FIGHTING FOR ITS LIFE :THE EURO ZONE IS IN INTENSIVE CARE

[Meanwhile large banks in Germany, Switzerland and Britain have more cash than they can put to good use as corporate customers shift their deposits from weaker countries or smaller banks. The beneficiaries are loth to tie the cash up in long-term loans because they fear that the flows could reverse at any moment. “It’s hot money,” says one bank chairman.] 

The euro-zone crisis

WHAT’S the French for “this sucker could go down”? Echoes of 2008, when the global financial system wobbled and George Bush gave his pithy view of the American economy, now resound on the other side of the Atlantic. Credit-default-swap spreads for European banks, a measure of how costly it is to buy insurance against their default, are at record highs (see chart 1).

The rates that banks charge each other for loans in the interbank market are rising, too, as they did then. Rumours swirl and panic flares: shares in BNP Paribas, a well-run French bank, dropped by 12% on the morning of September 13th following reports that no one would lend it dollars. BNP’s denials saw the shares bounce back later in the day. Shares in Société Générale, another French bank, whipsawed too. The French banks’ reliance on short-term dollar funding, which American money-market funds are increasingly leery of providing, is one reason why Moody’s, a ratings agency, downgraded Société Générale on September 14th, though exposure to sovereign default is also a key factor.

Meanwhile large banks in Germany, Switzerland and Britain have more cash than they can put to good use as corporate customers shift their deposits from weaker countries or smaller banks. The beneficiaries are loth to tie the cash up in long-term loans because they fear that the flows could reverse at any moment. “It’s hot money,” says one bank chairman.

Thus the role of the Frankfurt-based European Central Bank (ECB) grows larger. The northern banks deposit their excess cash there rather than lend in the interbank market. The banks on the periphery increasingly depend on the ECB for liquidity. More than a fifth of Greek bank funding is now provided through Frankfurt; Italian lenders have upped their ECB borrowing sharply over the summer.

Banks are finding it hard to issue longer-term debt, too. The market for unsecured bonds has been closed for weeks, leaving banks with no option but to sell covered bonds at usurious interest rates that will challenge their profitability.

One way of bolstering the banking system would be to inject more capital into it. Goldman Sachs, an investment bank, reckons that Europe’s 38 biggest banks might need between €30 billion and €92 billion ($41 billion-$126 billion) in extra capital to cope with haircuts to Greek, Irish and Portuguese government bonds and losses on Italian and Spanish government debt. An analysis by the IMF suggests that banks would see a hit of close to €200 billion if the default probabilities implicit in today’s market prices were realised, although European governments and banks dispute the fund’s calculations.

Raising capital in current markets will not be easy. Bank valuations are low; several banks might need to raise several times more than their current market value. Those shareholders that do not participate will have their holdings deeply diluted. That suggests governments might have to underwrite some of the rights issues.

Here the parallels with the credit crisis three years ago become ominously inexact. In 2008 governments did what was needed to protect their banks: guarantees were issued, equity injected. In the euro-zone crisis the threat of sovereign default renders some governments impotent, while those which could act have chosen not to do so decisively.

The government at the heart of concerns again this week is that of Greece. Panicked officials are racing to plug a gaping hole in the budget and accelerate reforms in the face of speculation that international lenders will withhold the next €8 billion tranche of the country’s bail-out. If the funds are not released within two weeks, the government risks being unable to pay wages and pensions. A hastily announced property tax should raise about €2 billion, which may just keep the budget deficit below 9% of GDP this year.

The troika monitoring the Greek plan (the European Commission, the ECB and the IMF) also wants to see a realistic budget draft for 2012. That means making drastic spending cuts as revenues are being squeezed by the deepening recession. The Greek economy is likely to contract by at least 5.3% this year. The government has already decided to increase the number of public-sector workers parked on 60% of their salaries pending dismissal or retirement. About 40,000 workers are now likely to be made redundant by year-end. Greece’s debt managers are also finalising a €135 billion package of debt swaps and rollovers for private-sector investors which would allow the country to delay the repayment of about one-third of its bills for up to 30 years.

The scrambling might be enough to allow Greece to escape immediate default; but it will also make a more brutal restructuring in the future much harder. And such a future restructuring seems inevitable. On September 12th Philipp Rösler, the leader of Germany’s Free Democratic Party, the junior partner to Angela Merkel’s Christian Democratic Union, said it was time to address the taboo subject of a possible Greek bankruptcy. Some go further still: the prospect of a Greek departure from the euro is now widely discussed.

Stark choices

Mrs Merkel is having none of it. On September 14th, after a conference call with George Papandreou, the Greek prime minister, she and Nicolas Sarzoky, the French president, reaffirmed Greece’s place in the euro zone. For now euro-zone leaders seem determined to plough ahead, shepherding the second Greek bail-out package through national parliaments along with measures to increase the scope and firepower of the European Financial Stability Facility (EFSF), Europe’s bail-out fund.

The problem is that although a beefed-up EFSF will be able to cope with the smaller peripherals, it is unable to support the refinancing needs of an economy as big as Italy. At an auction of Italian five-year bonds on September 13th its borrowing costs jumped to 5.6%, up from 4.9% at a similar auction in July.
The pressure on European banks will keep increasing unless something else is done. Rumours that China will ride to the rescue of struggling countries are fanciful. Again, the real last resort is the ECB, which could relieve the pressures on the system by being prepared to buy without limit the bonds of solvent euro-zone countries. But the ECB is itself riven by disagreement.

On September 9th Jürgen Stark, the central bank’s chief economist and a former Bundesbanker, announced his resignation “for personal reasons”. Mr Stark opposed the ECB’s buying of Greek government bonds last year. When the bank began supporting Italian and Spanish government bonds, too, it was apparently more than he could take. Axel Weber, the head of the Bundesbank until May 1st, ruled himself out of the running to replace Jean-Claude Trichet, the ECB president, earlier this year because of similar qualms.

The German government moved swiftly to fill the hole left by Mr Stark. Jörg Asmussen, chief secretary at the finance ministry, will move to the ECB, assuming the formalities go without a hitch. Both Mr Asmussen and Jens Weidmann, Mr Weber’s successor at the Bundesbank, appear more flexible personalities than their predecessors. But persuading them, and the German public, to sign up to what amounts to a policy of massive quantitative easing (creating money to buy bonds) will be extremely difficult. In 2008 free-market Americans swallowed their misgivings to rescue Wall Street. Inflation-phobic Germans now face a similar choice.

@ The Economist