Angela Merkel at the Justus Lipsius building in Brussels (Photo: AFP/Getty)
Will the grand plan cobbled together by eurozone leaders in the early hours of Thursday morning work in saving the euro? As Sir Mervyn King, Governor of the Bank of England, remarked before it had been signed, it might buy a little time, but it is no kind of long-term solution.
Before explaining why, let's first pick some holes in the plan itself, which amounts to pretty much a clean sweep for the German view on how to proceed and poses almost as many questions as it answers. The only bit which is done and dusted is the banking recapitalisations, where 70 banks have been stress tested and some very precise numbers have been put on the required additional capital.
The overall impact of the banking package is none the less somewhat underwhelming. The stress tests are widely thought wanting by many market participants and the additional capital therefore inadequate. BNP Paribas for one should be able to achieve its €2bn through earnings retention alone. The tests seem once again to have been designed so as to bring about the least possible commitment of new public money rather than once and for all to underpin banking solvency.
Furthermore, the statement seems to imply enforced bail-ins of subordinated debt holders before sovereign support is tapped. This is only going to further unnerve debt holders and will likely further enhance the difficulties many eurozone banks face in accessing wholesale market funding.
On Greece, nothing is done and dusted at all. The suggested 50pc haircut amounts to no more than a statement of intent. Persuading private creditors to accept such a write-off voluntarily will remain an uphill struggle. Many of the banks with big holdings of Greek sovereign debt have hedged themselves against default through CDS contracts. They thus have a positive incentive not to agree the haircut and instead force a "credit event". Only in these circumstances can they claim compensation through the CDS contracts.
There is a sense in which they are damned if they do and damned if they don't. If they agree the haircut, they lose the full amount and cannot reclaim it through the CDS. Yet if they trigger the CDS, they create market mayhem and may therefore end up even worse off. Nobody knows for sure what an uncontrolled default would do, but given the experience of Lehman Brothers, it is perhaps best not to try and find out.
A voluntary deal on the other hand in effect amounts to a breach of the CDS contract. In such circumstances all CDS insurance on sovereign debt essentially becomes worthless. Either way, someone, somewhere is going to lose a lot of money.
But the main strictures must be reserved for the European Financial Stability Facility, the main eurozone bailout fund. Here's what this morning's euro summit statement said about it.
We agree on two basic options to leverage the resources of the EFSF: • providing credit enhancement to new debt issued by Member States, thus reducing the funding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market; • maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets.
This is fine as far as it goes, but as the statement makes plain, investors will be required to pay for the insurance option. It's not clear, given what's just about to happen to CDS contracts on sovereign debt, that they will be willing to do this. What markets now aptly refer to as the "SPIV" option looks a little more promising, but even if it works in leveraging the fund to the €1 trillion policymakers are looking for, it will still fall short. This is what the economics team at Royal Bank of Scotland had to say about it this morning.
To put this number in perspective, if EFSF 3 was to continue buying Italian and Spanish bonds at the same pace as that of the ECB, this would give only 2 years of purchasing power, assuming no other country would require help from the EFSF.
Precisely so. It's nowhere near enough. And this really goes to the heart of the problem. The EFSF is no more than a fig leaf, a wholly inadequate alternative to the European Central Bank, which is precluded from providing the limitless liquidity which would undoubtedly do the job by the German veto.
Think of it like this. In countries such as the UK with their own sovereign currencies, there are certainly risks attached to buying public debt, but default risk is not one of them, since in extremis the central bank can always print the money to redeem the debt at maturity. The default risk only materialises if the sovereign starts raising debt in a foreign currency. In such circumstances, it cannot print money to pay it back.
That's the situation the eurozone periphery nations find themselves in. They have effectively borrowed money in a foreign currency – the euro. Now of course it wouldn't be a problem if the ECB were able to buy the debt without limit, as effectively the central banks of the US and the UK have been.
But scorched by the memory of Weimar, Germany will not allow any such nonsense. The ECB is expected to be the keeper of the Bundesbank tradition in maintaining sound money. It's all very admirable on one level, but it's the wrong policy for a liquidity crisis. There are risks in sanctioning the ECB to let rip with massive QE – moral hazard, inflation and possibly catastrophic balance sheet loss – but it's the only way the eurozone will ever finally lance this sovereign liquidity/solvency problem. Unfortunately, Germany is too stuck in its ways to allow it. Instead, we have the wholly inadequate alternative of the EFSF.
Nor does any of this address the underlying problem of widely divergent competitiveness between the eurozone core and its periphery nations. The sort of governance, structural and budgetary reforms suggested by the statement – including, astonishingly, the creation of yet another European President to manage the affairs of the eurozone – will take years if not decades to make inroads into these imbalances, and that's making the heroic assumption that they are infact implemented. Again Germany is the only country in any position to solve the problem. If it were massively to reflate its own economy, that would help. The chances of this happening are zero.
Big things have been agreed overnight, but policymakers remain in a state of intellectual denial. On the present policy mix, the euro cannot survive.
