Crunch time for Europe

By Nathalie Thomas
Published on Saturday 12 November 2011 16:37

The ECB faces mounting pressure to begin Quantitative Easing in a bid to prevent a two-speed Europe. Nathalie Thomas examines the consequences...

MARIO Draghi watched nervously as the markets rounded on Italian government debt on Wednesday, pushing yields to record and “unsustainable levels”. But even he, a veteran at managing debt crises, couldn’t help losing some of his sang froid.

The 64-year-old Italian, who has taken the reins at the European Central Bank at the height of the Eurozone’s battle for survival, is an old hand at dealing with the near collapse of economies. He made his name during the nineties when he steered the Italian Treasury to safety in a crisis that brought it “within an inch” of bankruptcy.

But as the former Goldman Sachs banker saw yields on ten-year Italian bonds soar above 7 per cent, he too was touched by the rising tide of panic engulfing European policymakers.

With fears of an Italian default spreading through the halls of the ECB’s headquarters in Frankfurt, Draghi picked up the phone to convene an emergency meeting of the central bank’s governing council and called on his brightest lieutenants to come up with temporary steps to quell the mounting alarm.

Traders, who watched in horror as the euro and European equities bombed, noticed the ECB was buying up small amounts of bonds in an effort to stabilise the markets and stop yields spiralling even further out of control.

Although it is not long ago that markets were mulling the possible consequences of a Greek default, there was a heightened sense of terror on Wednesday as economists admitted that Italy was “too big to fail, but too big to bail”.

The Eurozone crisis entered a fresh and more deadly chapter as it became clear that political efforts to build a firewall around Italy, and to stop the contagion spreading from the periphery to the core of the 17-country bloc, had failed.

While the world has been living with talk of a sovereign debt crisis in Europe for months, it dawned on many in the Square Mile that what was previously a worst case scenario – a major Lehman-style credit crunch, banking crisis and prolonged recession – was becoming a very real possibility.

As Azad Zangana, European economist at Schroders, summed up: “Events over the past two weeks in Europe have been extraordinary.

“We believe that the outlook for the Eurozone economy is now significantly more negative and that politicians have missed their opportunity to prevent a European credit crunch.”

Rumours leaked out of Brussels that even French President Nicolas Sarkozy and German Chancellor Angela Merkel, the two admirals battling to keep the good ship Eurozone afloat, were beginning to lose hope and had met to discuss a radical overhaul of the bloc, reducing it to a much smaller and more tightly integrated group of economies.

Although Merkel firmly rejected such talk, Sarkozy had earlier in the week told an audience of students in Strasbourg that a “two-speed Europe” may be one of the only ways to ensure the Eurozone’s survival.

The unprecedented events on Wednesday also spurred Prime Minister David Cameron into action as his best number-crunchers at the Treasury warned of the effect on the UK economy of an Italian collapse. Sources suggested an Italian default would knock “several percentage points” off Britain’s already anaemic GDP growth. Banks headquartered in this country also hold around £42 billion of outstanding loans to Italy – around £10bn of which is sovereign debt.

Cameron urged his colleagues in Europe the following day to act now, warning that “the longer they delay, the greater the danger”.

While all attention this weekend is on the political events unfolding in Italy, economists believe changes in government are likely to have little effect in restoring calm in the long-term. Questions are being asked whether the unprecedented events of last week will prove to be the first major steps towards the break-up of the eurozone, almost 13 years after it was created. Or could Sarkozy and Merkel – dubbed “Merkozy” for their close alliance during the crisis – lead the way to creating a new, smaller Club Med?

Barry Norris, co-founder of European equity specialist Argonaut Capital Partners, dismisses talk of a two-speed Europe as “just political pressure” designed to hammer home to the governments of peripheral Eurozone countries the dire consequences facing them if they do not enact hard-hitting and serious austerity plans.

“Although the way out is difficult, we don’t believe it is beyond the wit of man to solve this crisis,” Norris says. “If we look at the solution to all of this, it has to involve proper austerity and economic reform in the periphery.”

This, he says, will involve European governments putting aside politics and electioneering and “telling their electorate the truth about what the alternative is”.

Like many others in the City, Norris argues that one of the keys to avoiding Armageddon in Europe also lies in the hands of Draghi.

Pressure is growing on the ECB, which was set up in the image of Germany’s Bundesbank, to follow Britain and the United States into printing more money – an option it has so far refused.

The path to quantitative easing (QE) for the ECB is not a simple one – particularly as Germany, which is still haunted by the hyper-inflation of the Weimar era and its political aftermath, is vehemently opposed to it.

However, analysts believe Germany may be forced into supporting QE if the only alternative is a break-up of the Eurozone – a harrowing consequence that leaders of all European countries, Britain included, are desperate to avoid.

Ted Scott, director of global strategy at F&C Investments, says the events of last week proved that the Eurozone bail-out fund, the EFSF, does not have the fire-power to calm bond markets and to build a firewall around core economies such as Italy and Spain, which are too big to bail.

“The only institution within the Eurozone that can do this is the ECB but it will have to change its current policy of intervention through its securities market programme to one of unsterilized asset purchases through QE,” Scott said in a research note.

“If the authorities do not want to risk a break-up of the EMU [European Monetary Union] the ECB will have to step in soon,” he added.

Norris points out that were the ECB to pursue QE to roughly the same levels as the UK and US, it would ease fears over a default of one of the larger Eurozone economies such as Italy.

Were the ECB to do QE to the value of around 15 per cent of Eurozone GDP, he says this would mean printing roughly ¤1.4 trillion – close to Italy’s public sector debt. “You can see that it is a big enough figure for the market to have its fears eased about a possible default,” he says.

Although QE in Europe would run the risk of an “inflationary event” further down the line, analysts say the risk is worth taking.

“Everyone is pinning their hopes in the medium-term on the ECB,” says Jeremy Batstone-Carr, head of research at Charles Stanley stockbrokers. “There isn’t any great desire from countries at the core to go to a two-speed Europe. It would be a bit like an ejector seat but whether it works would remain to be seen. It would really be a last ditch or beyond the last ditch – something they would only do in the event of collapse.”

A two-speed Europe could also pose problems for Britain as it would be up against a highly competitive core group of countries, led by Germany, while the periphery group would also have the power to vary their own interest rates to boost their economies. “My sense is there would be an issue for Britain associated with all of that,” says Batstone-Carr.

Although a “two-speed Europe” remains an outside chance for the moment, few are kidding themselves that even if the ECB were to press the button on QE, the Eurozone – and the rest of the world economy – isn’t in for a long, hard haul.

International Monetary Fund head Christine Lagarde has warned of a “lost decade” for the global economy while economists believe it is inevitable that there will be further bank failures – and as a consequence nationalisations – in Europe.

Third quarter GDP data for the Eurozone, out on Tuesday, is expected to mask some of the deeper problems within individual countries but most economists are braced for a deep and prolonged recession in the bloc next year.

European leaders meet again in Brussels on 29 November to examine further options following the failure of their three-pronged approach, unveiled just last month. While few will at this stage rule out any one option there is at least one certainty: more volatility to come.

As Batstone-Carr of Charles Stanley concludes: “The air of crisis will remain elevated until the ECB decides it has no other choice than to act.”

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