Greek election prolongs uncertainty
The victory of the centre-right New Democracy party in Sunday’s general election has damped fears of an imminent euro area exit, but kept alive doubts about Greece’s continuing adoption of the euro – and indeed the euro area’s longer run survival.
The market’s worst fear was a victory by the far-left Syriza coalition because Syriza had threatened to ‘tear up’ the MOU with the troika. In that event, the troika had said it would cut off further bailout funding. And without such funding, the government had calculated it would ‘run out of money’ by July 20. To make matters worse, there was also the possibility that the European Central Bank (ECB) would halt its liquidity support of Greek banks.
The risk thus arose that
- starved of cash, the government could repudiate its debt and issue IOUs to public servants and suppliers
- depositors would make runs on banks the government would respond with bank holidays and capital controls
- the turmoil would spill across borders into other vulnerable countries in Peripheral Europe
- other governments with bailouts – Ireland and Portugal – could seek to renegotiate their terms
- the turmoil would also reach the Core of the EU, because the debt repudiation would erode the solvency of the EU’s rescue fund, requiring Core taxpayers to recapitalise it, and also hit the ECB
- the Greek government could be tempted to redeem its IOUs in drachmas – thus sleepwalking out of the euro area, even though it had avowedly wished to stay within it.
The New Democracy victory appears to head off such a meltdown. Neither the New Democrats nor their likely coalition partner, PASOK, want to tear up the MOU; they merely want to renegotiate it – to moderate the austerity it demands. In return, the EU and Germany have said that they could consider extending the time over which the country delivers its austerity. They are, however, insistent that austerity is necessary and must remain.
There seem to be four courses that events can now take: first, the adjustment program gets back on track and succeeds (in restoring fiscal and banking solvency and growth); second, the adjustment program gets back on track but doesn’t succeed; third, the two sides fail to reach agreement on new terms; fourth, the EU changes its whole approach to crisis management by placing a greater stress on symmetrical and growth-oriented adjustment.
The first course seems unlikely: as we argued in our May newsletter, austerity isn’t working. The second and third courses seem more likely. This means that the risk of an eventual Greek debt repudiation and exit from the euro area plus attendant contagion’ remains considerable.
The fourth course seems unlikely at this stage, but could be a stabiliser. EU leaders are reportedly going to do a big re-think at their forthcoming summit on June 28. The trouble is, forming a consensus around a new approach could prove difficult – as we discuss in the next story.
Spain gets a bailout ...
EU leaders announced on 9 June that they will lend Spain up to €100 billion to recapitalise its failing banks.
This makes Spain the fourth and largest euro area economy to get EU help – behind Greece, Ireland and Portugal – though Cyprus could soon be No 5 – see next story.
Events have moved quickly. In February the government insisted that it didn’t need to inject any more state money into the banking system (on top of the €34 billion it had already provided, about
half which it had recovered). But then on 9 May it part-nationalised the country’s largest real estate lender, Bankia, by converting a €4.5 billion government loan into equity. It injected another €19 billion of equity (about 2% of GDP) on 25 May. At the same time, the deputy prime minister insisted that her government would ‘absolutely not’ seek aid from Brussels for further bank rescues. But on 9 June the economy minister announced that the government did indeed intend to seek ‘European financing’ for its banks. Whereupon the ‘Eurogroup’ stated that it would ‘respond favourably to such a request’.
As the IMF has noted in a recent review, the banking system is suffering from a crisis ‘unprecedented in its modern history’, brought on by ‘the bursting of a real estate bubble after a decade
of excessive leveraging’. It suggests that the system might need another €46 billion-73 billion of capital to stay afloat. Market estimates of the recapitalisation need are mainly in the €60 billion-100 billion range.
Will the support solve Spain’s crisis? And put an end to the crossborder contagion? Neither is assured.
Disappointingly, the support won’t go directly to the banks: the euro area’s bailout rules forbid this. The funds will instead be channelled through the government’s books, potentially adding as much as 20% to public debt, which is unsettling financial markets. Bond yields yesterday crossed the important psychological threshold of 7% as a result. (Actually, EU leaders will discuss at a summit on June 28-29 whether their new permanent bailout fund, the European Stability Mechanism, can be allowed to lend directly to banks. But the largest shareholder, Germany, is strongly opposed.)
So there is a question mark over whether the rescue will solve one of the key underlying problems of the Periphery: the dubious solvency of banks and governments – an inter-connected problem.
