We have been waiting for this – the RBS report on eurozone debt crisis, policy options and end game scenarios.
And it doesn’t disappoint.
The RBS team, lead by chief economist Jacques Cailloux, reckons the Euro area is at ‘breakpoint’, which for those of you not familiar with the term is…
a means of acquiring knowledge about a program during its execution. During the interruption, the programmer inspects the test environment (general purpose registers, memory, logs, files, etc.) to find out whether the program is functioning as expected. In practice, a breakpoint consists of one or more conditions that determine when a program’s execution should be interrupted. [Wiki]
Cailloux & Co expect the crisis to continue and threaten the entire euro area because policy makers still don’t understand market dynamics. A Greek debt swap might bring temporary relief but investors will soon refocus on the systemic issues, they say.
As such a continent wide response is required to address the powerful contagion channels which are threatening the stability of the entire region.
Solutions are available but because of bungling by politicians the costs are rising. And that means the end game will be massive intervention by the ECB.
A Self-Fulfilling Crisis that requires system wide policy response
The inadequacy of the current tool kit might not have yet been fully accepted by policy makers but our guess is that they will increasingly come our way on that matter as market pressure rises.
The problems the euro area faces are deep rooted and it is unclear whether they can actually be solved once and for all. Here we focus on the short term policy response needed and leave for a following note the discussion surrounding the medium term policy response.
In the short term, the euro area needs a buyer of last resort. Outside of the region one can think of deep pocket investors or in extreme scenarios foreign central banks. But these look low likelihood scenarios. A credible domestic buyer of last resort is urgently needed.
One possible bond buyer is European Financial Stability Facililty (EFSF) or its successor the European Stability Mechanism (ESM). But given the systemic nature of the crisis Cailloux says they would have to be increased in size to 3.45 trillion and 3.0 trillion respectively.
Needless to say, that wouldn’t be politically acceptable.
Our simulation of the upsizing of the EFSF to an effective lending capacity of Eur2 trillion would require Eur3.45 trillion of guarantees. This is because the maximum lending capacity is constrained by the total maximum guarantee commitments of the AAA countries. In a worst case scenario where all lending capacity is considered as debt then this would cost Germany an extra Eur727bn or 28% of GDP on top of its existing (Eur212bn worth of) guarantees. This would bring the German debt above 110% of GDP. The increase in the maximum French guarantee commitment would increase their maximum contingent liability from Eur159bn to Eur705bn, equivalent to an increase of 27% of GDP, and would take the debt/GDP ratio higher to 112%.
At this level of contingent liability we see ratings threats for France but also Germany & The Netherlands.
Which means President Trichet and successor Mario Draghi are the eurozone’s only hope.
The ECB’s reluctance to conduct bond purchases is well-known. The downsides are that the programme is not based on any conditionality, it potentially increases moral hazard and might lead to a perceived loss of independence of the Central Bank. Also the ECB has made it clear over the past year that it needed Europe to bolster its backstop facilities.
The advantage of the ECB bond buying (which as we said above is also a drawback) is that it is unconditional and potentially unlimited, a key ingredient to restore confidence.
Should the ECB undertake a large scale bond purchase programme, it should be far more forceful than the one conducted to date. In particular it should now include most countries if not all countries and be conducted at a pace that gives the impression to market participants that the volumes might end up being near those conducted by the Fed.
While at this stage the ECB is probably arguing that this is a no go area, this option might eventually be the only one left on the table: this is effectively the only buyer of last resort than can be activated at any point in time and can be scaled to whatever size is needed.
One could imagine that the ECB will not let itself be pushed into undertaking such a purchase programme without imposing conditions on Euro area Heads of States. Trichet’s wish list was made public in his Aachen speech and one could easily imagine the ECB requesting a firm commitment from Heads of States to fundamentally reform the economic governance of the euro area.
More on this topic in the usual place.