italy (and, yes, Cyprus) all have household wealth several times German levels. When this was released last month, the German press had a field day with the message that Germany shouldn’t bail out rich southern Europeans.  There was pushback:  it was noted that if means rather than medians were used, Germany would be in the middle of the pack (reflecting a more skewed German income distribution).  Further, the high proportion of renting rather than buying homes in Germany means more housing wealth is off the household balance sheet.  Broader measures of national wealth, including capital, restore Germany to the top ranks in terms of income. The Pew survey (taken before the release of the chart), conversely shows Germans still support the European project, and are willing to pay to support it.  (By 52 percent to 45 percent, Germans support bailouts for countries in crisis, compared to 40 percent in favor in France.)  It remains to be seen, though, whether the chart below and the pessimism reflected in the Pew Survey resonates with less affluent German voters already suffering from bailout fatigue.  

Jaret Seiberg has an excellent summary of Ben Bernanke’s speech and Q&A today on financial sector regulation and reform.  This follows on Dan Tarullo’s speech Friday that highlighted the need for additional capital aginst short-term wholesale funding, an earlier Jeremy Stein discussion on liquidity regulation and the value of price-based regulation (rather than quantitiative limits on bank size favored by some in Congress), and similar comments by the OCC.  We now have as clear a signal as possible that U.S. regulators are ready, in Seiberg’s words, "to go beyond Basel 3 to impose to additional capital requirements on the biggest banks...[using]...a combination of a more restrictive leverage limit, a capital surcharge based on reliance on short-term debt, and a long-term debt requirement." It also underscores the divergent approaches toward reform in the U.S. and Europe, where, against the backdrop of weak growth and credit constraints, the pressures appear to be leading to a slower, more bank-friendly path.

Ken Rogoff and Carmen Reinhart (R&R) have a good piece in the Financial Times today, "Austerity is not the only answer to a debt problem." This, along with other pieces (for example, here and here), is moving the debate over their work in the right direction. On the one hand, recognition that debt still matters, and too much debt (whether the result of or the cause of low growth) is damaging to our politics and our economics. On the other hand, rejection of the idea that there is a universal growth "cliff" when debt exceeds 90 percent of GDP that is at work across countries (an idea their earlier work promoted, unfortunately).  R&R go on to argue that while fixing our debt problem is a central challenge, that doesn’t mean we need aggressive austerity today (though additional stimulus needs to be carefully decided on). The implications are not only domestic. As Richard Haass notes in Foreign Policy Begins at Home: The Case for Putting America’s House in Order, putting our own house in order is essential to an effective foreign policy as well. R&R’s comments on European debt also deserve note: "For Europe, in particular, any reasonable endgame will require a large transfer from Germany to the periphery. The sooner this implicit transfer becomes explicit, the sooner Europe will be able to find its way towards a stable growth path."  Those who read this blog know I agree strongly with this statement, and believe that we have a model already in place--the Paris Club--that provides a way forward.  Perhaps after the German elections we will get an open discussion of the need for official debt relief before another crisis hits, but I’m not optimistic.  

