Euro bank on brink as debt crisis spreads across continent


France and Belgium battle to save continental lender Dexia, as fears begin to grow of a delay to next bailout payment for Greece

Iain Dey and Robert Watts Published: 2 October 2011

The eurozone crisis entered a new phase this weekend with France and Belgium racing to rescue a large continental bank.

The countries’ finance ministers meet tomorrow to discuss the future of Dexia, one of Belgium’s largest lenders, with 35,000 staff and 8m customers in Belgium, Luxembourg and France. It has been crippled by the collapse of the inter-bank lending markets and large exposures to Greece.

A state co-ordinated rescue would feed mounting fears that Europe stands on the cusp of a second banking crisis.

The Dexia talks come as the future of Greece hangs in the balance, with doubts emerging as to whether the latest tranche of aid from the European Union and the International Monetary Fund will be paid on time. Striking government workers have stopped the IMF from gaining access to the Greek statistics office, delaying attempts to draw up a new budget.

A three-pronged rescue plan advanced at last weekend’s IMF meeting in Washington has also stalled.

With expectations building that the eurozone cannot survive in its current state, economists are warning that a break-up of the single currency would inflict a second Great Depression that would be felt across the globe.

Stephen King, the chief economist at HSBC, believes a collapse of the single currency would lead to “hyperinflation” in Europe’s struggling periphery countries and “economic collapse” in core countries, such as France and Germany.

King said the collapse of “Lehman was bad enough for the world economy and its financial markets but, under any plausible scenario, a break-up of the euro would be far worse. It must not be allowed to happen.”

In Britain, the Bank of England may recommence its quantitative easing programme on Thursday after a two-year hiatus. The Bank’s monetary policy committee signalled in the minutes from its September meeting that it would restart printing money to boost demand in the economy if the strength of the recovery did not improve.

Economists believe that if the Bank does not launch QE2 this week, it will do so in November, by which time the MPC will know how the economy performed in the third quarter. Experts believe the Bank will begin with a round of £50 billion to £100 billion, but further rounds may be necessary in the months ahead.

The European Central Bank is also believed to be close to announcing further measures to flood the markets with cash. Senior bankers believe the ECB will allow banks to post a broader range of assets as security for emergency loans. The central bank may also agree to extend the terms of the loans from one year to two years.

Economists at UBS also forecast that the ECB will cut interest rates to 1% — now at 1.5% — to help ease the strains on the financial sector.

The ECB is under renewed pressure to provide the liquidity needed to prop up Europe’s banks. Germany and France are both thought to be opposed to calls from the IMF for a large-scale recapitalisation of banks. Senior City sources said neither wanted to provide taxpayers’ money to shore up balance sheets and that the banks themselves were all strongly opposed.

Dexia’s position is more urgent. One rescue proposal is for it to be merged with the French state lender Caisses des Dépôts. Dexia’s management has been attempting to arrange a deal with Banque Postale, the financial arm of the French postal service.

Parts of the bank could also be spun off into a new organisation dedicated solely to financing public sector organisations and local authorities.

France, Belgium and Luxembourg all own stakes in Dexia thanks to a multi-billion bailout at the peak of the financial crisis. The bank has sold €80 billion of toxic sub-prime American mortgage debts over the past three years and is now trying to sell a further €20 billion of troubled loans.

Fitch downgraded Dexia last week over fears the market chaos would halt bids to cut the size of its balance sheet. The liquidity freeze could then exclude Dexia from international funding markets, the ratings agency said.

Spain’s official bank rescue fund, Frob, is preparing to nationalise three more groups of savings banks at the end of the month at a cost of nearly €5bn ($6.9bn), but could allow two others extra time to find investors to help boost their capital, the FT reports, citing to people familiar with the discussions. NovaCaixaGalicia (NCG), Caixa Catalunya and Unnim are expected to be recapitalised by Frob after failing to present adequate plans to secure new investors by a September 10 deadline. The two that are likely to benefit from a temporary reprieve are Liberbank and BMN (Banco Mare Nostrum). Foreign investors have recently been examining the assets of most of the banks with capital shortfalls and, says one Madrid businessman involved, “they have certainly been spending a lot of time and due diligence on it”. NCG, meanwhile, was quoted by Bloomberg as saying that Christopher Flowers of US private equity firm JC Flowers & Co met NCG executives in Galicia on Friday, in what is likely to have been an 11th-hour attempt by NCG to find a financial saviour and escape the clutches of the state

Debtors hail changes to EU rescue fund

By Joshua Chaffin in Luxembourg

Any bonds issued in future by the eurozone's new €500bn rescue fund on behalf of Ireland, Greece or Portugal will not enjoy "preferred creditor status" – an alteration to the fund intended to help those nations return more swiftly to private capital markets.

