Oct 01

- Germany must hit the eject button (Stratfor via Business Spectator, Sep 30, 2011):

The eurozone’s financial crisis has entered its 19th month. There are more plans to modify the European system than there are eurozone members, but most of these plans ignore constraints faced by Germany, the one country in the eurozone in a position to resolve the crisis. Stratfor sees only one way forward that would allow the eurozone to survive.

Germany’s constraints

Most of these plans ignore that Germany’s reasons for participating in the eurozone are not purely economic, and those non-economic motivations greatly limit Berlin’s options for changing the eurozone.

The post-Cold War era is a golden age in German history. The country was allowed to reunify after the Cold War, and its neighbours have not yet felt threatened enough to attempt to break Berlin’s power. In any other era, a coalition to contain Germany would already be forming. However, the European Union’s institutions – particularly the euro – have allowed Germany to participate in Continental affairs in an arena in which they are eminently competitive. Germany wants to limit European competition to the field of economics, since on the field of battle it could not prevail against a coalition of its neighbours.

This fact eliminates most of the eurozone crisis solutions under discussion. Ejecting from the eurozone states that are traditional competitors with Germany could transform them into rivals. Thus, any reform option that could end with Germany in a different currency zone than Austria, the Netherlands, France, Spain or Italy is not viable if Berlin wants to prevent a core of competition from arising.

Germany also faces mathematical constraints. The creation of a transfer union, which has been roundly debated, would regularly shift economic resources from Germany to Greece, the eurozone’s weakest member. The means of such allocations – direct transfers, rolling debt restructurings, managed defaults – are irrelevant. What matters is that such a plan would establish a precedent that could be repeated for Ireland and Portugal – and eventually Italy, Belgium, Spain and France. This puts anything resembling a transfer union out of the question. Covering all the states that would benefit from the transfers would likely cost around €1 trillion ($1.3 trillion) annually. Even if this were a political possibility in Germany (and it is not), it is well beyond Germany’s economic capacity.

These limitations leave a narrow window of possibilities for Berlin. What follows is the approximate path Stratfor sees Germany being forced to follow if the euro is to survive. This is not necessarily Berlin’s explicit plan, but if the eurozone is to avoid mass defaults and dissolution, it appears to be the sole option.

Cutting Greece loose

Greece’s domestic capacity to generate capital is highly limited, and its rugged topography comes with extremely high capital costs. Even in the best of times Greece cannot function as a developed, modern economy without hefty and regular injections of subsidised capital from abroad.

The problem is that no-one has a geopolitical need for alliance with Greece at present, and evolutions in the eurozone have put an end to cheap euro-denominated credit. Greece is therefore left with few capital-generation possibilities and a debt approaching 150 per cent of GDP. When bank debt is factored in, that number climbs higher. This debt is well beyond the ability of the Greek state and its society to pay.

Luckily for the Germans, Greece is not one of the states that has traditionally threatened Germany, so it is not a state that Germany needs to keep close. It seems that if the eurozone is to be saved, Greece needs to be disposed of.

This cannot, however, be done cleanly. Greece has more than €350 billion in outstanding government debt, of which roughly 75 per cent is held outside of Greece. It must be assumed that if Greece were cut off financially and ejected from the eurozone, Athens would quickly default on its debts, particularly the foreign-held portions. Because of the nature of the European banking system, this would cripple Europe.

European banks are not like US banks. Whereas the United States’ financial system is a single unified network, the European banking system is sequestered by nationality. And whereas the general dearth of direct, constant threats to the United States has resulted in a fairly hands-off approach to the banking sector, the crowded competition in Europe has often led states to use their banks as tools of policy. Each model has benefits and drawbacks, but in the current eurozone financial crisis the structure of the European system has three critical implications.

First, because banks are regularly used to achieve national and public – as opposed to economic and private – goals, banks are often encouraged or forced to invest in ways that they otherwise would not.

Second, banks are far more important to growth and stability in Europe than they are in the United States. Banks – as opposed to stock markets in which foreigners participate – are seen as the trusted supporters of national systems. They are the lifeblood of the European economies, on average supplying more than 70 per cent of funding needs for consumers and corporations (for the United States the figure is less than 40 per cent).

Third and most importantly, the banks’ crucial role and their politicisation mean that in Europe a sovereign debt crisis immediately becomes a banking crisis and a banking crisis immediately becomes a sovereign debt crisis. Ireland is a case in point. Irish state debt was actually extremely low going into the 2008 financial crisis, but the banks’ overindulgence left the Irish government with little choice but to launch a bank bailout – the cost of which in turn required Dublin to seek a eurozone rescue package.

And since European banks are linked by a web of cross-border stock and bond holdings and the interbank market, trouble in one country’s banking sector quickly spreads across borders, in both banks and sovereigns.

The €280 billion in Greek sovereign debt held outside the country is mostly held within the banking sectors of Portugal, Ireland, Spain and Italy – all of whose state and private banking sectors already face considerable strain. A Greek default would quickly cascade into uncontainable bank failures across these states. (German and particularly French banks are heavily exposed to Spain and Italy.) Even this scenario is somewhat optimistic, since it assumes a Greek eurozone ejection would not damage the €500 billion in assets held by the Greek banking sector (which is the single largest holder of Greek government debt).

