Will Germany insure Italy against default?
- 26 October 2011
- From the section Business
When the French president and German chancellor on Thursday conceded that the impending weekend eurozone summit would not announce the promised rescue package, they swore blind (well, in diplomatic speak) that we would have "a comprehensive and ambitious response" to the financial crisis by close of play today "at the very latest".
It is now clear that is not going to happen. With a following wind, there will be political agreement from eurozone leaders on the broad principles of the rescue - although that is by no means certain.
What we won't have is the all-important technical detail of how those principles will be put into practice.
So why haven't markets melted down? And why are we not seeing a wholesale withdrawal of vital finance from Europe's banks?
Well, whether it's cold logic or hot naivete, investors are persuaded that eurozone leaders will ultimately do the right thing - and that the direction of travel to a solution is clear.
That confidence could evaporate if the political crisis in Italy makes it less likely that there will be early moves in that country to reduce the massive burden of its public-sector debt by shrinking the state: in those circumstances German legislators will be hugely reluctant to use the German balance sheet to provide emergency loans to Italy; Germany won't want to throw good money after bad.
Even so, Germany's lower house of parliament is expected later today to give Mrs Merkel the authority to approve an increase in the financial firepower of the European Financial Stability Facility - presumably because they have been persuaded that the consequences of doing otherwise would rebound painfully on their country and economy.
As I have been banging on about, there's only about 250bn euros left in the EFSF kitty, following the bailout commitments it has already made to Greece, Portugal and Ireland, and taking account of disbursements it may have to make for the rescues of banks.
So there is only just enough to keep Italy afloat for the best part of a year, should the Italian government suddenly find it impossible to borrow on markets (not impossible).
For investors, emergency cash that could be exhausted in a few months by one unfortunate accident is no kind of insurance policy at all. If the firepower of the EFSF isn't massively expanded, the eurozone will be seen as unprotected against even mild storms, and not remotely ready for possible tsunamis.
Now the obvious way for the EFSF to obtain more bang for its euro is to mandate the European Central Bank to lend alongside it. This is what France - backed by the UK - wanted. And it would have been the "comprehensive and ambitious response" promised by Mr Sarkozy and Mrs Merkel.
The point is that there is no limit to what the ECB can lend, because (to state the bloomin' obvious) it can create money at will. Deploying the ECB in this way would have been the big bazooka that the British prime minister has been requesting.
But for German politicians, sanctioning the ECB to lend directly to governments would have been the slippery slope to debasement of the euro (there's hyperinflationary history haunting them here). So they said "nein", and the ECB is out of the picture (although whether it can be kept permanently offside is moot).
In place of central bank lending, therefore, we now have complex financial engineering to boost the bailout fund. Which some would see as one of those delicious ironies, since eurozone eminences have been among the most critical of how bankers in the US and UK abused financial engineering in the boom years to hide the risks that were accumulating in the financial system.
At this juncture, eurozone leaders want to use financial engineering to hide the risks their taxpayers would be taking in lending to over-indebted eurozone members.
The idea is for the 250bn euros left in the eurozone kitty to be used as a kind of insurance premium. What would happen is that those lending to an Italy, for example, would - for free - be insured by the bailout fund against the risk that Italy would be unable to repay its debts.
There are a couple of techniques for doing this under consideration. But the important points are these: using the 250bn euros in this way should mean that more than 1tn euros of new rescue loans could be created; the implicit risks taken by the bailout fund, and by Germany in particular as the main guarantor of the fund, would rise exponentially.
Which is why even this way of expanding the EFSF is massively controversial in Germany. It is why Mrs Merkel has been unable to give formal approval to boosting the EFSF, till mandated to do so by her parliament.
Is all this political and financial fudging and mudging reason enough to retreat back under the duvet and fear the worst? Not yet.
The other two elements in the eurozone rescue package are in better shape.
Agreement is expected to be reached - though not today - with private sector creditors on slashing what they'll be repaid by the Greek government by around 60%, so that Greece stands a fighting chance of crawling out alive from under the burden of its excessive debts.
"We're not going to get the deal with banks today," said an official. "But I think we can be confident there will be a deal."
Also most of the work on strengthening the eurozone's banks has been completed. In theory, we could still get official confirmation tonight from the European Banking Authority that eurozone banks will have to raise around 110bn euros to protect themselves against potential losses on loans to heavily indebted governments such as Greece, Portugal, Ireland, Italy and Spain.
And that means individual banks are likely to be forced by their respective stock-market listing authorities to disclose how much capital they are each being forced to raise and how they intend to do this.
As I have said before, the UK's banks have been passed by the Financial Services Authority as adequately capitalised: they won't have to raise a bean in new capital.
But in Spain, Italy, Portugal, Ireland, Cyprus, Germany, France - and especially - Greece, banks will have to find a way to obtain buckets and buckets of new capital.
Much of it, for countries like Greece that are already on financial life support, will have to come from the eurozone's bailout fund, the European Financial Stability Facility.
Which takes us back to the reason to be fearful.
There will be no stability for the eurozone without the bailout fund, the EFSF, having the resources to do its vital job of demonstrating to the world that there's no possibility of Italy or Spain going bust - or at least not for a year or two, during which Spain and Italy ought to be able to mend their finances.
And, right now, there is no certainty Germany will give the necessary underwriting to the EFSF, so that it will have big enough boots to bash up speculators betting on the collapse of Italy and Spain.
It is as well to start with news that will be viewed by investors as positive - which is that European leaders' expected statement about how to strengthen banks will generally be seen as sensible.
It involves many banks raising around 110bn euros of capital in total, as a protection against future losses. The only ones exempted will be those like Britain's and Ireland's, whose ratio of capital to assets is already more than 9%, after making provision for falls in the value of loans to over-indebted governments like Greece's.
And, to help banks borrow in nervous markets, and avoid a new credit crunch, banks will be offered taxpayer guarantees for their debt.
There's the rub. Those taxpayer guarantees will be another drain on the eurozone's bailout fund, the European Financial Stability Facility - and with all the commitments it's already made to assorted rescues, the kitty is looking depleted.
Which is why it really matters that there are more than woolly words from eurozone leaders on how they'll boost the bailout fund's resources
One deed that won't come - today at least - is a pledge by the International Monetary Fund to help augment bailout resources.
And nor will a deal be done - yet - with banks on reducing what Greece repays them.
If such delays to a credible rescue package don't spook markets, then European leaders will need to thank Mario Draghi - soon to take over as president of the European Central Bank - who promised that the central bank won't for now end its exceptional help to countries like Italy and Spain whose borrowing costs have soared to dangerous levels.