With developments in the eurozone continuing to escalate, a lack of clear political decisions has driven government bond yields of various eurozone members, notably in Southern Europe, to extreme levels, signaling that the status quo in place since the introduction of the euro in January 1999 is no longer tenable. In the absence of a credible destination and roadmap to point the way, we believe the European Central Bank’s (ECB) current policies and its acceptance as a lender of last resort can only serve as a bridge to a more sustainable and lasting solution that ultimately restores investor confidence in the eurozone.
At the same time, while ECB policy actions have helped stem capital flight and buy time for the eurozone, its policies have increasingly blurred the line between its core objective of setting monetary policy and the fiscal policy objectives of others. In essence, the ECB has filled the void left by the absence of political resolve to address the eurozone’s deeper structural issues. European governments, not the ECB, must provide more decisive leadership if the eurozone is to achieve a lasting solution. As the ECB and European policy makers struggle with the ever widening contagion, institutionalising the muddled middle status quo as the accepted norm is not a viable option for the eurozone, regardless of time horizon. Essentially, we see only two realistic and sustainable alternatives for the eurozone: 1) Either a full or perhaps partial break-up and reintroduction of domestic currencies or 2) a political and fiscal union to complement monetary union.
Without clarity of destination and guidance, given the fragility of the eurozone’s capital markets and rising political risks, few investors are likely to enter into long-term capital allocation decisions without a reasonable degree of confidence and certainty about the future parameters of their debtor. The greater the uncertainty faced by investors, the higher the risk premium they require to discount potentially volatile and uncertain future cash flows.
Unstable long-term equilibrium in Europe
Such an unstable equilibrium is depriving some eurozone states of private capital at reasonable interest rates as they seek to adjust internal and external balances. Evidence of this can be found in the broken transmission mechanism of monetary policy where companies’ borrowing costs depend more on their geographic location than their credit quality, as shown in Figure 1. In the current environment, “BBB” rated firms in Spain and Italy pay more than twice as much for their debt as “BBB” rated companies in Germany and junk-rated companies – “BB” and lower – in Germany are paying less over swaps on average than investment grade-rated companies in Southern Europe.
Taking a specific example, the cost of insuring against default as measured by credit default swap (CDS) rates on German cement producer Heidelberg Cement (rated high yield - Moody's Ba2, Fitch BB+) today remain below those on the Spanish telecom company Telefonica (rated investment grade - Moody's Baa2, S&P BBB, Fitch BBB+; see Figures 1 and 2).
The apparent market distortion results not from a shift in each company’s idiosyncratic default probabilities, rather from each firm’s underlying reference yield curves. For Heidelberg Cement, the underlying yield curve is the German government bond yield curve, which had a 5-year yield of 0.36%. For Telefonica, the yield curve is priced off Spanish government bonds with a 5-year yield of 3.6%. In short, Telefonica has to pay more to refinance its activities than Heidelberg Cement as borrowing costs for companies located in Spain and elsewhere do not reflect their company-specific business risk. (Bloomberg as of 26 March 2013)
Are lower-rated companies in Germany better quality businesses than higher-rated companies in Spain or Italy? Not likely. Instead, the fragmented market for credit in the eurozone continues to reflect uncertainty about the irreversibility of its monetary union, i.e., the euro. Fragmentation of the credit market reflects a market failure aided by the configuration of decentralised fiscal policy with centralised monetary policy.
What future does the eurozone want and need?
Ultimately, we believe that the eurozone will have to endure the pain of having to choose between a full or partial break-up that includes the reintroduction of domestic currencies or a political and fiscal union to complement the monetary union.
The consensus among Europe’s political leaders appears to indicate that “more Europe”, not less, is wanted. Indeed, Germany's Chancellor Angela Merkel stated in 2012: “(W)e don’t just need a monetary union, we also need a fiscal union, meaning more common budgetary policies, and, in particular, a political union; i.e., we will need to transfer competencies to Europe, step-by-step, going forward, and give Brussels intervention rights.” We concur and this is also the lesson to be drawn from the history of monetary unions. Those that endured developed federal fiscal policies, those that failed did not.
