Author: Joonatan Jakobs

Cyprus: A Small Country Raises Big Questions

Joonatan Jakobs

Recent negotiations over Cyprus’ bailout plan tested the hard wrought stability of a union which seemed finally to have solved a few of its core problems.

Few imagined that the Mediterranean country’s financial problems, well known in advance, could rattle the European Union anew. Yet an economy approximately one tenth the size of Greece’s, where the estimated sum of a bailout package would reach a maximum of €18 billion, in relative terms a paltry sum, raised more existential problems for the euro. Read more “Cyprus: A Small Country Raises Big Questions”

European Central Bank Signals Willingness to Intervene

Joonatan Jakobs

The oscillations of the European debt crises have become quite familiar to those observing it. A country or national bank suffers from a negative spiral of debt and fading confidence. This is followed by a new nudge in the direction of deeper integration, or a bailout package is announced. A northern country which is fiscally sound then makes a controversial statement of refusing to cooperate on the terms proposed. This process muddles on until a new country or institution is in a dire situation. Like last year, summer holiday season generates the greatest divide between the political process and the factors that affect the crisis.

Quite apart from this has been the European Central Bank. For this reason, Mario Draghi, its president, recently caused a stir that reverberated far from the usual central bank watchers. Read more “European Central Bank Signals Willingness to Intervene”

European Banking Union Step Toward “Transfer Union”

Joonatan Jakobs
A sunny day in Frankfurt, Germany, January 17, 2011
A sunny day in Frankfurt, Germany, January 17, 2011 (Flickr/Aeror)

In many European countries, two important but ailing institutions are currently interlinked: sovereign states and national banks. The interdependency between them explains in large measure why the continent’s leaders are contemplating a banking union.

A national bank tends to unofficially support its sovereign by buying government debt. An ailing financial system can by itself generate a large negative shock to the economy due to its function in allocating resources. This is especially true in Europe as it depends greatly on its banks for this function. Large, systematically important banks tend to be implicitly backed by their sovereigns. When either experiences considerable stress, the other suffers similarly.

The direction of causality is not always the same. In Ireland, a dysfunctional financial sector added too much debt to the sovereign when Dublin pledged to prop up its banks. In Greece, the amount of government debt generated a crisis which spread to its, and neighboring, financial systems.

When Mario Draghi decided in December of last year to provide an unlimited credit window to banks, it proved not enough to permanently instil confidence. Banks that have amassed assets on their balance sheet that may not look attractive remain fundamentally unstable. Indeed, given that the European Central Bank doesn’t necessarily operate as a “lender of last resort,” it has only put more strain on the balance sheets of sovereign states that are expected to save private banks from collapse. With this in mind, it was not a surprise that investors considered the €100 billion recently requested by Spain in support of its ailing banks as an addition to sovereign debt.

A banking union is seen as the next and a necessary step in “ever-closer union.” In view of all the other options that have been debated, most prominently eurobonds, the fact that a banking union is seen as the least worst compromise is telling.

The nature of eurobonds is comparatively simple and it is difficult to mask the fact that some countries would benefit from the fiscal discipline of others. A banking union is indirect and adds layers of complexity to the bailout process. Like the covered bond purchases of the European Central Bank during the worst of the crisis or more recent interventions, the direction of funds and who provides them is not obvious.

A European banking union, governed by the European Central Bank, would seek to correct two pressing issues. First, as deliberated above, it would decouple sovereign and banks’ balance sheets. It would give power to the European Central Bank and the European Stability Mechanism to directly support banks without having to go through the sovereign of that country. A common framework for member states should be more than able to cover the balance sheets of banks that are deemed systematically important.

Second, one prominent issue and fear has been bank withdrawals in the countries that have come under the greatest pressure. A pan-European deposit insurance would reduce the outflow for banks where there is fear of a banking collapse.

In a more general sense it would also coordinate banking supervision and regulation. As the Bank for International Settlements states in its annual report (PDF):

The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system. Put slightly differently, a currency union that centralizes the lender of last resort for banks must unify its banking system. Banks in Europe must become European banks.

With negotiations regarding the new framework beginning in September and the European Central Bank’s new powers coming to force beginning in 2013, there are a number of interesting aspects to pay attention to.

These changes will need to be defined and communicated for what they are — the reality of a “transfer union” will remain. In no way does a banking union and powers to directly recapitalize banks avoid this. Rather, as some banks are effectively shielded from the possibility of default, they may be induced to buy ever greater quantities of sovereign bonds.

