Tuesday, February 28, 2012

Stronger Europe “firewall” still needed

While it is positive that Greece has secured its second bailout, there is a lot of work to do and considerable pain to be endured. In particular, deficit reduction targets need to be met with a starting point of an economy that is already in deep recession.

Should Greece meet all its targets and obligations, its debt to GDP ratio will be 120.5% of GDP by 2020. That’s a tall order and is based on a number of assumptions, including the successful implementation of the debt restructuring (private sector haircut) and asset sales. Hmmmm. Should that plan go off the rails for any reason at any time, a bigger, better, stronger firewall still needs to be in place. As we have said before, that requires all of the European Central Bank (ECB), European governments via the European Stability Mechanism (ESM) and the IMF to come to the party.

This week the European Central Bank (ECB) undertakes the next step of its role by launching the second tranche of Long-Term Re-financing Operations (LTRO). This is part of the strategy of providing “unlimited liquidity” to the European banking sector.

The first tranche in December saw banks take up €489b in cheap ECB funding, some of which found its way back into short-dated (3-year) government debt (a.k.a. intermediated quantitative easing). This has resulted in a sharp reduction in yields in countries such as Italy and Spain and has been a significant contributor to reducing financial tension in the region. The market is expecting a similar take-up in the second tranche this week.

With regard to Europe and the IMF, Europe received a knock-back from the G20 finance ministers who were meeting in Mexico over the weekend. There was some expectation amongst European leaders of an imminent increase in IMF bailout resources which was not supported by the G20 collective. The G20 finance ministers (not unreasonable) expectation is that Europe should boost its own resources first. Paragraph 4 from the Communique:

“G20 members have been actively engaged in taking the steps needed to safeguard the global financial system and to avoid adverse scenarios. At Cannes, our Leaders asked us to review the adequacy of IMF resources. This review is particularly important against the backdrop of continued downside risks. Euro area countries will reassess the strength of their support facilities in March. This will provide an essential input in our ongoing consideration to mobilize resources to the IMF.”

So, further G20/IMF support first requires a greater contribution from Europe itself first. That seems fair enough to me. It would require boosting the €500b capacity of the European Stability Mechanism (ESM) when it is launched mid-year. Germany has previously resisted such a move but will most likely need to backtrack. A commitment to greater ESM resources is unlikely before or during the upcoming March 1-2nd European Summit, but will most likely be in place before the next IMF meeting in April.

The Greece problem has not gone away. Access to the second bailout and the private sector debt haircut hasn’t solved the problem, it has simply been parked for a few months. Importantly that allows vital structural economic reform time to be implemented – stronger economic growth remains the long-term answer to Europe’s debt woes. In the meantime Europe must continue to put the resources in place to cope with what will most likely prove to be renewed Greek economic and fiscal angst at some point in the not too distant future.