Hurdles along the way
Economic and cultural differences continue to represent significant, yet we believe surmountable, hurdles facing the 17-member eurozone. A prominent example of economic differences, and likely the most crucial, is the current account positions of different countries (see Figure 3). Notably, deficit countries ran large and persistent current account deficits up until 2008 when fiscal policy induced internal devaluation and higher borrowing costs led to a sharp correction in external positions. While Ireland and Spain moved into current account surpluses during the latter half of 2012, the key challenge for these countries is whether they can maintain external surpluses and grow given the continued contraction in the region. Without growth, today’s liquidity crisis, which the ECB is financing, risks morphing into the same sort of solvency crisis faced by Latin America in the early 1990s.
Apart from economic fundamentals, stark societal differences, mainly centered on the efficiency of the public sector, present a further challenge to a stable eurozone. As Figure 4 shows, countries with an external current account surplus tend to have more reliable legal systems, more effective governments, smaller shadow economies and more business-friendly regulations. In contrast, countries that run external deficits fall short in all these dimensions.
To make the eurozone more robust, economic and societal differences will need to be resolved. But to crowd in private capital over the longer term, we believe Europe’s policy-makers will need to give clearer guidance as to what they mean by “more Europe.”
The need for a credible roadmap
Two historical precedents already exist in the European Union (EU) for successful roadmaps, i.e., “more Europe”– the 1977 MacDougall Report, so named after its author Sir Donald MacDougall, on the role of public finance in European integration and the Delors Report, the 1989 blueprint by former European Commission President Jacques Delors for the introduction of the euro. In our opinion, a “new” Delors or MacDougall report would clearly describe a destination for the eurozone, thereby providing private sector agents with an anchor upon which to base their long-term investment decisions. The EU’s “Four Presidents Report” published in December 2012 by Presidents Herman Van Rompuy, Jean-Claude Junker, Jose Manuel Barroso and Mario Draghi went a long way in this direction; however, Europe’s political leaders failed to endorse it.
At a minimum, we believe a successful roadmap would specify a timeline to achieve:
- Structural reforms that establish common minimum standards for efficient government and labor markets, enforcement of laws, tax policies and measures to rein in shadow economic activity;
- A banking union with a centralised bank supervisory agency, bank resolution mechanism and harmonisation of deposit guarantee schemes;
- Political union to strengthen the eurozone’s democratic legitimacy and simplify its political governance structure.
- Fiscal union with a common financial capacity to address asymmetric shocks.
Europe’s current governance structure and fiscal capacity are inadequate to address these challenges. Institutions and policies are divided between 27 nations in the EU and subset of 17 eurozone countries, while the primacy of politics resides at the national level instead of the European Parliament (Pisani-Ferry, Sapir and Wolff, “The Messy Rebuilding of Europe,” 2012). The EU’s budget – of which 1% of its GDP is transferred across borders – is insignificant relative to other economic and monetary federations. The eurozone’s challenge is to balance conditionality, mutualization and democracy, which will require national legislatures to hand over more responsibilities to a centralised chamber of governance and enable its citizens to participate in choosing who to represent them in it. Without democratic representation, the eurozone cannot consider a common fiscal capacity.
A successful example of a common fiscal capacity is Germany’s solidarity surcharge. Adopted after Germany’s reunification and levied on taxes paid by all citizens, its proceeds are still being transferred to rebuild Germany’s new states and bridge the economic gap between east and west. Over the past 20 years, the solidarity surcharge has helped raise GDP per capita in Germany’s eastern states to levels on par with Spain and higher than those in some other eurozone countries. Introducing a 5% euro solidarity surcharge modeled on Germany’s tax and levied on general government revenue in the eurozone would create an annual fiscal capacity of approximately €115 billion, equivalent to 1.25 % of GDP (Eurostat as of 15 November 2012). This common fiscal resource would go a long way to cushioning the eurozone against asymmetric shocks and, in our opinion, would represent a very low price to pay to ensure the euro’s irreversibility.
Without individual member states implementing needed structural reforms and without political agents specifying and committing to a feasible destination for the eurozone’s governance structure, we believe the region will remain mired in stagnation reminiscent of Latin America’s lost decade in the1980s.
Looking ahead, we expect regional growth to be in a range of -0.75% to -1.25% over the next year, with the risk of high unemployment and bail-out fatigue disenfranchising its citizens from the benefits that a monetary union was supposed to achieve. The ECB can buy time, engineer lower interest rates and fix the fragmented market for credit. But without its political partners committing to a common destination for the euro that completes its fiscal architecture, we believe the ECB’s actions alone will not suffice.