Authors: Uri Dadush, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace
Billed as the “Grand Bargain” to save the euro, the March 24–25 summit of European Union leaders fell short of the mark. Some of the anticipated agreements were incomplete, while others were heavily watered down. Moreover, a series of other setbacks—in Portugal, but also more broadly—have overshadowed the meeting. And yet markets appear calm. The euro is climbing (it declined by just 0.4 percent following Portugal’s aid request), Spanish and Italian bond yields have fallen, and economic confidence is rising. The relative strength of Europe’s economic core—especially Germany—as well as Spain’s continued reform efforts appear to have stopped the crisis from spreading further. However, the failure of leaders to establish a convincing framework for resolving the crisis means that any new shock could cause a relapse.
An incomplete bargain
EU leaders were expected to take bold steps to resolve the euro crisis at the highly anticipated summit. Instead, they left many of the anticipated deals incomplete and many questions unanswered. Though the EU agreed to lower the interest rates on its loans to Greece in exchange for a pledge by the Greek government to sell public assets, Ireland refused to give in to EU demands to raise its corporate tax rate and could not reach a similar deal.
Observers also expected leaders to expand the lending capacity of the emergency rescue mechanism (European Financial Stability Facility, or EFSF) and its 2013 replacement (European Stability Mechanism, or ESM). But leaders put off the decision to increase the EFSF until later this month (at least), and failed to agree on how it will be financed. Policy makers did agree to the goal of expanding the ESM to 500 billion euros but, at Germany’s insistence, will only gradually capitalize it over the next five years, meaning it will not reach its full lending capacity until 2018. They also agreed to include collective action clauses in government bonds issued starting in 2013, which will help share losses among all bondholders in a debt restructuring, thus making it easier to effect.
Efforts to strengthen economic governance and macroeconomic cooperation yielded only modest progress. The “Euro Plus Pact”—a series of rules designed to improve competitiveness and policy coordination among euro zone members—reinforced the principle of peer review of fiscal and structural reforms established in previous agreements but offered no new enforcement mechanisms. The meeting did not even seriously discuss assisting those in crisis by increasing domestic demand or strengthening the fiscal union, as many observers had argued they should. Finally, the powers of the EFSF remain limited, leaving government bond-buying responsibility largely to the European Central Bank (ECB), potentially limiting its flexibility as a result.
Several setbacks in euro zone countries were perhaps even starker than the summit’s disappointments. On Wednesday night, after a series of credit downgrades in March and again last week and the resignation of Prime Minister Jose Socrates, Portugal joined Greece and Ireland as the third euro zone country to request financial aid from the EU. In Spain, credit ratings were also cut last month and Prime Minister Jose Luis Rodriguez Zapatero bowed out of next year’s election. Additionally, the French and German ruling parties suffered large defeats in regional elections.
And yet, markets remained calm. In the months before the Greek and Irish rescues were announced, the euro fell sharply and stock markets plummeted. But in the weeks preceding Portugal’s widely anticipated request for support, the euro strengthened, reaching its highest level since the crisis erupted, and stock markets barely budged.
Why are markets calm?
Despite the gloomy outlook in Greece, Ireland, and Portugal, Europe’s core economies have performed well over the last year. Moreover, though debt restructuring remains a possibility and modalities for it were incorporated in the summit agreement, it is no longer seen as an immediate threat. Perhaps most importantly, worries that the crisis will extend to Spain have receded.
Though the troubles of Greece, Ireland, and Portugal dominate headlines, the relatively strong performance of the much larger core, as shown in the chart below, is in some ways the more important story. Output in Germany, France, Belgium, Austria, and the Netherlands— which account for 64 percent of euro zone output, twice the combined share of Greece, Ireland, Italy, Portugal, and Spain (GIIPS)—expanded by an average of 2.2 percent in 2010, well above the 1.3 percent the IMF forecasted a year ago. (By comparison, Greece, Ireland, and Portugal contracted by an average of 1.4 percent last year, more than IMF expectations of 1.1 percent, while Italy and Spain grew by 0.6 percent, compared to a forecast of 0.2 percent.) The recovery has been particularly strong in Germany, where GDP grew by 3.6 percent, the fastest pace since reunification.
