Europe’s policy options in dealing with its problems, when the crisis re-emerges, are increasingly limited.
Further writedowns to reduce debt to sustainable levels, as in Greece and Cyprus, is difficult.
The European Stability Mechanism (ESM), European Central Bank, International Monetary Fund and European central banks now hold more than 90 per cent of Greece’s outstanding debt. The ECB and national central banks have substantial loans to eurozone central banks and banks respectively secured over the bonds of beleaguered countries.
Further debt writedowns, providing relief for the borrowing nations, would result in immediate losses, ultimately impinging on taxpayers in countries such as Germany.
The ECB’s Outright Monetary Transactions, which allow purchase of unlimited amounts of the debt of eurozone nations, has been hailed by its president Mario Draghi, self-effacingly, as the “most successful monetary policy measure undertaken in recent times”.
Details of the yet to be used programme remain opaque and its legal basis uncertain. It will be politically difficult for countries such as Italy and Spain to ask for assistance, as it requires a formal request and agreement to strict guidelines. If they are forced to seek assistance, then it will be under such extreme conditions and market pressures that ECB intervention may be too late.
The banking union was intended “to break the vicious circle between banks and sovereigns”. However, bank exposure to sovereign debt has increased. As at August 2013, more than 10 per cent of Italian banks’ total assets were sovereign bonds. Spanish banks’ holding is 9.5 per cent and Portuguese banks’ holding is 7.6 per cent.
Eurozone bank claims on the public sector range between 10 to 40 per cent of national GDP. European banks own around €700bn of Spain’s government bonds and €800bn of Italy’s. They also have significant exposure to Greece, Ireland and Portugal.
The key elements of any banking union are deposit insurance and a centralised recapitalisation fund.
Germany remains opposed to a eurozone- wide deposit insurance scheme. Additional financial resources for recapitalisation remain unclear. Claudia Buch, a member of the German Council of Economic Advisers, told the Frankfurter Allgemeine that bank recapitalisation would be carried out under “international control and national liability”, and highlighted the fact that peripheral nations do not have the capacity to support their banks.
The banking union is an inadequate supervisory mechanism for a small number of eurozone banks, maintaining the pretence of action and progress and allowing all governments to save face.
The scope of the €500bn ESM is limited, as it relies primarily on capital contributions from four countries: Germany, France, Italy and Spain. While there is no binding legal provision for remaining ESM members to increase their support, if Spain or Italy needs assistance then the contingent commitment of the remaining countries, especially France and Germany, may have to be increased.
Further IMF assistance may be difficult. Significantly the Latin American representative did not approve the release of the most recent tranche of IMF funding for Greece, on the basis that forecasts for its debt and economic growth are delusional and there is significant risk of loss.
History suggests that European governments and the ECB will be tested, revealing the weaknesses of key policies.
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