The amendment to the forthcoming European stability mechanism (ESM) was unveiled by eurozone finance ministers at a meeting in Luxembourg on Monday that was dominated by chaotic efforts to contain the Greek debt crisis threatening the single currency.

It marks a subtle, but potentially important, change to the terms of the ESM unveiled by European leaders in March. The hope is that this will eventually encourage investors to buy bonds issued by those governments without fear that they could be trumped by new debt in the event of another bail-out or a restructuring.

"This should make it easier for these countries to come back to the market," Jean-Claude Juncker, the Luxembourg prime minister and eurogroup president, said in Luxembourg.

"It is good news for Greece; it's good news for Ireland; it's good news for Portugal."

Michael Noonan, the Irish finance minister, described it as "very good news for Ireland that this scheme has been amended" so that anybody who borrows will have the same ranking whether there's an ESM programme or not.". He was told by investors in the US that Ireland and other countries subject to bail-outs "would find it virtually impossible to get back into the market and access private funds as long as this provision remained".

Mr Juncker also outlined changes to the capital structure of the European financial stability facility (EFSF) – the temporary rescue fund cobbled together in the midst of last year's Greece bail-out – in order to make its lending capacity match its €440bn ($630bn) headline figure. That will be achieved by having the 17 eurozone governments that back the fund boost their guarantees from 120 per cent to 165 per cent – thereby increasing its guaranteed capital to €780bn.

The ESM, which will replace the expiring EFSF in mid-2013, is one of the pillars of what eurozone leaders call a "comprehensive" response to the debt crisis. Like its predecessor, the ESM will provide money to stricken governments by issuing triple A bonds backed by eurozone government guarantees.

A difference is that the ESM's bonds were supposed to enjoy preferred status to those of all creditors other than the International Monetary Fund. That seniority would effectively put ESM bonds at the head of the queue for repayment. This could be important in the future, since European leaders have pledged to try to force private creditors to bear some of the losses in ESM rescues.

But it created an unexpected obstacle for Greece, Ireland and Portugal – all of whom have received bail-outs from the European Union and IMF – as they contemplate a return to private borrowing. Investors have worried that any new bonds they bought would be pushed down the credit ladder if one of those governments were forced to turn to the ESM for fresh help.

For Ireland, the worry is acute since its €85bn rescue package includes a pledge by Dublin to return to private borrowing in late 2012. The situation has also created problems for Lisbon because some of the money it is due to receive from its €78bn package may not be paid until after the ESM has replaced the EFSF.

As finance ministers fine tuned the new rescue fund, prospects remained uncertain for the other pillar of eurozone crisis response – a legislative package to force states to rein in excessive debts and make their economies more competitive.

Member states and the European parliament had been hoping to close a deal on this economic governance legislation in time for an EU summit in Brussels on Thursday. Yet the two sides continue to lock horns over how much influence politicians should have on profligate governments when it comes to disciplinary measures such as fines. While member states want more flexibility, members of the European parliament are demanding as little political interference as possible – a standoff that diplomats say is further unsettling markets.

With time running short, Olli Rehn, the EU's senior economics official, urged the two sides to reach a deal, saying: "I repeat my appeal to the council and the parliament to finish the job in June."

Additional reporting by John Murray Brown in Dublin

Is what's good for the euro zone so bad for some of its members that it would be better for them to leave, however painful the consequences may be?

This is a variation on the question that has hung over the currency area ever since it was formed. Back in the days before the fiscal crisis raised the stakes, the question we all asked was whether the interest rate set by the European Central Bank was as appropriate to the economic situation in Germany as it was to Greece.

Bloomberg News Irish Finance Minister Michael Noonan speaking in Dublin last week.

If the European Central Bank delivers its promised interest rate rise Thursday, the "one-size-fits-all" debate will get new legs, if it hasn't already.