I’d like to think that the ECB will surprise us tomorrow with a package that includes both a rate cut and measures to increase the flow of credit to the periphery.  That could produce a meaningful easing of financial conditions and a weakening of the euro, both of which are constructive for euro-area growth. A few points: 1.   Markets now expect a rate cut, at a minimum.  A majority of economists surveyed by Bloomberg expect the ECB to cut the benchmark refinancing rate to 0.50 percent from 0.75 percent. Weak April data, signals from the ECB that it is increasingly concerned about the downside risks, and a soft inflation outlook for the eurozone as a whole have moved expectations. (The ECB sees euro inflation at 1.6 percent this year and 1.3 percent in 2014, and that was before the latest soft price data.)  In addition, credit data continues to disappoint. Source: Eurostat 2.  Measures to ease credit conditions for SMEs may be close.  A trial balloon last week from Executive Board Member Yves Mersch suggested the ECB could provide liquidity support for the development of securitized pools of small business loans made by development banks. This is one of a number of ideas for spurring small and medium-sized enterprise (SME) lending in the periphery.  The Bank of England’s (BoE’s) Funding for Lending scheme is another possible model (though there isn’t convincing evidence so far that the BoE scheme has worked). It’s unclear any of these initiatives are ready to go forward, though. Below is a nice chart from Morgan Stanley pointing out the importance of SME lending for periphery growth. (It shows that countries with the highest SME lending rates have the highest SME share in gross value added, or GVA.) 3.  But the case for a rate cut has its critics... My colleagues Benn Steil and Dinah Walker summarize the case for caution.  The broken transmission mechanism could mean that those southern European countries with deflation and negative growth may see little direct benefit from a rate cut, while the north already has inflation close to or above the ECB’s target.   The counter argument, which I find compelling, is that the first-order effect of the rate cut is to reduce funding costs of those banks (notably Italian banks) that rely on funding from the ECB.  I do believe that, with demand faltering across the eurozone and overall inflation below target and expected to fall, the risks to price stability in the north are very limited.  Further, over the longer term, these types of inflation differentials also contribute to the needed rebalancing of demand. 4.  Quantitative easing as the endgame?  Gavin Davies’s summary of the options for the ECB gets to the same bottom line that I have.  An easing of collateral requirements can have a meaningful impact, but ultimately the ECB may need to consider a full-out quantitative easing if it is to meaningfully boost the size of its balance sheet.  As Steve Englander among others has highlighted (chart below), the relative size of the balance sheet is a good indicator of exchange rate moves.  It’s hard to see a return to growth in the periphery without some contribution from external demand. Some progressive critics of austerity will argue that when an economy is at or near the zero lower bound, the effectiveness of monetary policy is diminished and more of the burden needs to be carried by fiscal policy.  My problem with that line of argument is two fold: first, in Europe at least, politics as well as the reality of unsustainable periphery debt and finances limit the amount of fiscal easing that is possible; and second, the ECB hasn’t done all it can do--far from it.

Cyprus today passed the €10 billion EU-IMF bailout deal by a 29 to 27 vote, so it will receive its first installment of aid next month.  Capital controls (though eased a bit) will remain in place until at least the fall, when the bank restructuring is completed.  New financing gaps are likely to emerge quickly, as the economic assumptions still look too rosy, but the risk of default has diminished for now.

European best practice in crisis management is on display again with a mass of leaked documents--primarily on Cyprus--ahead of today’s Eurogroup meeting.  I’d note a few things 1.  The financing gap is €5.5bn larger than previously indicated (€23bn, not €17.5bn).  The €10bn loan from EU/IMF was based on this larger number.  This isn’t a great surprise, but it further undermines the government’s credibility; we need to watch to see if there is a domestic public backlash. 2.   To fill the gap, a number of new measures are identified, including additional taxes, sale of CB gold and a “voluntary” refinancing of €1 billion in local law debt.  They seem to be hoping the ECB will open up ELA access to banks to finance this rollover, but if not we will be in a Greek situation (threat of law change may be used to force exchange, which likely would be a credit event). 3.  As of now, they are making €1.4 bn June external debt payment (EMTNs).  But the documents emphasize that this is the largest discrete, near term payment that they are still making, and I can’t help but think this is a contingency for the government should other funding fall through.  Plus the politics of paying this debt, when everyone else is being hit, aren’t great. 4.   This isn’t done yet: I see three distinct risks:  (a) Cyprus fails to pass the prior actions to get EU money (the government isn’t talking as if they have the votes wrapped up); (b) the funding/measures they have identified fail to come through at last minute; and (c) the gap widens quickly, requiring more measures, and so on, and so on.  The macro assumptions in the program still look far too rosy -- the real gap likely is much larger, setting up the program for failure.