Europe on the Brink

By HU DAWEI

Europe on the Brink

By HU DAWEI

PUBLIC OUTCRY: A protester at a rally in Athens on September 22 against the Greek Government’s new austerity measures

Deepening debt crisis threatens the unity of the euro zone

The debt crisis in Europe is spreading to larger South European economies, and now is entering a new and much more dangerous phase. It will further damage the fiscal stability of core eurozone countries. In the meantime, the crisis has started to take a toll on Europe’s banking industry. Possibilities of a systemic financial crisis, sovereign debt default and a euro-zone collapse are increasing. European integration currently faces the toughest challenge in the past five decades. And the solidarity of EU members has been put to the test.

Deepening crisis

Despite the EU’s adoption of a second bailout for Greece worth 109 billion euros($146.2 billion), the debt situation of the euro zone has been deteriorating since mid-July.

Italy and Spain are facing sharply rising borrowing costs. At one point, interest rates on their sovereign bonds climbed to the 7-percent alert level, fueling concerns about the spread of the debt crisis to the two countries.

Italy is the third biggest economy of the euro zone, and Spain is the fourth. Italy’s public debt is triple the debt sum of Greece, Ireland and Portugal combined. Spain’s debt has reached 650 billion euros ($872.5 billion). Italy and Spain will need to raise a combined 840 billion euros ($1.13 trillion) within 18 months through financing. The huge amount is far beyond the European Financial Stability Facility’s (EFSF)rescue ability.

Default risks of sovereign debt have also started to affect the banking industry, and the euro-zone financial system faces systemic risks. Stress test results of European banks showed that the debt sum of the PIGS countries (Portugal, Italy, Greece and Spain) in the four biggest French banks had already reached 300 billion euros ($403.2 billion) by the end of 2010. The second Greek bailout plan contained clauses requiring private institutions to voluntarily share rescue costs.This directly increased the losses of many banks and fi nancial institutions. Share prices of Italian and Spanish banks plummeted.Global credit rating agency Moody’s downgraded the ratings of two French banking giants, Societe Generale and Credit Agricole.

Wrangling between Greece and international financial institutions over fiscal austerity made the bond market even more turbulent. There has also been speculation as to whether Greece would quit the euro zone. Greek Financial Minister Evangelos Venizelos warned on September 21 Greece might not be able to obtain its sixth rescue loan of 8 billion euros ($10.8 billion). He urged the Greek parliament to make a decision on further austerity measures, so as to reach the budget goals required by international creditors. Germany also declared there was possibility of an “orderly” bankruptcy for Greece in case of an emergency, but this declaration only made financial markets more restless.

Anti-crisis measures

The EU felt increasing urgency of coping with the sovereign debt crisis when it began to affect big economies of systemic importance. EU members and the European Central Bank (ECB) have adopted measures to prevent the crisis from spreading and re-store market con fi dence.

DOWN AND OUT: Window-shoppers check products on sale at an Athens store. The Greek Government has announced new austerity measures to secure international financial support and avoid default risks

The Italian, Spanish and French governments issued new fi scal austerity policies to bolster con fi dence in the fi nancial market and curb soaring debt financing costs. The EU gave the EFSF a broader mandate and more fl exibility in the second Greece bailout plan.For instance, it allowed the EFSF to buy government bonds in the secondary market,grant loans to countries suffering liquidity shortages in advance, and provide funds to banks. EU members promised to improve fiscal conditions, enhance competitiveness,address macroeconomic imbalances, and strengthen economic governance. They also vowed to pass laws on promoting economic growth and stability and improving macroeconomic supervision.

The ECB has intervened in European debt securities markets. After buying national debts of Ireland, Portugal, Spain and Italy,the ECB is now holding 96 billion euros($129 billion) in EU members’ government bonds. The European Securities and Markets Authority has announced new bans on short selling in Spain, Italy, Belgium and France in a bid to stem market volatility. The ECB declared on September 15 that it will pump U.S. dollar liquidity into European banks in the coming three months in collaboration with the central banks of the United States,the UK, Japan and Switzerland, intending to help the European banking industry get through the current crisis.

These measures have stabilized the situation for the time being. After the ECB purchased Italian and Spanish government bonds, interest rates of their 10-year bonds fell to about 5 percent. European stock markets also picked up.

Future uncertainties

The EU’s anti-crisis measures followed an established tradition: providing liquidity,tightening fiscal discipline, and ECB intervention. These measures did temporarily work to prevent further deterioration. But the EU neglected the institutional defects that have triggered the crisis. Therefore, the debt crisis might occur again in the future.

Fiscal austerity policies have come too late, given the fact that European sovereign debts have long been at alarmingly high levels. As a result, they will not be able to eff i ciently rein in rising fi nancing costs.

The EU’s decision to enlarge the EFSF faces political resistance in countries like Germany. The Germans have expressed strong dissatisfaction at constantly providing huge sums of money to South European debtor nations. They have urged the German Government to take a prudent stance.

Although the ECB’s intervention has played a signi fi cant role in restoring market confidence, the ECB is likely to encounter difficulties as it purchases government bonds. Analysts pointed out that the ECB would have to buy at least 100 billion euros($135.2 billion) in Italian and Spanish bonds to stabilize the long-term interest rates of the two nations’ government bonds. This amount is so huge that it will greatly limit the ability of the ECB to implement monetary policies.Worse still, excessive liquidity could give rise to growing in fl ationary pressure.

Currently, opinions vary in the ECB on financial market intervention. Most of the ECB Executive Board members hoped the EFSF could be put into operation as soon as possible so that the ECB can quit.

Rating agency Standard & Poor’s downgraded Italy’s sovereign debt rating on September 19 because of its lagging economy. It was the sixth euro-zone country that was downgraded in 2011 after Spain,Ireland, Greece, Portugal and Cyprus.

Global repercussions

The runaway European debt crisis poses a serious danger to world economic recovery and international fi nancial stability.

According to the European Commission’s 2011 interim economic forecast released on September 15, Europe’s economic growth in 2011 might drop because of the debt crisis and financial market turbulence. The report made downward revisions for the estimated economic growth rates of both the EU and the euro zone in the second half of this year. Sluggish growth in the EU will hinder progress in global economic recovery. The International Monetary Fund also issued a report recently, stating that the international financial system is facing growing risks because of Europe’s debt crisis.

The EU is now China’s biggest trade partner. The European debt crisis not only in fl uences China’s exports and its economic growth, but also threatens the security of China’s euro assets.

European countries have high expectations for China, hoping China can buy more European government bonds and help South European nations out of trouble. But the security of China’s investment can hardly be guaranteed given the euro zone’s poor economic governance. China will purchase more European bonds provided that its own interests are protected. In other words,if EU members show greater solidarity to overcome the crisis, China may increase its investment. European nations shouldn’t overestimate China’s role in tackling the debt crisis.

Fiscal austerity policies have come too late,given the fact that European sovereign debts have long been at alarmingly high levels

The author is an associate research fellow with the China Institute of International Studies