Thursday, November 10, 2011
Europe lacks firewall in debt crisis
The European Central Bank is for now the eurozone's only battle-ready weapon against the market turmoil that is nudging Italy — and the entire 17-nation currency bloc — to the brink of financial disaster.
But although its program to buy the bonds of indebted governments such as Italy theoretically has unlimited financial power, the ECB is unwilling to use it aggressively, saying it's up to governments to get their finances straightened out.
Defining the ECB's role in the crisis has become urgent because Europe has no other effective backstop to contain its raging debt crisis and give indebted countries the months — and years — they need to pass new legislation and fix their finances.
The eurozone bailout fund, which governments recently gave new powers to shore up confidence in government bond markets, was meant to be the main tool to protect economies like Italy. But European officials need more time to finalize it.
The crisis meanwhile is worsening by the day, with Italy's bond yields this week jumping above 7 per cent, the level that eventually pushed Greece, Ireland and Portugal to ask for rescue loans.
Higher borrowing rates mean the country pays more to raise money to pay off old loans — last year its average borrowing rate was 4 per cent. The higher costs add to its debt pile, worsening its financial prospects in a vicious cycle.
European officials need a way to keep Italy's borrowing rates down while the country labors to pass reforms to cut deficits and improve growth, a job that will take time.
Options are limited. Their new eurozone bailout fund, the EFSF, isn't ready yet and may not have enough lending power. Eurozone governments have balked at adding more money, so they are looking at ways to increase the existing euro440 billion ($600 billion) in financing to over euro1 trillion by allowing it to partially insure against losses on government bonds.
Such an insurance scheme has yet to be finalized, however, and might not cover Italy's massive financing needs — euro300 billion next year alone.
Alternatively, eurozone countries could jointly issue eurobonds, effectively linking the finances of stronger countries with weaker ones. But Germany, which is already funding the bulk of the existing bailouts, has made it clear that eurobonds are not an option.
That leaves the ECB. The bank has intervened in markets at critical moments during the debt crisis and again this month. Analysts say the ECB likely helped bring Italy's bond yields down somewhat on Thursday.
But while the ECB might lend a hand in moments of panic, it has made clear it is not in the business of protecting countries from the consequences of poor financial planning.
New ECB president Mario Draghi said forcefully last week that the bank wasn't going to ramp up the purchases and that it was up to governments to do what needed to be done to save themselves.
He said it would be "pointless" to expect the ECB to bring down rates long-term, insisting the purchases are temporary and limited. If a country's economic plans are credible, that will be reflected in the country's market borrowing rates.
The question these days, however, is not only one of principle but speed. Drafting, approving and implementing economic reforms can take weeks or months, whereas market movements can change a country's prospects in a matter of minutes.
This week's increase in Italian bond yields, for example, will cost the country an added euro60 billion ($82 billion), or 4 per cent of GDP, to roll over its debt through 2015 if they don't come back down. That's almost the size of Rome's most recent austerity plan.
Jennifer McKeown, analyst at Capital Economics, says the ECB may eventually cave in and buy large mounts of bonds, but not yet.
"Desperate times call for desperate measures and if policymakers fail to come up with a way of boosting the EFSF's firepower, the risk of a collapse of the eurozone's financial system might ultimately force the ECB to step in," she said in a note to clients. "But we do not expect it to come to the rescue in the near future."
The ECB in theory has unlimited power to help Italy, because as a central bank it can simply create new money to buy bonds. The problem is that can create inflation, which the ECB is tasked with keeping low as its primary job. It would also be difficult politically, because the bank would appear to be helping governments that did not properly reform their economies.
Both the U.S. Federal Reserve and Bank of England have created new money to help their economies, but the ECB has avoided doing so by withdrawing an equal amount of money from the financial system.
The Federal Reserve, however, has a broader mandate — to control inflation, promote financial stability and boost growth and jobs. The ECB, under the EU treaty that created the euro, must focus on inflation.
With no other help in sight, though, Draghi and the ECB may eventually find themselves before a momentous choice. The ECB can stick to its mandate and its efforts to push governments to reform — and watch Europe's third-largest economy default on its debts, with disastrous consequences that could include a breakup of Europe's 13-year old shared currency.
Or it can turn on the money taps and increase its purchases of Italy's bonds, so far limited to some euro90 billion ($123 billion), or less than 5 per cent of outstanding Italian debt. Last week it bought euro9.5 billion in eurozone bonds, double the euro4.5 billion from the week before, but Italian yields still rose.
Some economists say the bank will have to buy much larger amounts, or otherwise deploy its full potential to stop the crisis. Charles Wyplosz, an expert on monetary policy at the Graduate Institute in Geneva, says guaranteeing a fixed amount of European public debt would do it.
That would put a floor under bond prices and show markets that "the game is over," he said.
"The beauty of central bank guarantees is that they are 100 per cent credible because they can create as much money as they want," said Wyplosz. "Markets may test the ECB, but most likely they won't even. So it will cost the ECB nothing but a two-line press communique. "
The task is "not how to teach a lesson to governments but how to rescue the euro," he said.