Despite multiplying good news from the real economy, the past six months have been the most trying times for the euro – certainly the most testing since the height of the financial crisis in late 2008. Mounting doubts concerning the sustainability of sovereign debts and the fragility of Eurozone banks have pushing spreads over the German bund rates to unprecedented heights (Eichengreen 2010).
The sustainability of sovereign debts is a serious issue that must be confronted. The combination of large public sector deficits to support economic activity and persistently weak private demand raises questions of debt sustainability in the medium term (Fatás and Mihov 2010).
Financial markets, however, seem to have blown these fears out of proportion, leading to a full scale confidence crisis. After all, Greece’s public debt is a tiny proportion of Eurozone GDP and banks’ capital and there is no serious grounds to believe that another Eurozone member can become insolvent any soon.
Loose lips sink markets?
Indicative evidence presented here may indicate that politicians’ public disagreements and careless statements at critical junctures may have added oil to incipient fire. By creating the impression that domestic political interests would take precedence over orderly management of the Greek debt crisis, they raised broader doubts on their ability to address fundamental economic divergences within the area, which are the real source of debt sustainability problems in the medium term.
Our chart (figure 1) reports daily spreads for ten-year government debt between Germany, on one hand, and Greece, Portugal, Spain, Italy and France on the other. We have also indicated on the chart significant events in coincidence with observed changes in spread patterns (events are indicated with numbers referring to the event list in the appendix).
Figure 1. 10-years government bonds spread versus German bund for selected Eurozone countries, December 2009-June 2010 (in percent)*
* Daily data. Especially bad news in red. Source: Financial Times on Thomson Reuters.
As may be seen, up until the beginning of February 2010 by and large the Greek crisis is just that, a Greek crisis, reflected in the widening spread relative to all other government paper. But in the ensuing weeks all spreads start to widen and in the period of most acute instability in April and May all spreads follow similar patterns both in their upswings and downswings – albeit in different scale. Markets were somehow coming to believe that government insolvency would spread from one country to another, leading eventually to a banking crisis.
Let’s consider events at critical changes in market spreads. On December 8, 2009, Fitch cut its rating on Greek debt below A grade (event 1), calling markets’ attention to a deteriorating outlook. But the real jump in the spread by 170 basis points raising it to nearly 400 basis points, took place in the fortnight following the announcement that debt data had been falsified on January 12, 2010 (event 3). On that occasion Ms. Merkel declared that Greece’s mounting deficits risked hurting the euro; the statement was subsequently removed from the German government website.
The ensuing days were marked by confusing public statements, with reassurances by the European Commission apparently pushing spreads down (events 5 and 6) and tough German statements pushing them back up (events 7 and 8). March was also marked by great confusion, with Greece declaring that financial assistance was not needed and Germany implicitly using that statement to reassure the public opinion that German money would not be called upon. Germany and other member states at that time also called for the IMF to intervene in case of need. The effect was renewed uncertainty on the real willingness of Eurozone members to support Greece.
On 25 March Eurozone member states agreed on a rescue package for Greece involving bilateral loans as well as IMF financing (event 11); however, Greece still refused to ask for it while the Eurozone member states started bickering in public regarding the conditions applicable to the loan – with Germany demanding above-market rates that would of course make Greek debt even less sustainable; the request was later withdrawn (event 13-a). The spread on Greek paper rose above 400 basis points and started climbing to new heights since early April; other spreads also rose sharply. The key novelty here seems the decision, taken on April 11, to extend aid through bilateral loans (€30 billion from Eurozone member states, to be supplemented by the IMF; event 13-b), a decision that for the first focussed market attention on the fact that Eurozone governments would be directly liable for Greek debt – trashing the no-bail out clause of the Treaty.
Following pronounced market unrest, on May 2 the Eurozone member states agreed on a €110 billion support package for Greece (event 19), with Greece announcing that it will finally take it. However, after initially receding, spreads widened again even more, with confidence fading on the whole Eurozone. An emergency meeting of the Ecofin then agreed on a new European Financial Stabilisation mechanism entailing loans and guarantees up to €750 billion (event 21). No more bilateral loans – the lesson has been learnt, at a high cost. The ECB followed suit and on the same date announced a new package of liquidity support to meet renewed distress in the interbank market. The package included direct purchases of Greek and other Eurozone government debt bonds by the ECB.
Yet upon returning back home, Ms. Merkel announced a unilateral German ban on short selling that one again unsettled markets and pushed up spreads on the Bund (event 23), since it was seen as further indication of wanting coordination. A German member of the ECB governing board publicly voiced his disagreement with ECB support to the sovereign debt market. After coming down sharply in the days immediately following the new measures, spreads have been crawling up in a climate of mistrust and confusing statements by Eurozone governments. Good news from the economy and agreement within the Eurozone on the special purpose vehicle (event 24) have so far not managed in calming the waters.