Greek Debt Agreement Met With Cautious Optimism

Joonatan Jakobs

Last Friday saw the culmination of efforts that had started their official trajectory in the last days of July of last year when it was made official that Greece would be allowed to write off part of its sovereign debt.

Controversial at the time was the insistence on private bondholder participation, a demand that many felt increased the volatility in the sovereign debt market for all the countries that were vulnerable — Italy, Portugal, Spain.

Beyond this, the insistence by the European Central Bank that this would not trigger a credit event, effectively a way of claiming that Greek had defaulted, would not be allowed to happen. The rationale was that this would impede the ability of the bank to legally provide Greece with funds. Read more “Greek Debt Agreement Met With Cautious Optimism”

European Fiscal Compact Could Be Challenged

Joonatan Jakobs

With the recent appointment of a former European commissioner as head of Italy, a former vice president of the European Central Bank in Greece and the arrival of new leadership in Spain, the victory of the German path to save the euro was made even more explicit during last week’s summit.

While welcome that the euro countries are pushing for further integration, the problems with a plan dominated by long-term structural change will remain. With bond rates still close to an unsustainable level for both Italy (6.85 percent) and Spain (5.83), events may trigger a serious deviation from the proposed path and force leaders to accept interventions while facing issues of moral hazard.

The solutions proposed at last week’s conference can be divided into short and long-term aspects.

The long-term aspects take the form of a fiscal compact which states that government budgets must be balanced or in surplus and will be regarded as such if annual structural deficits do not exceed .5 percent of nominal gross domestic product. This rule is required to be implemented on a constitutional or similar level and the European Court of Justice will be tasked with verifying that countries live up to it.

Beyond this, the summit focused on ways to enforce deficit reduction plans and future monitoring of national budgets. What is likely to come into effect is the ratification of national budgets by the European Commission before they move on to national governments for approval.

These proposals, while still far from concrete, will be supported by further fiscal integration and a deepening of the nature of cooperation between the European states.

In the short term, the latest agreement sees funding going to International Monetary Fund of about €200 billion to contribute to the crisis. This could be seen in the light of the failure to generate outside participation for Europe’s temporary bailout fund and it is hoped that non-European countries contribute to the fund once administered by the IMF. This may well provide resources that can be easily deployed without the difficult legal and political battles within the European Union.

Perhaps equally important, the proposals reaffirmed the notion that private sector losses on Greek sovereign debt were an exceptional circumstance that would not be considered in any future date for any other country. This may just be the words of chastised politicians and complications may arise as the IMF is always considered a preferred creditor, meaning that the money owed to the IMF is repaid first.

What shines in its absence is a well defined role for the European Central Bank. Given the growth numbers forecast for the eurozone, the pressure put on the currency union as a whole by ratings agencies and the size of debt financing for major countries in the years ahead, it is very likely that the central bank will need to step in for one reason or the other in an ad hoc fashion that may have dramatic consequences in the market.

This could change the longer term approach with its fiscal and political consequences. The framework has thus a considerable flaw. Of course, the absence of any inclusion of the ECB may be a way of making it appear that the bank acts independently of the political process, something which is especially important with the arrival of a new central bank president who has yet to prove its inflation fighting credentials.

What could prove to be of greatest consequence is that this summit gave tentative signs that European countries will now actively need to answer the question of what European integration looks like and how much of it they are willing to tolerate. In this regard, Britain has already done much damage to the integration process by refusing to participate in last week’s proposals. Three other countries have also gone to their respective parliaments for final approval.

Those are sobering actions that could have wide consequences on the future political map of Europe.

Europe’s “Comprehensive” Plan Raises More Questions

Joonatan Jakobs

On Thursday morning last week, negotiations had finally come to a close. After a week of meetings between European leaders and parties involved in the continent’s sovereign debt crisis, a “comprehensive” package was presented to the world.

The summits were a response to three interconnected issues that had been discussed profusely before the summit — the worsening situation in Greece, recapitalization of European banks and safeguarding Italian and Spanish creditworthiness.

The situation in Greece has continued downward, where, despite parliamentary support for additional austerity measures, there has been an intensification of strikes and unrest. Read more “Europe’s “Comprehensive” Plan Raises More Questions”

Eurobond Issuance Thwarted by German High Court

Joonatan Jakobs
A bird sits on top of one of the spires of the German Reichstag building in Berlin, December 31, 2005
A bird sits on top of one of the spires of the German Reichstag building in Berlin, December 31, 2005 (Max Braun)

José Manuel Barroso, president of the European Commission, announced last week that the European Union’s executive body would soon release a report on the issuance of eurobonds. Joint sovereign bonds for the nations of the eurozone could help stem Europe’s escalating debt crises. It would provide funding for countries that have been cut off from the market and virtually guarantee the solvency of countries at risk, including Italy and Spain.