Clearly, one interest rate doesn't suit all of the euro-zone members all the time. Indeed, if the members of the ECB's governing council really do what they say they do, the interest rate they set is more likely to suit a large member of the currency area than a small one.

That's unless the small member manages to turn itself into a version in miniature of a large member—let's say, Germany— which is what the currency area's policy makers mean by the term "convergence."

Neither Ireland, Greece nor Portugal has yet managed to so transmogrify itself, and so if the ECB's interest rate suits Germany, it won't suit them.

Until now, the cost of being in a currency area hasn't been immediately apparent to most citizens in the euro zone's smaller members. In the run-up to the crisis, the ECB's key interest rate was too low for Ireland and Greece, but oddly enough, being able to borrow more cheaply than is good for the economy has never sparked widespread outrage. And since the crisis hit, the ECB's key rate has been at rock bottom.

That will change Thursday, and if the economies of Germany and France continue to recover, the ECB's key interest rate will rapidly become more damaging for economies that are already struggling, and mostly failing, to grow.

But there is a new tension between the interests of the parts and the whole. And last week provided a good illustration of a fault line that seems likely to widen and deepen in the months and years ahead, unless the euro zone gets a lot better at signalling that a member is being asked to act for the whole, and what it will do to compensate it.

During the recent election campaign, the parties that form Ireland's new government both pledged to ensure that holders of senior bonds bore some of the cost of recapitalizing the crippled banking system.

By all accounts, the Irish state's fifth attempt to estimate how much it will cost to fix the banks was by far its most rigorous, and the €24 billion ($34 billion) estimated cost is credible.

Shortly after the central bank announced that figure, Finance Minister Michael Noonan stood up in parliament to tell lawmakers what he was going to do about it. What a lot of people expected to hear was that part of the cost would be met by asking holders of senior bonds that aren't explicitly guaranteed by the state to share the burden.

That didn't happen. And the reason it didn't is that the ECB wouldn't allow it. It turns out that when they said they were going to require bond holders to "share the burden," the parties that are now in government meant that request would be made subject to the approval of the ECB.

The reason the ECB has a say in this is because it is basically providing the funding that allows Irish banks to get by, pretty much a day at a time.

And from the ECB's point of view, what's good for the euro zone is that all senior bonds issued by banks are honored, regardless of how foolishly the original borrower behaved, or how little care the bond investors took to find out exactly how their money was being used.

The ECB fears that if the Irish government were to "burn" the bond holders, banks across the euro zone would see their borrowing costs rise, and some wouldn't be able to borrow at all. The Irish government's response has been to announce that it will launch a diplomatic initiative to persuade other Europeans to see things their way and cut the interest rate charged on the bailout, which shows that for now, everyone is being very grown up about the euro zone's fiscal crisis.

It may not always be that way. The cost of being in a currency area is now becoming apparent to voters in the triple-A rated nations that are being required to bail out Ireland and Greece, and seem likely to be asked to help Portugal in the not-too-distant future.

But the cost of being bailed out is also becoming apparent to the Irish and the Greeks. Being in a currency union means you can't devalue in response to an economic shock, but it also now means that you can't allow your banks to restructure their debt. Even if that's what most voters have decided is a risk they'd like to take.

Indeed, it's pretty unclear what you can do, apart from what you're told.

There is no question that Ireland and Greece made a mess of their respective economies, and without anyone else's help or encouragement. But the process of getting out of the mess is being made hugely more complex and difficult because of the links that are perceived to exist between developments in those economies and the euro zone as a whole.

It may not be long before some of the euro zone's weaker members decide they are too weak to endure the harsh discipline required to safeguard the whole.

The only way to stop that happening is for the ECB and other euro-zone authorities explicitly to recognize when an action required by a member is chiefly intended to benefit the currency area as a whole, and come up with some compensating action.

Like cutting the interest rate charged by the euro zone on its bail-out loans.

Write to Paul Hannon at paul.hannon@dowjones.com

 
Prepare for a Euro Zone Divided in Two
 
When the euro-zone financial crisis is over, the 27-nation European Union will have fractured into two groups, the Gang of 17 and the Leftovers.
 
By Irwin Stelzer
 


Twenty-seven divided by two equals 17, with 10 left over. That's the new Euromath.

