Summary
Germany’s parliament voted Oct. 26 to limit the German commitment to European bailouts. This move shows Germany’s unwillingness to continue serving as the primary source of funding for Europe as a whole. This means circumstances within Europe must shift in order for the European Union and the eurozone to survive the current financial crisis. Sharp writedowns of Greek debt would have to not trigger a financial meltdown, EU member states would have to put the union’s interests above their own, and outsiders would have to be persuaded to become the primary funders for the European bailout mechanism.
Analysis
STRATFOR has watched with great interest as the eurozone crisis has unfolded over the past 21 months. In many ways this is the final stage of the post-Cold War interregnum. In the aftermath of World War II, the European Union (and its predecessors) was created to both constrain Germany and harness Germany’s economic dynamism to bolster French power. This was made possible because Europe was split and occupied by U.S. and Soviet forces, while Germany was denied the ability to unilaterally further its national interests. Those circumstances have changed. The Soviets left, the U.S. presence is a shadow of what it once was, and the Germans are reunified and once again looking out for themselves. With the Cold War over, the European Union is left to its own devices.
Germany benefits greatly from the European Union and the eurozone. These structures keep European competition firmly in the realm of economics and finance — areas in which the Germans, with their capital richness, central location, highly skilled labor and powerful industrial base, are well prepared to win. The European Union even created a regulatory structure that expressly puts German industry at an advantage.
But Germany is no longer willing to fund Europe, which it has done from immediately after World War II until very recently. The Germans have “bailed out” Europe several times. They paid massive war reparations — primarily to the French — after World War II. They funded the majority of the European Union’s development costs and agricultural subsidies for the first three decades of European integration. They paid — by themselves — for the rehabilitation of the former East Germany and contributed the largest share of funding for the rehabilitation of the rest of the former Soviet satellites. They also were forced to allow the other eurozone states to enter into the common currency at artificially depreciated currency exchange rates.
Dissatisfaction with this past role was apparent Oct. 26 when Germany’s parliament, the Bundestag, voted overwhelmingly to approve Chancellor Angela Merkel’s negotiating position at the EU summit later that day.
The Bundestag capped Germany’s financial guarantee to the European Financial Stability Facility (EFSF) — the eurozone’s bailout mechanism — at its current level of 211 billion euros ($294 billion). (The EFSF does not contain actual state cash; it uses government guarantees as backing to raise money on private bond markets. Contributing states only have to fill their guarantees if states undergoing bailout procedures default, in which case investors will be reimbursed with state money.) The Germans believe they have done enough, and they will no longer serve as Europe’s cash machine.
The other important prohibitive clause in the legislation the Bundestag approved is opposition to the European Central Bank’s (ECB’s) purchasing any state debt. Such purchases are already illegal under EU treaties, but in order to prevent financial meltdowns the ECB has been making indirect purchases (it lends money to banks to buy the debt and, through economic machinations, ends up holding the debt). The Germans see such actions not only as undermining a clause they fought very hard to get included in EU treaties, but also as directly undermining their efforts to get the weaker eurozone states to implement austerity measures. Whether the ECB will follow the German recommendation — and it is a recommendation, as the ECB is officially independent — remains to be seen. Mario Draghi, the Italian who will take over as ECB governor Nov. 1, has made it clear that he intends to maintain the purchase policy. Discussions at the summit should be quite vigorous.
Between the prohibition on new government guarantees and the demand on ECB actions, the Germans have constrained — perhaps outright eliminated — the two largest and most credible sources of potential funding for the eurozone’s bailout systems.
Amid the financial crisis, Europeans see their banks’ biggest problem as rooted in their sovereign debt exposure. As a rule the largest purchaser of the debt of any particular European government will be banks located in the particular country. However, much debt remains for outsiders to own, so when states crack, the damage will not be held internally. Half or more of the debt of Greece, Ireland, Portugal, Italy and Belgium is in foreign hands, but like everything else in Europe the exposure is not balanced evenly — and this time, it is Northern Europe, not Southern Europe, that is exposed. When Europeans speak of the need to recapitalize their banks, creating firebreaks between cross-border sovereign debt exposure dominates their thoughts — which explains why the Europeans belatedly have seized upon the IMF’s original 200 billion-euro figure. The Europeans are hoping that if they can strike a series of deals that restructure a percentage of the debt owed by the Continent’s most financially strapped states, they will be able to halt the sovereign debt crisis in its tracks. This plan is flawed. The figure, 200 billion euros, will not cover reasonable restructurings. The 50 percent writedowns or “haircuts” for Greece under discussion as part of a revised Greek bailout would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder. Moreover, Europe’s banking problems stretch far beyond sovereign debt.
