Wolfgang Münchau might have been accused a few months ago of being unduly pessimistic about the future of the eurozone in his regular Financial Times columns and Eurointelligence articles. But as he himself confesses now, the successive months have shown him to in fact have been overly optimistic in his earlier diagnoses of the still-unfolding crisis. In a lucid and lively session entitled “The Way Forward for the Eurozone” at the fourth annual CFA Institute European Investment Conference in Paris yesterday, Münchau highlighted the impending disasters that will come if the necessary political will is not forthcoming — and experience to date has not been promising to say the least.
While Münchau does not foresee the total demise of the eurozone, there will certainly be significant changes (including the potential exit of Greece from the eurozone), and ultimate survival in any fashion will be achieved only with great difficulty, he contended.
As Münchau pointed out, the eurozone in aggregate is in relatively good shape. Its overall debt-to-GDP ratio is a manageable 80%. The euro currency itself enjoys relative stability, supported by sound monetary policies of larger member states. And the eurozone includes some of the world’s most advanced and competitive economies. If it were actually a single state, there would be no perceptible crisis.
Münchau emphasized that problems have clearly arisen from the large internal imbalances between large and small nations within the single market, the prime example being Greece versus Germany. Sovereign bonds issued by many nations within the zone have been shown to be anything but risk free — with the possible exception of German bunds — and the much-needed rescue packages that have been proposed are constrained by the requisite size and even legality.
The European Financial Stability Facility (EFSF), created last year, has only propagated the crisis, Münchau explained, given its dependence on the deteriorating creditworthiness of its sovereign owners. Potential investors in the facility are not overwhelmed. In addition, funding by the European Central Bank (ECB) is politically and legally unpalatable and hence there is currently no lender of last resort, which is a critical component.
The recent summit on the problems of Greece have proposed a 50% “voluntary” haircut on Greek debt to lower the country’s debt-to-GDP ratio to 120% from the year 2020. Münchau stated that not only is this haircut underestimated — realistically, it should be more like 60-70% — but also that the resulting debt-to-GDP ratio of 120% is still too high, and it is wildly optimistic to believe even this can be achieved. By some estimates, €106 billion is needed to recapitalize the banks affected by the sovereign crisis in order to achieve a 9% core tier-one ratio. However, this assumes zero risk-weighting of sovereign bonds, which are certainly not risk free. (Münchau estimated that if Italian government debt was properly risk-weighted, the recapitalization need would be four to five times the current figure — some €400-500 billion).
Münchau also recognized that a lack of a credible backstop makes the EFSF unattractive to investors. Stated policies, especially in Germany, are explicit about limited liabilities. Guarantors could easily default (think Italy), and large EFSF shareholders like France could be downgraded. His view is also that the German constitutional court has been pushed to the limit of what it can allow currently.
Leveraging the EFSF to optimize funding has been a key subject of discussion in the ongoing debate about resolving the eurozone crisis. But Münchau noted that insurance is not practical given its inflexibility and its focus on primary markets only. The FT commentator argued that repackaging EFSF debt into collateralized debt obligation (CDO) structures offers more flexibility, with opportunities to trade in secondary markets, as well as tranching — a seemingly plausible solution, but perhaps less than compelling given the more recent (troubled) experience with CDO investments. Moreover, investors can on their own replicate such structures.
There is no evident plan to deal with the risks of leveraging the EFSF, Münchau said. And he argued that the consensus to achieve a “joint and several liability” status for the EFSF will not occur overnight, even though sovereigns do have some leverage over the big banks (i.e., take 30% on your sovereign debt or get nothing).
Münchau reminded the audience that it took 30 years to establish the euro as a currency. In order for it to continue, both fiscal and financial union have to be combined together in a coherent fashion, he stated. So far, the much-needed European Union political commitment, much like in the United States, has not been demonstrated. Regarding Greece, he said that the country’s default is necessary, but not sufficient. Greece may be the birth-place of democracy, but its political and social systems require radical change — as they do in other eurozone countries too, including Italy and France — but this will obviously take time and events may well outpace political progress.
The ECB must accept lender-of-last-resort status, Münchau said, while politics moves towards fiscal and political union, which is currently illegal in many member states. Otherwise the eurozone risks political and even military intervention, particularly in Greece, which has a proven history of such actions and may already be on the brink of civil war.
On the brighter side, Münchau does not rule out upside surprises — but investors would be well-served by not laying too great odds on optimistic scenarios.