It would be going much too far to say that the last few days were “the week that saved the euro”, but real and substantial progress has been made, and the eurozone is in a far stronger position today than it was a year ago. We believe that the risk of a major crisis in the months ahead has fallen substantially and a “muddle through” scenario is now far more likely.
After the August lull for European policy makers, developments have come thick and fast in the last few days. Last week, the European Central Bank spelt out its plans to provide unlimited financial support for peripheral countries, and a relaxation of its collateral rules. Today, Wednesday, the German constitutional court gave the go-ahead to the German government to approve a key EU treaty setting up a new bailout fund, while the European Commission issued detailed plans for the creation of a new single bank regulator for the EU – which is a key condition before Germany will allow European bailout funds to provide direct assistance to troubled banks.
It’s worth looking at each development in turn, as they all have significant implications for the eurozone fiscal crisis.
ECB “Unlimited” support
It seems very clear now that the ECB has “got serious” about this crisis. This latest phase in its response began when Mr Draghi, the ECB President, spoke at a conference on July 26th, and said,
“The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”
That was a very categorical and clear statement of intent, and the markets rightly sat up and took notice. It was followed up a couple of weeks later by an ECB decision, in principle, to buy peripheral government bonds on certain conditions, and this was further confirmed, with much more detail, last week when the ECB spelt out in detail how the bond-buying programme will work.
Probably the most important term in the announcement of the ECB plan was the word “unlimited”. The ECB has agreed that it will buy unlimited amounts of peripheral market bonds, albeit with conditions attached. This is enormously significant because it essentially removes what we think was the single biggest risk to the future existence of the eurozone, i.e. that a country would simply not be able to raise enough money from the financial markets or from other eurozone countries (through existing or new bailout funds) to pay its bills.
Before this change of plan from the ECB, if Italy was not able to fund itself on the financial markets, it would ask other EU countries, and the IMF, for help in the form of a similar bailout programme as Greece, Portugal and Ireland have already received. But Italy is such a large country and has such a huge amount of outstanding debt (about €2 trn) that the bailout funds (EFSF and ESM) just would not have enough funds to rescue Italy. In those circumstances Italy would have to default on its debts and that would very likely cause the eurozone to collapse.
Now, however, in the same circumstances Italy could apply not only to other EU countries (via the bailout funds) but also to the ECB, which – in exchange for conditions – would buy unlimited amounts of Italian debt. The ECB is in effect to become the lender of last resort to peripheral countries and - provided those countries comply with conditions - it is now almost impossible for a market crisis to force a sovereign default. This is a very significant change, as already stated.
Of course, as mentioned several times above, the ECB will insist on strict conditions in exchange for this assistance. Firstly, the country must explicitly ask for help by means of a formal request to other EU countries and their taxpayers for assistance. Next, the country must then agree with EU leaders, and possibly the IMF, on what austerity and other measures need to be taken in exchange for assistance. It is only when or if agreement is reached on these measures that the ECB would get involved as well.
This means that some level of risk remains of course – for example perhaps agreement might not be reached between EU leaders, the ECB, and the government of the country in question on the required measures to be taken. But the risk of a country running out of cash is dramatically lower now than it was before the new ECB plan.
Important hurdle cleared in Germany
In another very important development, the German constitutional court ruled today that its government could go ahead and ratify the European Stability Mechanism (ESM) and “Fiscal Compact” treaties. The ESM is a new and permanent bailout fund, designed to replace the more ad-hoc bailout fund that was used to provide funds for Greece, Ireland and Portugal. Opposition groups and individuals had challenged the treaties in the court, arguing that the treaties were not compatible with Germany’s Basic Law. While the technicalities of the case are not worth going into here, the implications if the court decision had gone the other way were very significant. If Germany had not been allowed to ratify the treaty, the ESM could not be established, bringing further into doubt the ability of Europe to deal with future crises.
The court did establish some relatively minor conditions, saying for example that both houses of the German parliament must approve future bailouts (not just the lower house), and setting a (very high) absolute cap on the total German payout to peripheral countries, but at this early stage it looks as if Germany will formally ratify the Treaty within days or weeks.
Proposals for new banking regulator
Today also, the European Commission published proposals to establish a single bank regulator for European banks, to replace the current situation where each country has its own regulator. Normally such a technical proposal would not get much media or financial market attention, but this time around these proposals are particularly important, especially for Ireland.
The importance of these proposals comes from the fact that at an end-June summit, EU leaders agreed to allow bailout funds to directly support troubled banks. In the past, bailout funds were lent to the government in the country where the banks were located, and then the government in turn gave the funds to the bank. That helped the bank, but only at the cost of increasing the national debt of the country.
The EU also said,
“the Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme”.
This was, and is, taken to mean that the EU would look at ‘retrospectively’ helping the Irish taxpayer in relation to the many tens of billions that have been poured into the Irish banks, and was very welcome news – although many details remain to be worked out.
However, there was a very important condition attached: this will only be allowed after a single EU-wide banking regulator is established. Hence the rush to get one up and running as quickly as possible! Today’s proposals come just ten weeks or so after that summit, a very fast pace indeed for EU policymaking. The proposals, as expected, suggest a phasing in of the new regulation system, to be fully up and running by the end of 2013. Importantly, the proposed date for the start-up of the regulator is as early as January 1st of next year, so technically from then on it may be possible, under the terms of the June summit deal, to provide assistance directly to banks and to find an arrangement to ease the burden of past bank bailouts for the Irish taxpayers.
A Changed Landscape
As the dust settles after all these developments, it is instructive to think about where we are today, in September 2012, vs. where we were a year ago.
· Then, banks faced huge problems in raising funds and many were arguably short of liquidity. Now, about one trillion of liquidity has been provided in three-year funding to the banking system via the “LTRO” plan of the ECB.
· Then, the ECB had stopped buying government bonds of peripheral countries, and had essentially made it clear that it would not do so again. Today, the ECB has explicitly stated that it is willing to do so on an “unlimited” scale, albeit with strict conditions.
· Then, the Italian government was about to collapse, while Spain and Greece were due elections which the incumbent governments were expected to heavily lose. Today, a much respected technocratic government leads Italy with cross-party support, while Spain and Greece have governments with comfortable majorities and pro-European views.
· Then, no funding was available from Europe to help rescue troubled banks. Today there are concrete proposals to do so very shortly.
· Then, the Fiscal Compact and ESM treaties had not yet been agreed. Today both are nearing the very final stages of ratification, making it considerably easier to arrange future bailouts, if required.
We have long held the strong view that the risk of a eurozone break-up is very small, at around 5%. But we also believed that there was a significant risk (around 45%) that there would be a further and much more serious crisis than anything seen to date, which would in turn bring about a much more substantial policy response than anything seen to date. And we put at about 50% the probability that the eurozone would “muddle through”, without either a dramatic crisis or a dramatic solution, but improving gradually over time.
Today, in light of the significant developments in the last few weeks, and particularly over the last few days, we are changing those probabilities.
We reduce our expected probability of a further dramatic and severe crisis to 25%, and raise our expected probability of a “muddle through” scenario to 70%, while retaining a notional probability of about 5% for a eurozone break-up (though even this, in practice, is probably overstating that risk).
As can be seen from those probabilities, we now think that the eurozone crisis is unlikely to get significantly worse in the months ahead. But we caution that that does not mean that the crisis will end. To forecast a “muddle through” scenario is certainly not to forecast that the crisis is over. There will be many twists and turns along the way before this crisis ends. But we do think that we are moving into a new phase, a phase where each wave of the crisis is somewhat less severe than the previous wave.