Instead, the Germans are asking for much deeper private and non-European participation. They want holders of Greek debt to take a much larger restructuring than the 21 percent discount agreed upon in July. Leaks from the International Monetary Fund (IMF) have echoed this, indicating that perhaps a 60-75 percent reduction in the bonds’ value is necessary if Greece is to ever recover. In trade, the Germans are demanding that the current EU/IMF monitoring of Greece’s finances become permanent.
Somewhat surprisingly, there is no clear message on how the bailout fund will be expanded to handle more bailouts. At its current size — 440 billion euros — it might be able to barely handle Spanish remediation, but a banking crisis or an Italian bailout would utterly overwhelm it. In Merkel’s Bundestag speech Oct. 26, the chancellor indicated that some sort of financial leveraging option would be used, but that is something that will be debated and decided at the EU summit later in the day. Merkel will need to return to the Bundestag to get the specifics ratified.
With such limited financing options, the European bailouts are to be funded more or less by the kindness of strangers: The EFSF’s existing funding limits are woefully inadequate for the tasks at hand, and if the Germans will not lead the way to increase its volume directly, eurozone governments are now wholly dependent upon outsiders to meet those funding commitments the eurozone governments refuse to. The Germans have stated very clearly what they expect from the rest of the European Union: austerity. With no more German guarantees on order and with a leveraging plan that is somewhat dubious, the only means many EU states have of avoiding bankruptcy is to make extremely deep budget cuts. These states are now in a bit of a race to implement austerity measures before the markets cut off funding.
To work, this strategy requires three very unlikely developments.
First, sharp writedowns of Greek debt must not start a general crisis. The largest holders of Greek debt are the Greek banking sector and the Greek pension system, so sharp writedowns could save Athens on interest payments, but they will only increase the pension burden by causing a Greek banking meltdown that will require the Greeks — both state and private — to more aggressively tap the EFSF (which has not yet been expanded). Even this assumes that the banks agree to a “voluntary” restructuring and do not simply declare Greece to be in default, which would trigger the cascade of financial failures the Europeans have spent the past two years trying to avoid.
Second, all of Europe’s financially troubled governments would have to put the European Union and the euro ahead of their own survival. This is highly unlikely, but not (yet) impossible. The Slovak government has already fallen over the EFSF issue, but it still approved ratification. Additionally, in preparation for the Bundestag presentation and the subsequent summit, Merkel laid very heavily into one of Europe’s financial laggards: Italy. Merkel’s actions triggered a political crisis in Rome, where pension reforms were agreed upon but at the cost of the promised resignation of political and financial fixture Silvio Berlusconi as prime minister.
Third, forces beyond Europe would have to buy in, en masse, to the European bailout, likely without guarantees that their funds are completely safe. Under the pre-existing system any investors would be guaranteed to have 100 percent of their funds returned to them — courtesy largely of German taxpayers — should a weak state default. Under any leverage plan, that recovery percentage would be smaller; 20 percent is emerging as the likely number for an absolute guarantee. But the Europeans desperately need outsiders to buy in to provide the sort of bridge financing and financial safety nets required to keep Europe’s governments and banks afloat. To that end, EFSF chair Klaus Regling is already planning trips to China and Japan — the world’s largest holders of foreign currency reserves — to try and convince them to use their stored cash for assistance. Some purchases are likely, but if the Germans are unwilling to finance the rescue of a system they benefit from, it is difficult to envision others being willing to do more.
STRATFOR does not see any of these three scenarios as being particularly likely. But without a great deal of financial commitment from Germany and the other, richer eurozone states, this is what must happen if the eurozone is to survive.
