Eurozone sovereigns must be stabilized before banks
Note: This Appeared in the Financial Times's A-List on the 25th of November
Europe’s dance of death between sovereigns and banks has now turned frantic and much more dangerous. Troubled countries, such as Italy and Spain, continue to weigh their banks down. Growing problems in French, Cypriot and Belgian banks are putting pressure on the countries.
As Mohamed El-Erian argues, action is needed on multiple fronts to stem the worsening crisis but I don’t fully share his priorities.
Fact is that no amount of capital or funding support for Europe’s banks will be enough to restore confidence so long as doubts remain about the solvency of Spain, Italy and other eurozone economies. With borrowing costs at almost seven per cent, the two large countries may soon face a debt snowball – particularly as austerity measures push the region into deep recession.
Given the worsening economic outlook and the institutional and political gridlock in the European Union, almost everyone expects the economic situation to worsen. In the absence a clear political endgame and more substantial economic support from European Central Bank, there is no visibility on how bad the economy could get. Irresponsible talk of a possible break-up of the eurozone, only adds fuel to the fire.
Unless borrowing costs for sovereigns are brought down to sustainable levels first, most policy measures to strengthen EU banks would be ineffective and may even backfire.
The best, and perhaps only, way to provide credible sovereign support would be for the ECB to set a yield target of four to five per cent for illiquid, but solvent, sovereigns, such as Spain and Italy. This is also necessary to repair the broken transmission of monetary policy and enable the banking system to restart the flow of affordable credit to the real economy.
Even with lower borrowing costs, the eurozone’s most indebted countries could be faced with unsustainable debt levels as economies shrink sharply under the weight of austerity measures. Policymakers must use the economic space provided by any additional ECB support to slow down deficit reduction programmes in troubled economies, trigger stimulus spending in healthy economies and embark on a growth-enhancing infrastructure projects financed by a doubling of the European Investment Bank’s callable capital.
Greece’s problems meant that EU policymakers prematurely shifted their focus away from the still-unresolved problems in the EU banking sector. Now those endemic capital and funding problems faced by financial institutions have resurfaced at a critical juncture. The kind of sovereign funding guarantees and recapitalisations that pulled EU banks back from the brink before are simply not possible now, particularly for banks in troubled sovereigns that most need such support.
In fact, asking countries such as Spain and Italy, at this point, to guarantee bank funding and provide capital backstop will not just be ineffective but would actually worsen the already fragile sovereign credit. The repeated rejection by eurozone leaders of proposals for providing pan-European funding guarantees and capital support has meant that the dance of death between countries and banks has become increasingly frantic.
I am not arguing that EU banks don’t urgently need more capital and access to unsecured funding, they clearly do. But they have lost access to sources of funding for two main reasons. First, the possibility of incalculable losses due to their exposures to various eurozone sovereigns; Second, the increasing potential losses on their holdings of private assets in deteriorating eurozone economies. No one wants to be exposed to banks that can lose so much money.
ECB support for countries will instantly minimise the first. Growth will significantly reduce the second. This will reopen access to private funding and capital markets, as EU banks would cease to be seen as bottomless wells.
Policies such as a two-year moratorium on bonus and dividend pay-outs, an European Financial Stability Facility-backed bank capital backstop and a EFSF-backed term funding guarantee will put the eurozone banking system back on its feet. However, this will only work if all doubts about the solvency of the sovereigns have been put to rest for good.
The writer is managing director of Re-Define, an economic think tank, and a visiting fellow at the London School of Economics