The euro zone has to tread a narrow path sown with landmines in the next few weeks to survive perhaps the most dangerous phase of its sovereign debt crisis, policymakers and bankers say.
European Union governments have until a summit on December 9 to come up with the outlines of a much bolder and more convincing strategy, with some form of massive, visible financial backing.
The prospects are uncertain because the German government, the Bundesbank and hardliners in the European Central Bank have so far blocked key policy options. These include issuing common euro zone bonds, mutualising the euro zone’s debt stock, letting the ECB create money to fight the crisis, or act as a lender of last resort, directly or via the euro zone rescue fund, Reuters reports.
“Between now and December 9, Germany has to decide what it is prepared to put on the table to save the euro, and the others, especially the French, have to show how far they are willing to go to meet Germany’s requirements,” said a senior EU official.
Chancellor Angela Merkel is demanding a much closer integration of the euro zone, with changes to the EU treaty to grant intrusive powers for European authorities to enforce fiscal discipline on wayward states.
She has not made clear publicly what she is prepared to do in return and Bundesbank President Jens Weidmann seems to be doing his utmost to tie her hands by opposing almost all the possible solutions under discussion.
This analysis is based on discussions with a dozen European and international policymakers, government advisers, central bankers and private bankers, all of whom spoke on condition of anonymity because of the sensitivity of the situation.
RELIEF BUT RESPITE SHORT
The immediate relief that greeted the appointment of two respected European technocrats, Lucas Papademos and Mario Monti, to lead temporary national unity governments in Greece and Italy showed how investors are clutching at signs of hope that a euro zone debt meltdown can be avoided.
But with European banks dumping sovereign bonds to shrink their balance sheets, meet new higher capital requirements, and reduce their risk exposure, it is unclear who will buy the mountain of debt Rome needs to issue in the coming months.
In the short term, the key indicator to watch is whether Italy and Spain find buyers for their bonds at a sustainable price without having to resort to the euro zone’s still embryonic rescue fund or the International Monetary Fund.
A 3 billion euro Italian auction of five-year paper went smoothly Monday at yields below those on the secondary bond market, but still the highest since the launch of the euro.
Both Monti and Papademos face daunting obstacles in imposing tough austerity programs and structural economic reforms on feuding politicians and vested interests in labour unions, business lobbies and protected professions.
And they have little time. Papademos heads an unwieldy 46-member government which may last only 100 days, since the main parties have pencilled in an early election for February 19.
Some policymakers fear the parties will dump the former ECB vice-president and return to business as usual as soon as Athens receives the first major payment of tens of billions of euros from a new bailout package due in February.
Monti’s emergency cabinet, expected to feature a small core of unelected experts, seems unlikely to last until the next Italian elections due in mid-2013. Italian commentators expect an early poll in June, or at the latest in October.
That would give him time to enact a rise in the retirement age, some labour market deregulation and perhaps a new electoral law to reform the paralysing system introduced by Berlusconi. But it is already clear he faces deep suspicion from centre-right parties.
“He will have to keep threatening to resign and use the bond market as his ally to discipline the politicians,” an Italian banker said.
Even if Europe succeeds in the short term in restoring tattered confidence on financial markets, years of painful adjustment loom for southern European euro members, aggravated by a prolonged recession with a high risk of political revolt.
INCREMENTALISM VS BIG BANG
While policymakers recognise the acute urgency of the crisis, some still believe the current incremental approach of tightening fiscal discipline, recapitalising banks and trying to leverage up the euro zone’s 440-billion-euro ($600 billion) rescue fund can succeed.
The head of that European Financial Stability Facility, Klaus Regling, sounded gloomy last week about the prospect of achieving the 1 trillion euro leverage announced by EU leaders on October 26. The EFSF barely managed to raise 3 billion euros in the market last week to lend to Ireland.
Regling blamed tough market conditions, but some bankers say it is the other way round — the lack of credibility of the EFSF’s leveraging strategy is itself deterring investors.
The most critical say the EFSF strategy has already failed, illustrated by Europe’s failure to win any commitment to invest from China and other major economies at this month’s G20 summit in Cannes.
After that meeting, Britain, Canada and Russia openly urged Europe to use its own central bank to provide the resources to underpin the bond market, despite an EU treaty prohibition on the ECB funding governments.
U.S. President Barack Obama also privately urged euro zone countries to pool their borrowing rights with the International Monetary Fund to provide more firepower for the rescue effort, participants said, but the Bundesbank refused.
There is a widespread consensus among non-euro zone governments that Europe needs a far more dramatic circuit-breaker to stop the debt crisis running out of control. But again, the German central bank is opposed.
One European central banker said he believed Italy might have to accept an IMF loan program.
Fallen Prime Minister Silvio Berlusconi said he rejected an offer of an IMF loan at the Cannes G20 summit on November 3-4, when he was pressured into accepting IMF monitoring of Italy’s long delayed pension, labour market and budget reforms.
European officials in Cannes said it was hard to see how far an IMF loan could help Italy, since it would only be about 50 billion euros, and Rome has to roll over some 340 billion euros in maturing debt in the next 12 months.
But Monti may find the idea of a formal IMF program more helpful to discipline his country’s politicians, and less of a humiliation than prolonged bond market torture.
NOT LAST WORD?
Central bankers and European policymakers say the ECB has not said its final word, despite a concerted barrage of statements by its policymakers last week warning against trying to draw the central bank deeper into crisis management.
Asked whether the ECB would ultimately have to act as the lender of last resort one way or another, one central banker parried that it should not be used as a lender of first resort.
The implication was that the euro zone had not yet reached the last resort, but that the ECB could act if it did.
The central bankers are acutely conscious of moral hazard — creating incentives for bad behaviour. Their experience with Italy in August, when Berlusconi backed away from promised reforms as soon as the ECB started buying Italian bonds, underlined the danger.
Two ECB policymakers acknowledged that the bank’s current piecemeal approach to buying limited amounts of Italian and Spanish bonds to try to steady the markets were not working.
Investors are unlikely to regain confidence if the central bank appears to be holding its nose as it buys euro zone debt with visible reluctance while trying to use stop-go purchases as a means of pressure on recalcitrant governments.
Perhaps the most intriguing opening to a possible big bang crisis solution came last week from the German government’s council of economic advisers, who recommended a euro zone debt resolution system.
The proposal for a temporary fund to dispose of Europe’s excess debt stock with the threat of crippling financial penalties on states that go off the fiscal rails was the first big German initiative to mutualise euro zone debt.
Merkel’s first reaction was to reject it, and the proposal would be a hard sell to euro zone partners, but as a senior EU policymaker likes to repeat: “The Germans will go on saying ‘nein’ until at the end they say ‘ja’.”