All is relatively quiet in the eurozone these days – or at least that is what you might think, speaking to portfolio managers over the past few months. German chancellor Angela Merkel has visited Greece, Ireland has re-entered the bond markets and the ECB’s balance sheet is in play for Spain and Italy, so what is there to worry about?
Plenty. While the most disastrous possible risk – a complete, disorderly disintegration of the eurozone – has been greatly reduced by the ECB’s new bond-buying programme, Outright Monetary Transactions (OMT), the worst of the eurozone crisis is by no means behind us.
Greek exit still on its way
While, just a few months ago, businesses and analysts were preparing for an imminent exit of Greece from the eurozone, there has been a widespread lowering of probabilities for that scenario. The main reason for this seems to be that the German administration has entered its campaign period in the run-up to general elections in September 2013. Merkel would rather not accept responsibility for whatever is unleashed when Greece leaves the eurozone, in case it derails her re-election.
If Germany wants to keep Greece in the euro, the logic goes, then Greece will stay in the common currency area. This logic is flawed for a few reasons.
First, even if Merkel wants to keep Greece on life support for now, Greece needs more time to make the fiscal adjustment being demanded of it, and more time will require more money. There is no way Merkel will succeed in coaxing more cash for Greece out of the Bundestag.
Second, even if Germany manages to cough up more funding for Greece, its other troika partners may not be keen on doing so.
Greece released its 2013 budget last week, indicating that public debt will surge to 189 per cent of GDP by the end of next year. If Greece’s debt burden cannot be deemed to be on a sustainable path, the IMF cannot release more money.
The only way to reduce Greece’s debt burden effectively and sufficiently is to write down some of its debt. So far, Germany, the ECB and the IMF have all indicated they would refuse to take a hit on their Greek government bond holdings.
Third, even if Germany wants to give Greece more time and money to achieve a swingeing fiscal adjustment, Greece might not have any interest in doing so, particularly not after five years of economic recession.
The current plan of undergoing an internal devaluation is not politically or socially tenable. Public support for eurozone membership in Greece has fallen significantly since mid-2012, and will continue to do so when the government sucks another €9 billion out of the economy next year, as demanded by the troika.
Sharp divisions are emerging within the Greek coalition, and the government will do very well to survive the rest of 2012 intact. I expect the coalition will collapse over the next few months, and new elections will place a Syriza-led government in power.
Syriza is likely to stick to its promises of no more austerity and a debt moratorium, in which case the Greek government and the troika are likely to negotiate Greece’s exit from the euro, with the troika providing bridge financing to mitigate the blow for Greece. This could happen as early as the first half of next year.
Ireland, a model student
In contrast to Greece, Ireland has been identified by creditor countries as a shining example of how Europe will emerge from the crisis.
It is true that Ireland has stood apart from the other bailout countries in a few important ways. For starters, Ireland has dipped a toe back in the bond markets, despite being in a bailout programme. Investors also seem relatively confident that Ireland will not default, as exhibited by lower, long-term Irish bond yields than its Greek, Portuguese, Spanish and Italian counterparts.
According to the Purchasing Manager’s Index (PMI), Ireland has seen its manufacturing activity expand over the past eight months. This is in sharp contrast with the eurozone, which has, on average, seen manufacturing activity contract for 15 consecutive months.
Ireland’s PMI data is encouraging, with new foreign orders particularly buoyant in recent months. This is a positive indicator for Ireland’s export sector, which should keep expanding.
But here’s the big problem in Ireland: there is no economic growth. While exports have remained buoyant, domestic demand continues to provide a drag on economic performance. Unemployment has stabilised at very high levels (around 14.7 per cent) and, as the government works out the details of yet another austerity budget, there are increasing signs of austerity fatigue.
I expect the Irish economy to contract by around 0.5 per cent this year, and stagnate next year. This is much more pessimistic than the government’s forecasts. Without growth, Ireland’s debt burden – quickly approaching 120 per cent of GDP – is clearly on an unsustainable path. While Ireland will have access to credit lines from the EU bailout funds, it will eventually have to write down its debt.
A debt restructuring in Ireland could come in many different forms. Merkel has singled Ireland out as a “special case” in the eurozone, and has suggested the country may receive a deal on retroactive direct bank recapitalisations from the European Stability Mechanism (ESM), one of the EU bailout funds.
This has always been a red herring. By now, Irish sovereign and bank debt are so intertwined that parsing them out retroactively will be like trying to unscramble an egg. The debt relief from retroactive bank recapitalisations is unlikely to be a game-changer for Ireland.
Another way to reduce Ireland’s debt burden is if Ireland wins a deal on restructuring its promissory notes.
The ECB remains opposed to this, preferring instead that any debt relief come from the EU bailout funds with strict conditionality attached.
Ireland could also undergo a debt restructuring that resembles the Greek private sector involvement deal, with a haircut imposed on those holding Irish sovereign debt. There is absolutely no appetite for this at present.
Whatever the form of debt relief, it is clear that, despite low government bond yields, Ireland is not out of the woods yet.
Is the OMT a silver bullet
The ECB’s OMT has been a key cause for market calm in the eurozone. While the OMT will continue to fuel a market rally once it is finally activated by Spain, the euphoria surrounding the ECB’s programme is unlikely to last.
A number of triggers could undermine investor confidence in the OMT. A Greek exit from the euro or Italian political parties campaigning on an anti-euro platform could worry investors.
More importantly, the OMT only really addresses the fiscal side of this crisis. All of the bond-buying done by the EU bailout funds and the ECB will take place against a backdrop of awful economic indicators, as Spain and Italy continue to retrench and implement structural reforms.
Finally, the EU bailout funds and the ECB are a double act, with the latter only buying bonds for countries that have submitted to the conditionality attached to the former. The EU bailout funds have a very clear lending ceiling of €500 billion and, as that ceiling is approached, investors will worry that, with no more bailout cash and therefore no more conditionality, the ECB will turn off the taps to troubled countries as well.
Once investor sentiment shifts and bond yields creep upwards, Spain will probably be pushed into a full troika programme. When the bailout cash runs out, we could see Spain unable to regain market access and pushed into a debt restructuring.
The euro crisis is currently in a lull that could present a big opportunity for eurozone policymakers. If leaders used the market calm to make swift progress on establishing a political, banking and fiscal union, many of the forecasts outlined here could be avoided. Sadly, market pressure has often been the driver of change in the eurozone. It is much more likely that this opportunity will be squandered and that there will be plenty of drama in store for the region over the next few years.
A version of this piece originally appeared as an op-ed in the Sunday Business Post and has been reproduced here with their permission.