In sum, governments may have contributed quite a bit to turmoil with their public display of confusion and their statements to assuage domestic public opinions. Their behaviour undermined the credibility of the specific actions they were undertaking and, more broadly, of their ability to address effectively underlying imbalances in the Eurozone.
The good news is that even this confused and ill-advised bunch was eventually forced to come together and approve unprecedented measures to rescue the euro from disaster. At the recent meeting of the European Council, they have now agreed to publish in July the results of stress tests on 25 large banks in the area (event 26) – which should help dissipate uncertainty on their real exposures.
If Eurozone governments continue to show unity of purpose, and that they seriously intend to address underlying imbalances threatening the sustainability of the euro, there is hope that financial markets will relent and accept that the Eurozone is not about to crumble.
Eichengreen, Barry (2010), “Drawing a line under Europe’s crisis”, in Richard Baldwin and Daniel Gros (eds.), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Fatás, Antonio and Ilian Mihov (2010), “Fiscal policy at a crossroads: The need for constrained discretion” in Richard Baldwin and Daniel Gros (eds.), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Timeline of significant events - December 2009 – June 2010
- December 8: Fitch cuts rating on Greek debt to BBB plus with negative outlook - first time in 10 years a leading rating agency has rated Greece sovereign paper below A grade
- January 11: IMF announces mission to Athens.
- January 12: Greece is condemned by the European Commission for falsifying data on its public finances. Angela Merkel says that Greece’s mounting deficit risks hurting the euro, which faces a “very difficult phase” in the coming years (comment posted on a government website and later removed). Three days later Merkel praises “Herculean effort” of Greek government to tame the budget deficit.
- January 28: Bungled attempt by Greece to sell government debt to China becomes public.
- February 9: EU Commission (Rehn) offers “support in broad sense” to Greece – German government reported to be preparing an assistance package for Greece, though depending on “strict conditions”.
- February 11: Eurozone leaders promise support to Greece in exchange for deficit reduction plan.
- February 15: Greece to lose voting privileges in the EU in case of bailout, says Kurt Lauk, head of CDU’s Economic Council.
- February 24: Hans Michelbach, influential CSU lawmaker, says that Germany must resist any moves to provide financial aid for Greece because any assistance would provoke a “spiral without end”.
- March 11: Schaeuble calls for tough sanctions to back EMF, so as to enforce budgetary discipline, including expulsion from Eurozone as a last resort sanction.
- March 21: Merkel: “I do not see Greece needs money at the moment, and the Greek government has confirmed that. We do not want to create unrest in the markets by raising false expectations”.
- March 25: Eurozone agrees on emergency plan for Greece, but immediately after divergent interpretations of agreement surface between member states and unsettle markets.
- April 9: German government demands emergency financial aid to Greece be at close to market rates.
- April 11: a) Germany accepts to lend to Greece at below market interest rates; b) Eurozone members commit to provide up to €30 billion in loans to Greece, to be supplemented by money from the International Monetary Fund that could yield an additional €15 billion.
- April 22: Moody’s cuts Greece's rating for the second time in the year. German government lawmaker Frank Schaeffler says Greece should be prepared to leave the euro region if it can’t push through enough austerity measures to cut its budget deficit.
- April 23: Greece asks activation of Eurozone/IMF loan – EU says terms of aid may be agreed in a matter of days, but Merkel says Greek government must satisfy very stringent conditions.
- April 26-27: Merkel says she won’t give funds until Greece shows it has a sustainable credible plan to cut its budget deficit – “I have said for weeks that Greece must do its homework first”- “Germany will help when the correspondent conditions are fulfilled”. Standard and Poor’s downgrades Greece’s long-term credit rating to junk.
- April 29-30: emergency multi-annual loan programme for Greece from Eurozone and IMF announced to be concluded within days. Greece adopts €24 billion austerity package – Merkel confident it will keep the euro stable.
- May 1: Merkel says EU should be able to temporarily revoke voting rights from member states who violate deficit limits.
- May 2-3: €110 billion Eurozone-IMF support package for Greece adopted. ECB relaxes collateral policy for Greek sovereign debt.
- May 7: German Parliament approves law to release funds (€22.4 billion) to Greece.
- May 10: EU stabilization mechanism adopted (€500 billion from Eurozone and EU; €250 billion from the IMF). European Central Bank adopts package of measures to ease tensions in financial markets, including purchase of Eurozone government bonds and reactivation of US dollar swap lines with the Federal Reserve. German court refuses to block Athens rescue.
- May 15-16: Merkel: “if euro fails, more fails”. Germany calls for Eurozone budget laws (based on German model).
- May 18: Germany adopts ban on short-selling.
- June 7: Eurozone ministers establish the €440 billion SPV (the European Financial Stability Facility) envisaged in the May 10 package and find an agreement on its functioning.
- June 14: Moody’s downgrades Greek sovereign debt to junk.
- June 17: EU leaders decide that detailed results of stress tests on the health of 25 big European banks be made public.