Cause and Effect in European Politics and Law

The Canaries’ Problem

Ralitsa Kovacheva, September 16, 2011

The rating agency Moody's lowered the credit rating of the French banks Crédit Agricole and Société Générale as it is continuing the review of the largest bank in the country, BNP Paribas, for a possible downgrade. The reason for the rating agency's decision is French banks' great exposure to Greek debt against the background of increased concerns about a possible Greek default. Christian Noyer, governor of France’s central bank, insisted on Wednesday that the country’s banks had enough capital to withstand any losses that might stem from a Greek default, The Financial Times reported. The news comes at a difficult time for the French banks because their share prices have declined steadily in recent weeks.

French banks hold fewer Greek government bonds than Italian banks do, though they hold more than German banks, which sold many of these assets early in the Greek crisis, The New York Times writes. According to the newspaper, Société Générale holds Greek bonds worth 2 billion euros and Crédit Agricole - 800 million euros, while BNP Paribas has 4 billion euros in Greek debt. The first two banks, however, have subsidiaries in Greece, which makes them vulnerable in case of a default. According to the newspaper, “many investors now expect the United States Federal Reserve, the European Central Bank and other monetary authorities to step in with various measures to pump more liquidity into the financial system if markets remain volatile and economic conditions continue to deteriorate".

At the annual meeting of central bankers in Jackson Hole in late August, the International Monetary Fund managing director, Christine Lagarde, called on Europe to take care of its banking system and to recapitalise banks. On September 14, the deputy managing director of the IMF, Min Zhu, said at the Summer Davos in Dalian (China) that "the short-term banking crisis is the biggest concern Europe is facing," urging politicians "to take decisive action today."

European officials played offended by Ms Lagarde's words, arguing that the stress tests have shown European banking system's resilience. Given the overhanging danger of Greek insolvency, however, financial markets are apparently distrustful to those allegations.

The expectations of a Greek default have been reinforced by the suspension of negotiations with the EU-IMF mission in Athens, provoking fears that Greece might not get another tranche of its 110 billion euros loan. The negotiations were resumed after the government in Athens announced the introduction of a new property tax to raise its budget revenue. This, however, has not reassured investors, especially after it became clear that Germany was preparing a plan to help its financial institutions to meet losses of 50 percent if Greece went bankrupt.

Market tensions are rising also because of ongoing negotiations on a Greek debt restructuring, as agreed by the eurozone leaders on 21 July. It is not yet clear what part of the big financial institutions will take part in the deal that is expected to take place in October. Private sector participation was a precondition for granting a second bailout to Greece, while the agreement on it is still blocked because of Finland's request to obtain collateral for its participation, followed by other countries.

It is expected these issues to be discussed at the meeting of eurozone finance ministers within the informal Council of EU finance ministers in the Polish city of Wroclaw this weekend. US Treasury Secretary Timothy Geithner will join the meeting of the eurozone finance minsters for the first time ever - another sign for the seriousness of the situation. Against this background, some analysts have estimated the risk of Greece going bankrupt in the next five years to almost 100 percent.

Even if Athens avoided a credit event in the short term, achieving economic growth in the coming years and respectively - debt reduction, would be extremely difficult, analysts from the Centre for European Policy Studies (CEPS) Daniel Gros, Thomas Barnebeck Andersen and Mikkel Barslund believe. The reasons are population ageing and as a result - the rapidly declining workforce and the structure of the Greek economy. Over the past decade Greek growth has been driven mainly by non-tradable sectors – domestic services, such as retail and wholesale trade, which were severely affected by the austerity measures and reduced domestic demand. Tradables, as agriculture and manufacturing, have too small a share in the Greek economy to become an engine of growth, the authors say.

Greece, however, is simply a "canary" of the debt crisis in the eurozone, according to an analysis of CEPS Director Daniel Gros and the chief economist at the Deutsche Bank (London), Thomas Mayer. "Canaries used to be kept in coal mines because they die faster than humans when exposed to dangerous gases. When the birds stopped singing, miners knew that it was time to prepare for an emergency. Greece, as it turns out, was the eurozone’s canary. It was nevertheless resuscitated, and a small rescue mechanism was set up to revive a further canary or two – but beyond this the warning was ignored. The miners kept on working. They convinced themselves that this was the canaries’ problem."

The authors argue that the recent measures agreed by the euro leaders on 21 July would not help solving the crisis, including the decision the eurozone rescue fund EFSF to buy debt of troubled eurozone countries on the secondary markets. According to Gros and Mayer, it just does not have enough money for that, given it should continue to pay the loans to Greece, Ireland and Portugal. Not to mention that it is perfectly possible the number of countries providing guarantees to the fund to decrease.

According to the EFSF rules, any country facing difficulties and asking for financial assistance may stop providing guarantees for future debt issuance by the fund. Moreover, the authors note, "even if it is not explicitly regulated, it can be expected that a country facing high borrowing costs (as in the case of Italy and Spain if rates stay at crisis level) will step out as guarantor". The current situation of France is also worrying, given the decreased ratings of two French banks and the danger the country to lose its triple A rating. Then one of the biggest nightmares of Germany will be fulfilled - to pay alone for all. As the analysts note, "this would not only be politically unacceptable but also economically impossible – the Italian government debt alone is equivalent to the entire GDP of Germany."

While "as usual, banks are the weakest link", the solution is a massive infusion of liquidity into the euro area, the authors believe. To that end, the rescue fund should be registered as "a (special) credit institution with access to re-financing by the ECB in a case of emergency," which the authors call the European Monetary Fund. The advantage of this fund will be that it could provide liquidity backstop to the countries in case of "a widespread breakdown of confidence". Not least, this proposal is in line with the current European legislation and does not require treaty changes, the authors underline.

They also refute the widely promoted idea of eurobonds, arguing that a political union cannot be introduced without democratic legitimacy. "… Holding taxpayers fully and unconditionally liable for spending decisions taken in other countries would most likely turn into a poison pill for EMU [Economic and Monetary Union]." Political opposition against the eurobonds from the stronger member states could even result in “a probable break-up of EMU”, Gros and Mayer believe, while summarising: "Eurobonds can only make sense in a political union and even then only when debt levels are low," and at current levels they would amount to a large transfer of risk.

However, the idea of eurobonds has a strong lobby among the leaders of the member states and in the European Parliament. On 14 September European Commission President Jose Manuel Barroso announced to the MEPs that the Commission would soon present options for the introduction of eurobonds, some of which could be realised within the current Treaty, but others would require treaty changes, Barroso warned. Markets reacted with satisfaction to his speech - however, whatever arguments are pointed by analysts, economists and politicians against the eurobonds, investors seek only security. At this point there is a large deficiency of it and no signs of a coming back on the markets soon.