Sooner or later, the euro-zone financial crisis will be over. Greek, Irish, Portuguese and probably Spanish creditors will have neatly trimmed hair, the banks will have had to shore up their inadequate capital, German exporters will continue to cash the profits from the euro their southern partners have obligingly weakened, and the eurocracy will have found other reasons to meet. But Europe will not be the same.

It will be changed in two very important ways. First, the 27-nation European Union will have fractured into separate groups of 17 and 10. Second, the economies of the Gang of 17 will be centrally managed by a Franco-German coalition, while the nations among the 10 "leftovers" will fight a losing battle to effect the policies of the EU of which they are paid-up members. Peaceful coexistence between the 17 and the 10 is no sure thing.

The 17 euro-zone countries have made the direction in which they are heading very clear. The felt need to prevent defaults by its overly indebted members is leading to a more pervasive system of central economic management. The 17 are to have access to Germany's balance sheet, in return for which Germany is quite properly demanding a say in how they manage their economic affairs. Not only their budgets, but all the factors that affect their international competitiveness: methods of wage bargaining; the generosity of their welfare states, including the timing and terms of retirement; regulations concerning access to various occupations; and, most of all, tax rates.


It's not on for Greece to borrow money from the stronger euro-zone countries while operating loss-making, nationalized transport systems; or for euro-countries to index retirement benefits to wage rates rather than retail prices, with Germany the payer of last resort; or for one member to maintain corporate tax rates at half the level of the group average. It has become clear that a one-size-fits-all interest rate must be accompanied by more uniform fiscal and related economic policies. Joy unbounded in Paris as the long-sought French goal of a 17-nation euro-zone "economic government" comes closer to realization, marginalizing EU institutions.

The nations outside of the euro zone, the left-over 10, maintain their own national currencies, and retain control over their own interest rates. The value of their currencies can fluctuate, allowing depreciation if they are over-valued, and appreciation if inflation threatens. Their central banks can raise or lower interest rates in response to changing economic conditions. And to some extent they are free to follow the more liberal economic policies they prefer, rather than hew to the line set by the more anti-free-market euro-zone 17.

Those differences between the 17 and the 10 are creating a threat to the cohesion of the 27-member European Union. The euro-zone countries are developing rules for coordinated economic management without consulting the excluded group of 10. Next step: apply some of those rules to the 27-nation EU to prevent non-euro countries from gaining a competitive advantage over euro-zone members, as France and others complain Britain has done by allowing the pound to float, countenancing a less regulated labor market, and keeping regulation of financial services to an essential minimum.

The excluded 10 are well aware of their exclusion from meetings that set policies that will affect them. "It really rankles that they [Denmark and Sweden] can't get into important policy meetings," reports the Economist. Add Britain to the increasingly rankled as Brussels makes it more costly to employ part-time workers and weaves a new web of regulations around the U.K. financial services sector, and you have a core group that just might decide that exclusion from euro-zone summits makes membership in the EU less attractive. After all, majority voting allows the bloc of 17 to dominate rule-making in the EU.

France has a solution for the under-represented, non-euro countries: get rid of your national currencies adopt the euro, and get to have a say—a tiny one compared to Germany and ours, but a say nevertheless—in the rules being drafted to implement the new European-wide system of economic management. That has little appeal for many members of the excluded 10. Britain's economic reasons for refusing to buy a seat at the table by surrendering its own currency are rooted in basic differences from euro-zone countries—a more interest-rate sensitive economy, greater reliance on financial services, the need for a currency that adjusts to changing economic conditions. These remain as powerful a deterrent to membership as when they were first developed by then-Chancellor of the Exchequer Gordon Brown and the current shadow chancellor, Ed Balls.

Meanwhile, Sweden points out that its economy is the fastest growing in the EU, Danish voters believe they are not Ireland because the krone is not the euro, and euro members Greece and Ireland are wondering whether friends-in-need should have to pay usurious interest rates to their friends-in-deed.

The American colonies went to war to break away from Britain, and fought under the banner, "Taxation without representation is tyranny." The excluded 10 will have to decide just how long they want to tolerate marginalization before deciding that regulation without representation is equally tyrannical.

Irwin Stelzer is the director of economic-policy studies at the Hudson Institute in Washington.