The announcement seems an attempt on the part of the commission to direct decisions away from individual states toward the political process of the EU. As the crisis has developed, the central forces have been Germany and France, Europe’s two largest economies. Although their leadership role allows decisions to be made quickly, it has also generated a sense of disorder as there has not been a clear understanding as to who is ultimately responsible. Equally, the EU has failed to provide a clear unified voice during the crisis, exacerbating market uncertainty.

While political decisions that relate to the whole of the union should undoubtedly have the consent of those they affect, Germany is in a position of power. As the strongest economy in the eurozone, the sentiment of the government in Berlin will decide whether there is or isn’t a eurobond.

A recent German supreme court decision ruled that although the bailout measures undertaken by the country to avert a sovereign default in Greece, Ireland and Spain were lawful, further action that would impact Germany fiscally needs the approval of the federal parliament before it can be implemented.

The ruling not only frustrates the pace of future resolutions; it also reduces the probability of there being an issuance of eurobonds in the near future. Germany has been a reluctant paymaster of this crisis and it believes that any issuance before reforms have been enacted will diminish the incentive to restructure.

As such, the issuance of eurobonds will likely be a question for the future. If the euro manages to come out of current troubles unschated, with countries ready to accept the reforms needed in order to bring the economies of the European Union into balance, eurobonds may well be one of the expressions of European integration.

Eurobond Faces Major Obstacles

Joonatan Jakobs

Without appearing too philosophical, it may be safe to state that the economic and political choices currently facing Europe’s leaders are those of choosing a future identity.

With the debt ceiling troubles in the United States and the unconvincing resolution to the European debt crises, markets have moved dramatically the last few weeks. As the share prices of core euro banks are losing a large amount of value and the cost of sovereign debt has increased spectacularly, there are grave concerns over the current outlook. There are questions of how long the euro can muddle trough without forcing a drastic change in its whole economic and political structure. As George Soros said in an interview recently, “financial markets have a very safe way of predicting the future. They cause it.”

The pressure from markets have a number of consequences for the countries most affected. Outside of the fad of so-called austerity economics, the countries most in need of running deficits are, due to markets current risk aversion, unable to do so. This not only hinders their ability to take advantage of automatic stabilizers that in downtimes smoothen demand and reduces the pressure of unemployment; it also takes away the choice of stimulating the economy which could make the contraction and the structural changes that are necessary to emerge from it less painful.

For a more technical and immediate problem, the pressure recently put on France may reduce its credit rating. If that there were to happen, the AAA rating of the European Financial Stability Facility, which derives its funding from eurozone countries and thus its creditworthiness from them, may be at risk, possibly increasing the cost of funding for the vehicle.

With uncertainty in the markets and the immense pressure sovereign debt is currently under, the proposition of a so-called eurobond has been recommended from a variety of sources. The eurobond would be a financial vehicle backed by the entire euro area. As such, instead of each country auctioning its debt and paying the interest markets supply to them, all countries would use the same vehicle to finance deficit spending, thus paying the same price.

This was practically a reality prior to the 2007 financial crisis when peripheral countries were able to borrow at close to the same price as Germany. Interest rates for countries as Greece, Ireland and Portugal rose sharply in the wake of the financial turmoil when markets began to worry that they might not eventually be able to pay back their debts. These countries, in fact, teetered on the brink of bankruptcy and had to be bailed out by their fellow eurozone nations.

Since most countries in the single currency area are economically stable, a eurobond would enable the least competitive among them to receive funding from the markets, substantially lowering the costs for countries that are currently in trouble.

There are objections of the sort that a eurobond, much like when the Germans replaced their mark with the euro, is to sacrifice the benefits of a prudent economy, and possibly not only raising the cost of their own borrowing, but effectively subsidizing the economies of southern countries at their expense. This would create a moral hazard where peripheral economies, loath to implement structural reforms, would be able to borrow on the good credit of others.

While an abstract objection, none of the more serious propositions of how a eurobond would be structured resemble that description. Most suggestions have come up with ways to embed into the bond tools that would enforce the fiscal rules of the Stability and Growth Pact that few countries have ever lived up to, including Germany and France.

