Thursday, July 28, 2011

Enough is not enough

This summer is likely to be very hot as the temperature of financial markets is dangerously soaring. Rational arguments are here of no use; psychological factors are decisive like in any war. In fact, financial markets - big players like hedge funds and big banks - have decided to increase their pressure on sovereign debts of peripheral countries in the euro area with a view to make further profits on debt bonds.

A week ago, the European Council has agreed on a new rescue plan for Greece. It includes a new loan package, with a new loan of € 109 bn and € 50 bn of private contributions from banks and insurance companies as well as buyback of Greek bonds. For all new loans, interest rates will be 3,5% and repayments will be due in 15 up to 30 years. The novelty is that the Fund will buy back Greek bonds on secondary markets in exceptional circumstances and provide guarantees to Greek bonds if Greece were in selective default. The financial sector will contribute on a voluntary basis in multiple ways, either with bond exchange ( exchange of old bonds with new ones), roll over ( rescheduling of newly issued bonds over longer periods) or buy back ( purchase by Greek government of debt in private hands). In addition, there will be a task force to reactivate the Greek economy with structural Funds investments.

The accord was received positively by financial markets in Europe after the declarations of European and IMF leaders. The Greek crisis is apparently resolved but not at all. A rating agency, Fitch (the smallest among the three agencies) issued the term 'selective default' to invert the positive trend and nurture speculative attacks. It seems like if financial agents have ignored the scale of the loan package, the increased powers of the European bailout Fund which will be able to buy bonds on secondary markets, the favourable conditions which will apply to new loans, the purchase of Greek bonds held by domestic banks at a lower value. This creates a dangerous precedent: if the EU has accepted a partial default for Greece, this may also happen to Spain or Italy. This paves the way for a new cycle of speculation.

Indeed, the accord was meant to stop contagion to other countries such as Spain or Italy. However, their sovereign debts are still under pressure, especially Italy - the spread with German bonds widens, more than 300 points. With current growth and interest rates, debt service will increase 1,5 percentage point of GDP. This reflects long term, structural weaknesses of the Italian economy and the inadequacy of the political class in power, with wide corruption and scandals which certainly undermines the credibility of the country. Remember in 1992, after the attack against the lira by some hedge funds ( led by the famous raider, Soros who made a fortune with that operation), the Amato government had to ask for sacrifice to the Italian people as the country was about to collapse as it had to repay debt with interest rates soaring at 15%. Apparently, this lesson has not been learnt and Italian people are paying the consequences of the folly of a discredited political class, and of a single man who thinks to rule the country pursuing his own, narrow and controverted interests.

After the calm, the tempest may come in the next months. What went wrong? The EU accord on Greece is an important step forward but it came too late given current EU decision making rules. However, the real issue is that it does not build an effective economic governance to contrast speculative behaviour from banks and other agents. The European bailout fund has been increased up to € 450 billion but if Italy or Spain are under attack it will be insufficient to curb speculation. National governments do not need increase their current debt levels but the European Union which has no debt could borrow money at low interest rates. EU leaders know that the accord is not enough and will reconvene in September to agree on the way forward. The voluntary participation of the private sector is still to be further defined to avoid any moral hazard (if anything goes wrong, will States intervene again to save the banks?). In fact, EU leaders showed little enthusiasm to evolve toward a more federal management of the EU with the creation of eurobonds and stronger coordination of national fiscal policies. It is not too late to move in that direction if there is a common political will and awareness of risks and dangers of the current situation.

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