Mirror, mirror on Europe wall - I

Written by Percy Mistry | Updated: Jun 29 2010, 06:59am hrs
Sovereign debt issued by the 16 countries comprising the Eurozone (i.e. countries that have adopted the euro as their currency) out of the 27 members of the European Union (EU) is now posing a serious threat to global financial stability; in part because it threatens to precipitate a second banking crisis. The problems began with realisation in the last quarter of 2009 that the cumulative sovereign debt of Greece was probably beyond the capacity of that country to bear or service.

The Greek dilemma has rapidly morphed into a wider crisis affecting all the southern Eurozone countries (i.e. Portugal, Italy, Greece and Spain) and included Ireland as well. Collectively, these five countries are referred to, in recent financial vernacular, as PIIGS. As of the time of writing, Greece was already under ECB/IMF administration.

Indications are that Spain is likely to follow.

Unfortunately the PIIGS are not the only Eurozone countries in which an overhang of sovereign debt may precipitate a wider financial and economic crisis, thus tipping the world into the second leg of a W-shaped recession. The UK, Hungary, Belgium and the Netherlands also have public debt levels proportionately as bad as those of Spain.

Central bank holdings of Eurozone sovereign paper may now be larger than commercial or investment bank holdings, which are estimated by the BIS to account for about 22% of the total sovereign debt issued by Eurozone countries and still outstanding. Central banks of reserve-surplus countries (e.g. China, the oil-surplus OPEC Gulf states and India) shifted a large proportion of reserves decisively to euro-denominated bonds in 2007-09 when the integrity of US paper came into question and the euro appreciated. So, while generally ignored, the value-loss implications of euro-denominated sovereign bonds for central banks around the world may be more dramatic than for private commercial and investment banks; although such losses will be obscured by the opacity and inter-account transfers that typifies central bank accounts.

But though global banks may hold only 22% of the total debt issued, it is enough to destabilise their balance sheets and financial foundations for the second time in two years. Unfortunately, global policy makers and other (i.e. central bank and regulatory) authorities are now left with no choice but to cope with a second banking crisis (which may be in the offing) by resorting again to monetary policy. Fiscal options are effectively exhausted. There is no space left in EU budgets that face contractionvarying from 15-40% in different member countries depending on their particular circumstancesin relative and absolute terms. Therefore, treasury-financed bank capital support, as happened in 2008-09, is out of the question in every country. That means more quantitative easing (QE) to bolster bank portfolio values by transferring credit risk from bank balance sheets to central banks to avert recapitalisation.

Such a transfer may be temporary in intent, but will become permanent in fact; especially for a few extreme cases like Greece, Spain and Portugal. In the event another bank crisis blows up, it is likely that the approach taken will be to avoid acknowledging portfolio value impairment and recapitalise banks. The EU and Eurozone authorities will do all they can (as with the euro 750 billion ECB/IMF rescue programme) to prevent rapid marking down of values of the sovereign debt of suspect countries in the Eurozone (i.e. the PIIGS) and possibly others in the EU, should things go wrong (e.g. in the UK, Hungary, Belgium or the Netherlands).

Concomitantly central banks, rather than national treasuries, will need to act decisively to prevent debt values from eroding, in order to prevent the possibility of a second round of recapitalisation from materialising. Whether they will be able to do that credibly remains to be seen. They have already indulged in QE to excess. Greece is now in play for the ECB and IMF. But Spain is about to hit the buffers although it is trying to keep quiet its negotiations for immediate IMF support. If Spain has to avail itself of IMF assistance, the contagion effect throughout Europe will be almost impossible to contain or stop.

The problem, however, is that a monetary alternative to acknowledging up-front the reality of a value-loss problem is always sub-optimal and paralysis-inducing, as the experience of Japan amply demonstrates. Instead of recognising losses, writing them down, recapitalising the equity part of the resultant impaired bank balance sheet and getting on with life as typical accounting conventions would demand, a monetary solution fudges things. It results in obscuring the value loss through accounting legerdemain.

In the case of the Eurozone (and the larger EU), what it means is that the ECB resorts to QE (money printing) by becoming the buyer of last resort of toxic sovereign paperon which the real value loss today might well be in the range of 30-70% for different PIIGS, assuming that obligations were written down to what governments like that of Greece could actually afford to service in the foreseeable future.

The ECB has several options, in addition to the SPV it has created under its euro 750 billion rescue arrangement to issue euro 440 billion of senior supra-sovereign debt that is automatically guaranteed by all EU governments. Going beyond what the SPV could do, the ECB could by itself further guarantee the face value of sovereign paper issued by member governments and denominated in euro. That would allow banks to hold such paper and not be required to acknowledge any value impairment requiring write-down and loss of capital. Such holdings might not be zero-risk weighted any longer to induce an affordable degree of annual capital build-up through retained profits.

Alternatively, the ECB could exchange toxic sovereign paper for its own ECB bonds under terms where the coupon might be reduced and the maturity stretched. Thus the ECB would end up owning all troubled euro-denominated sovereign paper of Eurozone members instead of banks while banks would end up owning a surplus of ECB paper. It would effectively mean a retroactive monetisation of troubled Eurozone debt and, if necessary, of all Eurozone debt.

Third, the ECB could accept such paper as collateral for long-term loans, or for evergreen liquidity facilities to banks and refuse to recognise any impairment of collateral value on the assumption that members in temporary difficulty would eventually make good. This is the same principle that the IMF and World Bank have applied in refusing to acknowledge that any member has actually ever defaulted on an obligation. Such an approach would avoid any sudden calls of such loans that might impair bank liquidity or solvency.

The ECB might avail itself of any or all of these options. But, whatever it did, it would be idle to pretend that it would solve the problem of Eurozone overborrowing and the real value-loss that should accrue and be recognised, as a consequence of prolonged fiscal incontinence. It would simply transform an immediate value-loss into a much longer period of virtual paralysis.

(To be continued)

The author is an economics and corporate finance expert