24 July 2012
John Carran, Senior Economist at Gareth Morgan Investments
While the Euro Soccer Tournament was in its final stages at the end of June, the markets were following a European nail biter of a very different kind. Would the two-day EU leaders’ summit in Brussels finally result in a credible plan to resolve the region’s financial woes?
Since the beginning of April a number of factors had conspired to re-intensify the European debt crisis.
First, Greek voters threatened to reject their country’s austerity conditions under their agreement to receive financial aid from the rest of the eurozone. This raised the prospect of Greece immediately exiting the eurozone and plunging many European banks into insolvency.
Second, Spain revealed that its banking system was in serious trouble due to loans backed by massively deflated domestic property prices. Financial aid to Spain became inevitable.
Third, signs started to emerge that the Chinese and US economies were softening, removing critical support pillars for global activity.
The eventual election of a pro-bailout Greek government in May only provided brief respite for markets as the Spanish situation became the more critical issue. With Spanish government debt at around 80% of GDP, a budget deficit of around 8% of GDP, and an economy in free-fall, the Spanish government was in a precarious financial position. Because Spain is too big to save, a drastic deterioration in market confidence in Spain’s ability to pay its bills would have flowed to the entire eurozone area, putting the euro’s continuing existence in doubt.
It became obvious that the eurozone needed to act quickly to shore up its financial system, not just to stop its economy from falling into a deeper abyss, but also to reduce fear in the global economy. However, Germany is concerned that any collective sharing of outstanding eurozone debts needs to be complemented by fiscal discipline and robust central controls over member country finances. This would take years. France, Italy and Spain, on the other hand, argue that if short-term market pressures and severe economic conditions are not addressed, the eurozone could break up before it has a chance to properly integrate. It seemed a stalemate had been reached.
Investors did not hold out much hope that meaningful actions would be implemented to address the immediate pressures in eurozone bond markets and the banking system before the European leaders’ summit began on 28 June.
What was actually announced at the conclusion of the summit exceeded the market’s expectations. Yes, there were the usual platitudes from leaders about fiscal integration and vague plans to move in that direction. A widely expected growth package, involving EUR120bn of centrally-funded infrastructure projects throughout the region, was also announced. But there were two big surprising elements of the package that cheered markets.
A relatively concrete plan was announced to establish a European banking union by the end of this year. This would entail centralised supervision of banks and the provision of direct aid to troubled banks (bypassing the need to deliver aid through the governments of the countries in which the banks reside).
It was also announced that official holdings of Spanish government debt – i.e. debt held by the European Central Bank and the European central rescue fund – would not have preferred status over private sector holdings. Leaders announced that this deal may also be extended to Ireland, where banks earlier received a eurozone rescue package. This removes a significant disincentive for the private sector to continue buying Spanish and Irish debt.
The package announced by eurozone leaders reduces the vicious link between indebted countries and the European banking system. This is a promising development in the region. However, it is not guaranteed that the debt crisis will be solved. Details of the banking union still need to be fleshed out and approved by member countries. There remains the possibility some member countries backslide and the plan cannot progress as envisaged.
The plan does not absolve indebted countries from tightening their belts to get their finances in order and bring debt levels down. And, importantly from a longer term perspective, eurozone countries still need to undertake major structural reforms that free up their labour markets and make their economies more globally competitive.
But for now the latest eurozone policy package should help quell intense market anxiety that had threatened to reach fever-pitch.
Back to top