One particular suggestion would see the creation of “blue” and “red” bonds, whereby the blue bonds backed by all euro countries could only be issued up to an amount equaling 60 percent of GDP — a safe amount of debt to handle. Red bonds, by contrast, would not be backed and cost more. This would encourage countries to keep the size of their debt within limits as the interest rates on red bonds may well be punishing.

No matter the potential structure of a eurobond, there are two great obstacles. Under the Maastricht Treaty, which created the eurozone, subsidizing other euro countries is effectively forbidden as it would disrupt the “systems competition” envisaged by the currency’s founders. They wanted to incentivize countries in the single currency area to pursue structural changes in their labor laws and entitlement programs so as to remain competitive. Amending the treaty would be highly undesirable given the enormous strain imposed on European governments by past treaty revisions. Considering present circumstances however, this may not be the most pressing issue.

A more urgent problem is the resolute German resistance to eurobonds. The German attitude reveals not only a resistance to the risk of having to pay more to borrow but calls into question the future of the currency union. As far as Berlin is concerned, the eurobond is a question for future generations. Before it could become reality, there has to be a higher degree of economic and political integration first.

There are signs that this is indeed what will follow from a recent meeting in Paris where Chancellor Angela Merkel and President Nicolas Sarkozy announced that they would work to harmonize tax rates between their countries and urge fellow eurozone governments to meet regularly to coordinate fiscal policy.

Some see this as the emergence of a core euro bloc that is integrating at a more rapid pace within the European Union. This could ultimately mean two tiers of eurozone members — a stronger middle, run by Germany and France, and those countries that are currently on life support who would be kept out of the integration process until they are ready.

While the energy displayed by Merkel and Sarkozy is commendable and shows that the euro area has the political will to find a solution that both reassures and deals with its democratic deficit, one wonders how long the currency union can muddle trough without implementing major reforms that would calm the markets.

Eurozone Crisis Enters New Phase

Joonatan Jakobs

The last two weeks have proven interesting for people who follow the unfolding situation in Europe for two separate events.

On July 15, the European Banking Authority released reports on the health of the European banking system. These “stress tests” measured the stability of banks by evaluating their ability to hold a minimum amount of core capital when set against economic situations similar to a prolonged recession. Another function for these tests was to establish which banks were exposed to Greek sovereign debt and thus enhance trust among financial institutions, as banks are wary of lending to each other if the extent of exposure is unknown.

On July 21, eurozone leaders came together and agreed on far-reaching measures that were the most convincing for rescuing Greece to date.

Although these two events have provided transparency, time and confidence, a number of issues remain unresolved. Indeed, the reason that a relatively weak compromise on averting bankruptcy for Greece could be met with great relief in financial markets may be a lack of clear political direction within the singly currency area. There are crucial questions still unanswered and there is real risk that the framework may be the seed of an unfavorable outcome.

The larger outlines of the deal are well known by now. Greece has been alleviated of the burden of relying on the market for funds for a considerable time. This was achieved by a combination of support from the European Union and the International Monetary Fund and a voluntary, private-sector rollover and debt swap.

After much controversy, private-sector involvement was introduced partly to make the resolution feasible in Germany to continue providing funds for Greece. Although this solution entails writing off a share of the original value due to investors, for the time being it effectively removes the fear of a disorderly default that would lead to contagion. Fear of a “Lehman Brothers” moment has disappeared for banks exposed to Greek debt.

Important was also the lowering of the interest rate of Greece’s debt to 3.5 percent which will apply to Ireland and Portugal as well, in the hopes that this relief can keep them safe from further intervention. Lastly, the summit saw a widening of the powers of the European Financial Stability Facility, a financial vehicle that was granted the power to intervene if a country in the eurozone is under financial duress. This “European IMF” may prove to avert the dangers of a self-fulfilling crisis for the countries that are still deemed to be at risk.

Positive news as this is, the foundation which this solution relies upon is fragile. Although Greece will have funds at its disposal for the time being, it does little to increase the competitiveness of the Greek economy. Even with the latest package, debt-to-GDP ratios will still be higher than those of Italy at 120 percent. If Greece’s economy is not reformed in the coming years, it could need another bailout in the future.

A worry with wider implications is found in the words of the summit’s communiqué (PDF) which states that,

As far as our general approach to private-sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

All other euro countries solemnly reaffirm their inflexible determination to honor fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms…

This is currently the only guarantee that private investor debt in countries with similar problems will not face a similar write off as was the case with Greece.