With much of the euro zone now recovering, worries that the GIIPS will pull the continent back into recession or worse appear to be abating. As the chart shows, the Economic Sentiment Indicator for the euro area as whole has risen steadily since dipping last May, despite continued weakness in the periphery.
Will Spain hold the line?
As Europe’s economy has strengthened, concerns about contagion to Spain and Italy have eased. Since the euro crisis erupted last year, GIIPS’ bond yields had moved together—the spike in Greek and Irish yields prior to their rescues were matched by surges in Portuguese, Spanish, and Italian borrowing costs. But decoupling has appeared recently: even as Portuguese bond spreads over the German bund rose by 87 basis points last month, Spanish and Italian spreads fell by 20-25 basis points.
Now that Portugal has been forced to ask for EU and IMF assistance, all eyes are turning to Spain, widely considered the next potential domino. A market attack on Spain would overwhelm the current support mechanisms: GDP in Spain is nearly twice as large as the combined output of Greece, Ireland, and Portugal, and a rescue package of proportional size could cost up to 500 billion euros. Furthermore, a run on a large economy such as Spain could call Italy’s public finances into question. With a debt burden of 1.84 trillion euros—50 percent more than all of the other GIIPS combined—Italy likely could not be rescued, even if Spain could.
Therefore, stopping the crisis at Spain is critical. For their part, Spanish authorities have passed an ambitious, three-pronged package of reforms that aims to cut budgets, rebuild the financial sector, and restore competitiveness. These reforms have won the confidence of the markets at least temporarily, but three questions linger.
Will budget cuts be enough?
In response to the growing euro crisis last year, Spanish policy makers passed an austerity budget that plans to cut the government deficit from 9.3 percent of GDP in 2010 to 3 percent by 2013. The budget is frontloaded—two-thirds of the cuts come in 2011—but Prime Minister Zapatero’s announced departure underscores the political challenge confronting incumbents as they move toward austerity, and doubts persist about whether Spain can meet the budget-cutting targets.
How much capital will the banking sector need?
Since 2007, Spanish property prices have fallen by 17 percent. To ease the subsequent banking crisis, Spanish authorities pushed many Spanish savings banks, or cajas—which invested heavily in the property market —to merge and restructure. The changes have been far-reaching, with the cajas merging from 45 before the crisis to seventeen now. Spain’s central bank estimates that the banks will need 15 billion euros—a manageable 1.4 percent of GDP—to meet capital requirements. However, Moody’s estimates that the need could be as high as 50 billion euros (or 4.8 percent of GDP). It is worth noting that the trouble in Portugal could expose Spanish banks to about 80 billion euros in potential losses.
Will long-term reforms be enough?
In order to reinvigorate growth, Spain has tried to improve labor market flexibility and restore competitiveness. Specific reforms include modestly reducing severance pay and easing the criteria for fair dismissal of employees. Though early adjustments have been promising—Spain has recovered about one-third of its competitiveness lost in the pre-crisis period—more changes are needed to maintain this progress. Greece, for example, has passed much more ambitious labor market reforms, yet the IMF expects Greece to regain only about half of its competitiveness lost in the previous decade over the next five to six years. Moreover, as the chart shows, Spain’s unit labor costs have seen little change relative to Germany, Europe’s largest economy. Even though Spain and Germany may not compete very directly in international markets, Germany’s unit labor costs matter to Spain and other countries in the periphery because they critically affect the value of the common currency.
Conclusion
European leaders have pledged to do whatever it takes to end the current crisis. Their policies, however, have not matched their rhetoric. For example, the ECB raised its primary interest rate today for the first time in nearly two years. Though the hike may make sense for Germany, where unemployment is low and headline inflation is perking up, it will slow the recovery in the periphery and make the competitiveness adjustment more challenging.
Given these mixed signals, any number of events could set the euro crisis, which has seen lulls before, off again. The rescue of Portugal, which is turning to the EU and IMF with a caretaker government, could prove even rockier than those of Greece and Ireland. Continued ECB interest rate hikes could destabilize the weakest sectors, such as the Spanish property market. More Middle East turmoil and a surge in oil prices could place Spain and Italy in an even tougher spot. In any of these instances, markets will look for strong leadership at the core of the euro zone. This, the “Grand Bargain” has not provided.
Leave a Reply