london July 28, 2012, 17:20 IST
london 07 28, 2012, 17:30 IST
As talk persists that cash-strapped Greece might have to exit the euro, and bond markets panic over Spain, the fate of Europe's single currency could soon be hanging in the balance again.
After "Grexit" and "Spanic", is it finally time to get ready for "Eurover"?
The euro certainly seems in danger of market-driven disintegration, as signalled by wildly divergent borrowing costs among the nations sharing the currency. Bond yields in Spain are at euro-era highs because investor confidence has evaporated, while yields on two-year German notes and 12-month Dutch bills are negative.
Ever-greater economic divergence is assured, scaring investors still further.
But if the currency does break up, it will be for want of political will, not for want of policy solutions.
"Is there some point at which the integrity of the region is sufficiently undermined that we pass the point of no return?" asked David Mackie, an economist with J.P Morgan in London.
"I don't see that happening in a technical sense, because anything happening in the capital markets at the moment can easily be reversed," Mackie added. "The break-up of the monetary union is not something that can ever be forced by financial markets."
That is because the European Central Bank, like any other central bank, could if necessary expand its balance sheet, or "print money", without limit to contain capital flight or buy up the debt of besieged member states.
Things would be different if the ECB were defending a fixed exchange rate with a finite stock of foreign-currency reserves. That is the position that the central banks of France and Spain found themselves in 19 years ago this month.
MASTERS OF IMPROVISATION
Selling pressure on the French franc and peseta was so intense on July 30, 1993, a Friday, that the central banks threw in the towel, unable to keep their currencies off the floor of the Exchange Rate Mechanism (ERM), the precursor of the euro.
Britain had pulled out of the ERM for good the previous September under speculative attack from George Soros and other investors, while Italy had suspended its membership of the currency grid.
If France were to go the same way as Italy, or even suffer the milder indignity of a devaluation, it would deal a body blow to the Maastricht Treaty on economic and monetary union signed in March 1992. The launch of the euro scheduled for 1999 would be delayed, if not scuppered.
What to do? At a Sunday crisis meeting in Brussels that ended just before dawn, finance ministers emerged with an ingenious compromise: they simply moved the goal posts, widening the ERM's permitted trading bands to 15 percent either side of the grid's central rates, from 2.25 percent before.
The tactic worked. Selling of the French franc soon petered out as market participants recognised that they did not have the firepower to test the capacity of central banks to defend the widened bands. The dream of the single currency was still alive.
At least two lessons from that fraught episode are relevant for today's crisis. First, markets underestimate at their peril the political determination of Europe's elite, when their backs are against the wall, to do what is needed to support the euro.
The ECB's provision of 1 trillion euros in cheap three-year loans to euro-area banks in December and February and last month's agreement in principle to euro area-wide banking supervision are further examples.
Second, when a central bank intervenes, it must deploy overwhelming force.
Just as ERM speculators knew in the early 1990s that the Bank of England and the Bank of France did not have a bottomless chest of foreign exchange reserves, market participants today know that the euro zone's rescue funds, the European Financial Stability Facility and the embryonic European Stability Mechanism, have limited resources.
If they started buying Spanish or Italian debt to bring down yields, markets would begin forecasting how long their money would last, said Laurence Boone, an economist with Bank of America Merrill Lynch in London.
"Investors might therefore seize this opportunity to sell bonds now rather than later, before the EFSF/ESM ran out of cash and the corresponding bond prices fell sharply. This in turn could precipitate wider market falls," she said in a note to clients.
Options for boosting the firepower of the rescue vehicles are thus being hotly debated. Essentially, they entail drawing on the ECB's resources: the ECB could buy the ESM's debt or give the ESM a banking licence, as ECB policymaker Ewald Nowotny suggested on Wednesday.
The first proposal would be controversial, to say the least; the latter would be possibly illegal. But Paul de Grauwe, an economics professor at the London School of Economics, said the only strategy that can work is one that is centred on the ECB.
That is because the central bank, as a money-creating institution, has an open-ended capacity to buy government bonds -- quantitative easing in short.
Practically, De Grauwe said the ECB should announce that it would defend a cap on the spreads of Spanish and Italian bonds of, say, 3 percentage points above benchmark German yields.
"Such an announcement is fully credible if the ECB is committed to use all its firepower, which is infinite, to achieve this target," he wrote in an article for the voxEU.org website.
EUROPE'S LEHMAN MOMENT
For now, the ECB is definitely not committed to drawing on the unlimited firepower that De Grauwe describes.
Even though some policymakers worry that the sovereign debt and banking crisis could pose an existential threat to the euro, most view proposals to beef up the ESM as in effect crossing a deep red line that bans central bank financing of governments.
But to govern is to choose, and the Governing Council of the ECB could be forced sooner than it likes to choose whether to sacrifice its principles or the euro. The euro zone's "Lehman moment", when policymakers must step in or risk financial meltdown, could come as early as this autumn.
Greece's international lenders are likely to report in September that Athens is way off track on its loans-for-reforms programme.
Creditors' demands for further austerity, or a refusal to extend more loans, could push Greece out of the euro.
For Spain, the moment of truth could come in late October, when it has to roll over 20 billion euros of maturing bonds.
Madrid has already agreed to borrow up to 100 billion euros to recapitalise its shaky banks, but markets are betting that, like Greece, Ireland and Portugal, it will be unable to sell its debt and will have to request a humiliating bailout from Europe and the International Monetary Fund.
Tim Legierse, senior international economist at Rabobank in Utrecht, said the ECB would act in the event of a full-blown crisis, possibly extracting in exchange a promise of some sort of debt mutualisation to restore confidence in weaker euro zone members.
In return for such a pledge, Germany and other creditors would demand more central oversight of debtor states' budgets.
"Our view is that the ECB is going to be an interim solution as a step to a more political solution, which is not going to be forthcoming quickly enough to withstand the contagion that might result from either Greece exiting the euro or from Spain getting a full bailout package," Legierse said.
Mackie of JP Morgan said Spain would put off a full rescue for as long as possible but was likely to succumb by the end of the year, possibly by applying for a precautionary credit line from the euro zone rescue fund.
As for Greece, he said it was in the interests of creditors to keep Athens inside the euro for the next six to 12 months at least, even if that means stumping up more cash, in order to avoid the risk of contagion engulfing neighbouring Italy.
"This is a very difficult environment. I feel they will navigate their way through this, but it's not easy to see how," Mackie said.
Nor was it easy to see a way out in the currency crisis of July 1993.
(Editing by Will Waterman)