For the market this will create uncertainty as the promise comes from the same leaders whose credibility is in shatters. What market uncertainty implies is hard to say at present yet when Moody’s recently further downgraded Spanish sovereign debt, it cited the possibility of future private-sector involvement as one of the main concerns. Also worrying is that since Greece’s write off will be voluntary, it does not trigger credit default swaps. The trigger may have the effect of raising borrowing costs for other highly indebted economies as investors shift to the CDSs of their debt, thus leading to higher volatility in debt spreads and increased market jitters.

What emerges from the past weeks is that no scenario is impossible. Although many important steps were taken in bringing clarity to the situation, we have yet to see the final outcome. Many saw these resolutions as a step toward further integration of the eurozone however it is unclear how strong the popular mandate is for such a development. The short-term outcome will likely entail more last-minute compromises, high stress put forth by the markets and a new financing plan for Greece. The depth of last week’s political efforts does offer some optimism for a more coherent path forward.

Europe Aims to Regulate Credit Rating Agencies

Joonatan Jakobs

Among the many culprits appearing after the great recession were the credit rating agencies. Their negative effect on the financial system has been well documented, both externally and internally by the agencies themselves. Indeed, the quick updates on European sovereign debt are justified by arguing that the industry wants to mend the mistakes of the recent past in that it was not responsive enough. The international community is actively working on ways to regulate the credit rating agencies because of the weaknesses that were revealed after the crisis and the effect that rating downgrades have had on the fragile debt situation of a number of European countries.

Originally set up to rate the probability of a company, country or financial institution defaulting, the current scope of their involvement in the economic system is far greater. What has proven especially important is the way the agencies operate and the artificial power they have obtained over deciding who is allowed to invest in a company or country. The agencies are so powerful because Basel II, the international framework for banking rules (now supplanted by Basel III) requires a positive rating from the agencies in order for public and pension funds to invest in them. In effect, if a country does not have a positive rating, it may not be eligible for investment by other sources.

One of the more radical ideas proposed by the European Union is the creation of a “European Credit Rating Foundation” that would decrease the power of the three main raters of sovereign debt which are all American. Yet its creation seems ill devised and an attempt to solve a political problem that is to a large extent caused by a flawed regulatory framework to begin with. If one of the main problems of the current system could potentially be solved by removing the regulatory power of the rating agencies, it is questionable if setting up a new ratings agency would be a valuable part of a solution.

An important aim to credit rating regulation is improving competition. This is partly justified by the fact that the “big three” — Moody’s, Standard and Poor’s, Fitch — make up 95 per cent of market share and their earnings are well above anything suggesting a healthy market. Strengthening competition, it is argued, would increase transparency and prevent the big three from dominating the market.

Some European politicians also argue that since the companies are all based in the United States, they are not in a position to rate European markets properly while the timing and content of recent downgrades may have been politically motivated.

The first and more serious problem is complicated by the fact that increased competition has a host of other problems, mainly that it may exacerbate the issue of customers picking the rating agency that would give them the highest rating. The more firms there are to chose from, the bigger the chance of rating inflation.

The second part deserves less attention — the credit raters have offices in Europe, with European staff and have had the habit of buying up successful local European agencies with the knowledge and expertise they provide. The introduction of a European foundation, or any other agency for that matter, need not be an answer to the proposed problem.

The aim to regulate the credit rating market is nothing new as the EU has pursued this goal since the early 1990s. The agencies’ prevalence in today’s headlines shows how sensitive the market is to uncertainty and the power the ratings agencies have when downgrading sovereign debt. Thus they are heavily criticised for deciding on ratings days before important political negotiations take place, further increasing uncertainty. European regulation states that this is one of the main problems with the framework, outlining how a host of structured financial instruments had their ratings radically downgraded when the financial crisis occurred, implying both a lack of stability and a flawed system that did not provide accurate ratings.

True as this certainly is, one needs to remember that the situation did not apply to sovereign debt ratings which did not come out of the recession with the same tainted reputation. It is also important to consider how sensitive markets would be to perceived political influence if the EU were to be seen to exert pressure on a new agency. The purpose of it entering the market could therefore quickly be seriously damaged.

Considering these issues — Basel II rules giving credit rating agencies power over creditworthiness, the likelihood of ratings inflation with increased competition, the sensitivity of perceived political pressure over ratings — the EU could do better by partly or completely reducing the power given under Basel II (which the big three don’t oppose) so that investors are not told what to do and need to take other factors into consideration. This, as well as working on ways to reduce the inherent conflict in having issuers pay the agencies for a ratings could reduce many of the problems faced by them. This seems to be a situation where the EU can do so much more with less.