Making Europe work without Greece

Greece needs to be cordoned off so that its failure would not collapse the European financial and monetary structure. Sequestering all foreign-held Greek sovereign debt would cost about €280 billion, but there is more exposure than simply that to government bonds. Greece has been in the European Union since 1981. Its companies and banks are integrated into the European whole, and since joining the eurozone in 2001, that integration has been denominated wholly in euros. If Greece is ejected that will all unwind. Add to the sovereign debt stack the cost of protecting against that process and – conservatively – the cost of a Greek firebreak rises to €400 billion.

That number, however, only addresses the immediate crisis of Greek default and ejection. The long-term unwinding of Europe’s economic and financial integration with Greece (there will be few Greek banks willing to lend to European entities, and fewer European entities willing to lend to Greece) would trigger a series of financial mini-crises. Additionally, the ejection of a eurozone member state – even one such as Greece, which lied about its statistics in order to qualify for eurozone membership – is sure to rattle European markets to the core.

Technically, Greece cannot be ejected against its will. However, since the only thing keeping the Greek economy going right now and the only thing preventing an immediate government default is the ongoing supply of bailout money, this is merely a technical rather than absolute obstacle. If Greece’s credit line is cut off and it does not willingly leave the eurozone, it will become both destitute and without control over its monetary system. If it does leave, at least it will still have monetary control.

In August, International Monetary Fund chief Christine Lagarde recommended immediately injecting €200 billion into European banks so that they could better deal with the next phase of the European crisis. This figure assumes that the recapitalisation occurs before any defaults and before any market panic. Under such circumstances prices tend to balloon; using the 2008 American financial crisis as a guide, the cost of recapitalisation during an actual panic would probably be in the range of €800 billion.

The formula the Europeans have used until now to determine bailout volumes has assumed that it would be necessary to cover all expected bond issuances for three years. For Italy, that comes out to about €700 billion using official Italian government statistics (and closer to €900 billion using third-party estimates).

All told, Stratfor estimates that a bailout fund that could manage the fallout from a Greek ejection would need to manage roughly €2 trillion.

Raising two trillion euros

The European Union already has a bailout mechanism, the European Financial Stability Facility, so the Europeans are not starting from scratch. Additionally, the Europeans would not need €2 trillion on hand the day a Greece ejection occurred as even in the worst-case scenario, Italy would not crash within 24 hours (and if it did, it would need €900 billion over three years, not all in one day). On the day Greece was theoretically ejected from the eurozone, Europe would probably need about €700 billion (€400 billion to combat Greek contagion and another €300 billion for the banks). The IMF could provide at least some of that, though probably no more than €150 billion.

The rest would come from the private bond market. The EFSF is not a traditional bailout fund that holds masses of cash and actively restructures entities it assists. Instead, it is a transfer facility: eurozone member states guarantee they will back a certain volume of debt issuance. The EFSF then uses those guarantees to raise money on the bond market, subsequently passing those funds along to bailout targets. To prepare for Greece’s ejection, a key change must be made to the EFSF.

Following the successful German vote this week on the July ratification, the primary EFSF problem is its size. The current facility has only €440 billion at its disposal – a far cry from the €2 trillion required to handle a Greek ejection. This means that once everyone ratifies the agreement, the 17 eurozone states have to get together again and once more modify the EFSF to quintuple the size of its fundraising capacity. Anything less would end with – at a minimum – the largest banking crisis in European history and most likely the euro’s dissolution. But even this is far from certain, as numerous events could go wrong before a Greek ejection:

– Enough states – including even Germany – could baulk at the potential cost of the EFSF’s expansion. Increasing the EFSF’s capacity to €2 trillion represents a potential 25 per cent increase by GDP of each contributing state’s total debt load, a number that will rise to 30 per cent of GDP should Italy need a rescue (states receiving bailouts are removed from the funding list for the EFSF). That would push the national debts of Germany and France – the eurozone heavyweights – to nearly 110 per cent of GDP, in relative size more than even the United States’ current bloated volume.

– If Greek authorities realise that Greece will be ejected from the eurozone anyway, they could pre-emptively leave the eurozone, default, or both. That would trigger an immediate sovereign and banking meltdown, before a remediation system could be established.

– An unexpected government failure could prematurely trigger a general European debt meltdown. There are two leading candidates. Italy, with a national debt of 120 per cent of GDP, has the highest per capita national debt in the eurozone outside Greece, and since Prime Minister Silvio Berlusconi has consistently gutted his own ruling coalition of potential successors, his political legacy appears to be coming to an end. Prosecutors have become so emboldened that Berlusconi is now scheduling meetings with top EU officials to dodge them. Belgium is also high on the danger list. Belgium has lacked a government for 17 months, and its caretaker prime minister announced his intention to quit the post September 13. It is hard to implement austerity measures – much less negotiate a bailout package – without a government.

– The European banking system, already the most damaged in the developed world, could prove to be in far worse shape than is already believed. A careless word from a government official, a misplaced austerity cut or an investor scare could trigger a cascade of bank collapses.

Even if Europe is able to avoid these pitfalls, the eurozone’s structural, financial and organisational problems remain. This plan merely patches up the current crisis for a couple of years.

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