But it also won’t tackle the other problem: uncompetitiveness. The official answer to these twin problems is emergency financing (but not debt relief); fiscal austerity; structural reform; and
‘internal devaluation’. But as we argued last month, these policies aren’t working: the Peripheral economies continue to stagnate or slump, competitiveness is only inching up, and public debt/GDP
ratios continue to rise. As a result, banks and governments remain prone to capital strikes, runs and cross-border spillovers – and governments to the temptation to seek debt relief and leave the
euro area. Which means the covenant-light bank bailout may soon have to be turned into a full sovereign bailout.
To be fair to EU policymakers, they have noticed – and begun to talk about area-wide infrastructure spending and even higher wage and price inflation at the Core than at the Periphery, to help the Periphery export its way back to growth and solvency.
The end-June summit will also reportedly look at ways to achieve greater integration on the grounds that tightly integrated federations, such as the US, Canada, Switzerland and Australia, don’t fall apart whenever one or more of their constituents come under strain. The options to be considered apparently include a banking union, a pan-European bank deposit guarantee and public debt mutualisation.
But these measures are controversial particularly in the influential Germany. So it remains uncertain whether they will be implemented decisively enough to restore market confidence and keep the euro area together.
... and Cyprus could be next
Cyprus is widely expected to be the next country to apply to the EU for a bank bailout.
There are two parallels with Spain. First, the government initially denied that it would need a bailout, but has recently been coming out of denial, fast. In its latest calibration, the president said on June 1 that while he didn’t take a bailout ‘as a given’, nor did he want ‘absolutely to exclude it’. Second, the banking system has been hit by a property bust.
But unlike Spain, the island’s banks also have large exposure to Greece. In December 2011, the three main banks had lent €23 billion to the Greek private sector, and held €15 billion worth
of deposits for Greeks. Cypriot banks also have relatively large Greek sovereign exposures. According to the European Banking Authority, the two Cypriot banks included in an EU capital exercise had €4.9 billion of Greek sovereign exposure in September 2011 – representing almost two thirds of their total sovereign exposures and more than 100% of their core Tier 1 capital. The second largest bank, Cyprus Popular Bank (CPB), has been forced to write off €2.3 billion in Greek government bonds. This has reportedly wiped out its entire core Tier 1 capital.
So the questions that have arisen are, How to recapitalise CPB? And are other banks vulnerable? There is a plan to recapitalise CPB with a €1.8 billion rights issue, but this could prove difficult to execute, because the bank’s market capitalisation has fallen to almost nothing – €125,000 in early June.
The government has already lost market access and been downgraded to junk status. It has only been able to avoid an EU bailout so far by borrowing €2.5 billion from Russia to cover about €2.7 billion of debt falling due in 2012. It is currently in the throes of an austerity program featuring public sector pay restraint and pension reform, means testing of social transfers, and a two point rise in the VAT rate from 15% to 17%. But it is struggling because the economy is shrinking.
The nightmare scenario is a Greek exit from the euro area. This would trigger a full-blown crisis in the Cypriot banking system.
To prepare for such an outcome, some Cypriots have been urging acceptance of an EU bailout without delay. Others, however, note that there will be strings attached. They worry that Brussels could direct Nicosia to raise the 10% corporate tax rate, currently the lowest in the euro area – even though Ireland was allowed to maintain its 12½% rate after receiving a bailout. The 10% corporate tax rate has been credited with attracting many professional, scientific and technical services firms to Cyprus.
China and India slow to below - trend growth
The latest OECD composite leading indicators signal that growth in China and India is slowing to below trend. In recent years, ‘Chindia’ has been a key driver of world growth and Australian exports.
The composite leading indicators (CLIs) – designed to anticipate turning points in economic activity – signal that economic activity in the US and Japan is improving, although the growth rate may be moderating (Chart 1). In contrast, the CLI for the euro area points to below-trend activity, although it doesn’t suggest that activity will collapse.
Perhaps of greater concern for Australian exporters is that the CLIs suggest that China and India are slowing to a below-trend pace (Chart 1, RHS). This is consistent with recent official data. In China, growth in fixed asset investment, retail sales and industrial production have all eased noticeably in recent months (Chart 2). Chinese fixed asset investment grew by 20% year-on-year in May – the slowest rate since 2001. Meanwhile, Indian GDP growth was 5.3% year-on-year in the March quarter – a nine-year low.
