Propping up the eurozone

The latest EU summit was billed as a game-changer in tackling the financial crisis but there is a lot of horse trading to be done before a full assessment can be made, writes business correspondent John Walsh

THE latest EU summit was hailed as a “game-changer” in the eurozone’s efforts to find a comprehensive solution to the financial crisis.

Taoiseach Enda Kenny told the Dáil last week that “significant progress “had been made in Ireland’s efforts to restructure the banking sector and break the link between banking and sovereign debt. But following the meeting of eurozone finance ministers on Monday, it is still unclear what it all means for Ireland.

There is a lot at stake. Of immediate concern to the Government is its ongoing efforts to get some sort of a deal on the €64bn it has pumped into the domestic banks. At a wider level, unless the eurozone melds into some sort of coherent entity, which means a banking union and some sort of debt mutualisation combined with a convincing growth strategy, then the single currency’s future looks bleak.

Unfortunately, EU summit communiqués have become synonymous with vague commitments that promise much but consistently fail to deliver. Market rallies which accompanied previous summits faded by the time respective heads of states returned home.

The latest EU summit is only slightly different in this context. At the outset, it would seem that for the first time the highly indebted peripheral member states got their way. But as with everything in Europe, there is still a lot of horsetrading to be done before a full assessment can be made.

In a nutshell the eurozone is divided between the haves and the have nots. Ireland was a have until that night in Sept 2008, when the Government stood behind the banking system. It did so on the mistaken belief that the banks had a liquidity problem. Irish banks were in fact insolvent, which meant that the guarantee was invoked, which in turn rendered the State insolvent.

An EU/IMF bailout ensued in Nov 2010. Portugal and Greece are also in the have not camp. The combined GDP of these countries is not big enough to have any meaningful say in how this crisis should be resolved.

The much more formidable problem of Spanish and Italian funding difficulties was the backdrop to the last summit. Spain has very similar problems to Ireland. It experienced a decade-long credit-fuelled property bubble, which left the economy in a sclerotic state when it burst and the banks on life support.

At the start of June, Madrid reluctantly negotiated a €100bn bailout of its banking system. Its debt to GDP is only 68%. The Spanish government knew that if it took the banks’ liabilities onto its balance sheet, then it would soon need a full-blown bailout, similar to Ireland. It wanted the EU bailout funds to be put directly into the banks.

The election of François Hollande as French president in May has altered eurozone power dynamics. Germany has been implacably opposed to any form of loss sharing since the eurozone sovereign debt crisis erupted in 2008. To this end, the German chancellor, Angela Merkel, has had a staunch ally in the former French president Nicolas Sarkozy.

The Merkozy axis focused on debt reduction through austerity and increasing competitiveness as the most effective way of combating the crisis.

Any measures that would be seen as an unconditional bailout of “profligate” Club Med countries would not be an easy sell to the German electorate. Moreover, German banks have massive exposure to periphery economies. Any burden sharing would mean losses for German banks, which again focused minds in Berlin.

The Spanish and Italian governments made their demands known publicly before the last summit. They wanted the link broken between the sovereigns and the banking system. Rome and Madrid argued that the EU’s rescue mechanisms, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), should be used to buy periphery debt on the secondary markets and directly recapitalise banks.

Their chances of success appeared remote when Merkel opined at the start of the summit that eurobonds were unlikely in her lifetime. A game of tense brinkmanship ensued. Negotiations were described as forthright and acrimonious. The eurozone finance ministers’ meeting on Monday was also a rather fraught affair.

But the summit did agree a potentially significant departure in the eurozone’s approach to crisis resolution. The heads of state agreed that the €100bn Spanish bailout could be injected directly into the banks. The Spanish sovereign would not be lumbered with the bank debt. But over the past week or so, it looked like a volte-face by Finland and the Netherlands would scupper the summit deal.

So far, it looks as if the agreement has held up. Merkal insisted that a Single European Bank Supervisory Agency would have to be established as a quid pro quo for any direct funding of eurozone banks. The eurozone finance ministers on Monday agreed to release €30bn into Spain’s bank rescue fund. Crucially, this will sit on the sovereign’s balance sheet until the bank supervisory agency is up and running.

The troika will work on an Irish bank debt relief package over the summer. If a week is a long time in politics, then three months is a vortex in eurozone affairs.

The Government will drive hard to get as much debt restructured as possible. To this end, it faces a number of obstacles. How far will the ECB bend? How will the creditor countries, particularly, Germany, the Netherlands, and Finland react over the next few months?

The biggest question of all is who or what will ultimately pick up the tab for the banking losses. The next EU summit will decide whether the last Summit was really a game-changer for Ireland or not.

Best outcome

* Irish government debt is forecast to peak at 119% of GDP. If nothing changes then the chances of this country getting back on the sovereign debt market at the end of 2013 are extremely remote. The best possible outcome for the Government would be a complete restructuring of the Anglo promissory notes. As it stands, the Government has to make a €3.1bn payment every year for the next 15 years. This would be wrapped up into a 30-year bond with a much lower interest rate. What’s more, the remaining €29bn would be hived off into the ESM. Eurozone members would agree to a full scale banking union, with a region-wide deposit insurance scheme. The €130bn announced at the last summit to stoke growth has the desired effect. Germany does a volte-face and agrees to look at debt mutualisation.

Likely outcome

* The European Stability Mechanism has to protect European taxpayers so it is unlikely there will be any fiscal transfers. The Government may have ploughed €29bn into Bank of Ireland, AIB and Irish Life & Permanent, &but NCB economist Brian Devine estimates the Government’s equity in these banks is now worth €10bn and that is likely to be the size of the cheque the ESM will issue us.

Moreover, resources from the ESM could be used to reform the banks by hiving off non-performing loans and troubled assets. This will be accompanied by a restructuring of Anglo promissory notes.

A partial bailout will be needed as Ireland will not be able to regain full market access in 2013. But there is movement on a banking union. Enough progress is made to convince markets that the single currency will survive.

Worst outcome

* There is a massive creditor country backlash against the outcome of the last summit. Finland and the Netherlands block any deal on Ireland using the ESM to recapitalise its banks. There is no restructuring of the Anglo promissory notes. Ireland is unable to regain market access at the end of 2013 and has to go cap in hand for another bailout.

At a wider level, the Finns and Dutch are successful in blocking the ESM from buying sovereign debt on the secondary markets. Spain and Italy’s funding costs surge through the critically important 7% level. Both countries need a bailout. Merkel is true to her word and refuses to countenance any form of debt mutualisation. The world economy enters a deep recession on concerns over the fate of the eurozone. The single currency starts to unravel.

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