Euro Pressures Mount–Necessary for Eventual Resolution

By Marc Chandler

Personal challenges may help one overcome certain modes of thought and behavior. So too, a crisis allow officials to transcend ideological constraints. First principles and sacred cows can get sacrificed if political necessity is strong enough.

Those that call for the ECB to substantially increase its sovereign bond purchases, or for Germany to agree to euro bonds, want the opposition to unilaterally disarm. They insist on putting the cart before the horse.

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In effect, under monetary union, members outsourced monetary policy to the ECB. It took the early 1990s ERM crisis and the threat of a united but loosely tethered Germany to get countries to cede monetary authority, and just barely at that– remember Germany never had a euro referendum and France approved with only the slimmest majority.

Countries were willing to cede monetary control, but maintained fiscal sovereignty, though agreed to adhere to the Stability and Growth Pact, which capped deficits, in normal times, to 3% and debts to 60% of GDP. Leaving aside the fudging of the entry criteria and the fact that Germany and France were the initial violators of the Stability and Growth Pact but finagled their way out of penalties (fines), the fact of the matter is that, outside of Greece, the crisis caused the deficit overshoots, not the other way around. Spain and Ireland were running budget surpluses prior to the crisis, for example.

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Germany is using this crisis to tighten its hegemony in Europe. It needs to close the fiscal loopholes. Many have recognized that this was a necessary birth defect in EMU–monetary union without fiscal union. A fiscal union–where countries, especially those that struggle to adhere to the Stability and Growth rule, have to cede a greater degree of fiscal autonomy. This will take the form not of German officials, but EU Commissioners having greater say in the fiscal policies of the debtors.

Fitch’s decision to cut Portugal to below investment grade (BB+) is not surprising, but is a timely reminder that the EU/IMK/EFSF packages have not stabilized the situations–and it is not just Greece–. It has long seemed likely to me that Portugal would not be able to go back to the capital markets as soon as officials envisioned and that another aid package would be necessary.

Moreover, once the private sector is asked to forgive part–half–of Greece’s debt–the precedent has been set and some debt forgiveness for Portugal may also prove necessary. Further downgrades of the periphery (Spain, Portugal, Italy) are likely in the coming months. The risk to Belgium and France is also growing.

That said, there is talk in the markets that the European Stabilization Mechanism (ESM) that permanent replacement of the EFSF may drop its principle of involving the private sector in burden sharing. Yes it is true that some countries, especially France, Spain and Italy do not want to commit to private sector involvement due in part to their own self interest in terms of their exposures and need to issue and sell bonds.

In some ways, it reminds me of the Kellogg-Braind Pact which was signed by most the great powers (but not Russia) in 1928, which essentially outlawed war. We all know what happened. Similarly, bond holders should take no comfort if the ESM drops private sector participation. It does not mean there won’t be.

Many observers see only two potential resolutions: ECB has to step up its bond purchases or there has to be an European bond. On the contrary, the argument here is that a European bond is only possible after a resolution and ECB is not able buy unlimited amounts of European bonds without violating the spirit and letter of the law, it blurs fiscal and monetary policy and puts at needless risk the ECB’s independence.

The ECB though can do other things. At its next meeting it will likely cut rates another 25 bp, keep the door open to additional easing and likely provide new and longer liquidity provisions. The ECB has reintroduced a 12 month repo, though the participation was light (57 bln euros). Next month it will make 13-month loans available, which cover two year-end periods and demand will be greater. Next month it may also offer loans for 2-3 years, which would have some characteristics of a bond. It may also broaden its list of acceptable collateral.

In this environment, the path of least resistance is for a lower euro. It has lost 2% of its value against the dollar this week and further losses are likely. The $1.3145 area from early Oct remains the key near-term target, but there is more potential than that, especially if the market suspects that the rot has spread to Germany. Sterling, the Scandis and Australian dollar were even weaker and risk assets remain highly correlated with the euro.

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