Europe’s band-aid fix won’t solve the crisis
The European Central Bank’s intervention in the Spanish and Italian debt markets is no panacea for the troubles rocking the continent. While the move has brought Europe back from the brink, it is only a temporary measure to allow eurozone governments to come up with a solution to its crushing debt crisis. The core eurozone governments say they are committed to keeping the monetary union together, but political resistance in Germany and economic troubles in France (with talk of a possible downgrade of its debt), will make it difficult for Europe to put together a viable long-term solution to dig itself out of its current debt crisis.
The ECB officially became the lender of last resort to all of Europe this morning as it moved to buy up unwanted Italian and Spanish bonds in the secondary market. Concern that the two nations could default on their debt caused yields to skyrocket last week as investment funds stepped out of the market.
But the ECB’s actions successfully calmed the markets down, sending bond yields on the two nation’s sovereign debt down a significant 70 to 80 basis points in early morning trading. The ECB said the measure was temporary and urged the eurozone governments to get their act together and pass changes to the European Financial Stability Facility (EFSF), which would allow the special purpose vehicle set up last year to buy bonds in the secondary market.
Eurozone governments have already agreed in principal to allow the EFSF to enter the secondary markets, but the expansion of the rescue fund’s mandate requires the approval of each of the eurozone’s member parliaments. That would take months – time Europe did not have. The ECB’s move is therefore being seen as a sort of bridge loan to allow time for the member countries to pass the necessary changes.
The ECB said it finally intervened in the Spanish and Italian markets after the two governments “passed new measures and reforms in the areas of fiscal and structural policies.” The Italians said late last week that they would accelerate proposed budget measures to meet a balanced budget by 2013, while the Spanish made some budgetary tweaks within its autonomous regions. The ECB views the troubles affecting Europe to be a fiscal crisis, not a monetary one, so it needed to see that the two nations were making significant changes to their budgets before intervening.
Crisis of confidence
Jean-Claude Trichet, the head of the ECB, is effectively gambling with the eurozone’s future by taking on this huge commitment. The central bank cannot continually support the debt markets of Spain and Italy forever – they are simply too big. But Trichet is betting that the lack of liquidity in these two normally liquid debt markets is just a temporary phenomenon, and that the ECB’s actions would help bring investors back to the table in short order. The decrease in yields today is a sign that the market is calming down, but confidence remains in doubt.
“There is no panic here, just frustration,” says a portfolio manager at a leading Dutch asset manager, who wished to not be identified because he is not authorized to speak with the media. “The actions from the ECB are not enough to reassure us that it is safe to go back into the markets – today’s move is more symbolic, real action is needed.”
The ECB believes that ‘real action’ will come when the eurozone government eventually votes to expand the mandate of the EFSF bailout fund to allow it to buy sovereign debt in the secondary markets. But to do that effectively, the EFSF will need to increase the amount of money it can spend in the fund. Right now it is locked at 440 million euros. That might be enough to support the debt markets of Greece and Portugal, but it is not enough to be a lender of last resort to countries like Spain and Italy. For example, Spain and Italy need to raise 840 billion euros through the end of next year – almost double the entire fund’s size.
While expanding the fund’s mandate seems to be a done deal, expanding its size is in real doubt. Any further increase in the EFSF could begin to negatively impact the credit ratings of the core members backing the fund. France is the most at risk given its precarious fiscal situation. There is talk on European trading desks today that it would be the next country to lose its triple-A credit rating if the fund expands. While S&P chief economist for Europe told Les Echoes that France’s debt rating outlook was stable, he dodged any questions as to whether the country’s rating might be changed when it is up for review in December. It is unclear what the French will do if they were given a choice between funding the EFSF or keeping their triple-A rating.
Furthermore, Germany doesn’t seem too keen on expanding the size of the EFSF. They were one of the few countries last week that voted against the ECB entering the secondary markets. Any expansion of the EFSF will need German backing and it appears unlikely to happen given the current political situation inside the country.
If the EFSF stays small, the ECB will be forced to backstop the Italian and Spanish debt markets indefinitely. Trichet is betting it won’t come to that point, but it is hard to see how the EFSF will be expanded at this point. Confidence will only return when investors see real progress toward a viable solution, and today’s move by the ECB, while helpful in the short term, is not the long term solution needed to get Europe back on track.