Market Mover - BNP PARIBAS - Investment Services India

Sovereign Debt: Time for Europe to Act
The sovereign debt crisis in the eurozone is about a
lot more than Greece, Spain, Portugal and Ireland or
any other country. It is about the collective political
will of eurozone countries to set in stone the firm
fiscal foundations that are necessary to underpin
EMU. Remember that EMU stand for Economic and
Monetary Union and not just Monetary Union. In
short, the credibility of the project is at a testing point.
At the end of this period, EMU will emerge stronger
or significantly weaker.
If one or more countries have sufficiently poor fiscal
deficit and debt dynamics, then they risk undermining
EMU in several ways. Speculation about credit risks
for a sovereign can have knock-on effects on its
partners in the union. There may be upward
pressures on rates and dislocation in money
markets. Risk premia and uncertainty may rise,
undermining growth, or the currency and other asset
markets may become volatile. Monetary policy may
end up compromised or overburdened. For example,
potentially the ECB could end up in the invidious
position of having to choose between tightening
monetary conditions to reflect economic
developments when that would intensify a debt crisis
or setting rates too low to avoid a debt crisis.
As with any club, if one member imposes negative
externalities on the other members of EMU, then the
other members can reasonably expect to have an
important say on the future behaviour of that
member.
The mechanism that is supposed to achieve this in
the eurozone is of course the Stability and Growth
Pact (SGP). Now, it is not delivering much stability
and precious little growth. Unfortunately, despite the
Commission having endorsed the Greek stability
programme, the market has not put a lot of credibility
in the plan.
Greece could eventually manufacture its own
credibility by delivering on its promises. But the
market is unlikely to give them that amount of time. If
a country cannot establish quickly its own credibility
in the eyes of the market, what may be needed is an
effective reduction of that state’s sovereignty over its
own economic and to some extent social policies. It
can borrow the credibility of its stronger peers.
This is the rational behind the decision on Thursday
to offer potential financial support if needed, and to
bring in ECB and IMF expertise in the design and
monitoring of Greece’s adjustment programme. The
Commission will liase with the ECB to “closely
monitor the implementation of the [stability
programme’s] recommendations” and will draw on
the expertise of the IMF to “propose additional
measures”. These measures are designed to buy
breathing space for Greece to implement its plans
and for those plans to start paying dividends, while in
the short term alleviating potential funding problems
and market disruption.
If this sounds like an IMF-style programme to you,
then you are right. Note that we say an “IMF-style”
programme. Crucially, the EU are limiting its use of
the IMF to its expertise - a Fund programme might
help to fix the current crisis, but as we said above,
there is a longer-term game playing out here, which
is for the fiscal soul of EMU. If the Fund were to bring
a full programme to the eurozone, it will be an
admission of failure by the Commission and the
Council. It would be a public acknowledgement that
the Europeans cannot put their own house in order. It
would undermine the credibility of the institutions
supporting EMU and will set a terrible precedent for
the future.
The monitoring of Greece’s adjustment programme
in conjunction with the ECB and use of IMF expertise
to propose additional measures is a crucial feature of
the EU’s statement. If the EU had offered support to
Greece without monitoring or conditions then some
of the same problems would arise – EU institutions
and the fiscal underpinning for the euro would be
seen to be weak and deficient. We’ve learned a lot
about moral hazard over recent months and years
and the involvement of IMF expertise suggests the
Council and Commission understand the risks. If its
support were seen to be a pure “bailout”, then it
would have created a terrible moral hazard,
encouraging poor fiscal performance in the future by
current and future members of the EMU.
We could argue that infringing on the sovereignty of
a member state is not enshrined in any treaty.
Maybe, but it seems to us that the EU’s support for
an adjustment programme under strict conditionality
is precisely what was required. If this path is adhered
to, then EMU can emerge from this episode
strengthened and steeled. It will have come of age.
Anything less will leave it much weaker than before.
Paul Mortimer-Lee 12 February 2010
Market Mover
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