This content is from: Portfolio

Will the Euro Zone’s Bazooka Have Enough Ammunition?

The euro zone is close to building its bazooka. But will it have enough ammunition? Analysts say no.

Politicians and pundits have adhered consistently to a common military metaphor when discussing how to solve the euro zone crisis in recent months: Policy makers need to create a "big bazooka" to end the currency union’s plight. Loud hammering noises could be heard in Brussels early on Friday morning, as leaders at the EU summit tried to cobble something together. Has the bazooka been built?

The most important development is that the European Stability Mechanism (ESM) — the euro zone’s new rescue fund from July — will have the power to bail out troubled euro zone banks directly. Individual national governments will no longer need to borrow the money — and take on the debt — necessary to do so. In other words, the euro zone as a whole has taken a big step towards shouldering the region’s banking crisis on a collective basis, which will help to restore credibility in the sovereign debt of individual governments by easing their load.

A second important change is that euro zone leaders have agreed to allow the ESM to buy the primary debt of countries suffering from crises of credibility — not just secondary debt. This will help to boost confidence in the market for the hundreds of billions of euros of primary debt which peripheral euro zone states must issue in the next few years.

There is, therefore, a strong case for saying that in Friday’s talks Angela Merkel, German Chancellor and reluctant savior of the euro zone, truly cooperated with Mario Monti and Mariano Rajoy, eager advocates of a collective solution, to build the bazooka. Moreover, the move towards a euro zone banking union was given impetus not just by the ESM’s new power to bail out banks, but by agreement on creating a single European banking supervisor — very likely the European Central Bank (ECB).

However, skeptics argue that there is little point in having a bazooka if it does not have enough firepower.

The ammunition will be kept in the coffers of the ESM and of the other euro zone rescue fund which will run alongside it, the European Financial Stability Facility. Once this month’s agreement to rescue the Spanish banks via these funds is implemented, they will only have about €400 billion ($500 billion) left. That may sound like a lot of money, but Jonathan Loynes of Capital Economics, the London-based independent macroeconomic consultancy, calculates it is only 15 percent of the combined size of the troubled Italian and Spanish bond markets.

Given such mathematics, Ted Scott, director of global strategy at F&C, the London-based investment manager, describes the ESM’s funding as “patently inadequate” given the worsening of the crisis and the extra responsibility thrust upon it — which includes intervening in primary bond markets.

Many economists think that even a considerably higher number than €400 billion would not be enough to scare bond bears away from shorting euro zone peripheral debt; what is really needed is the kind of commitment to almost unlimited bond buying that can be made by conventional central banks, which have been given a lender-of-last-resort role, such as the Federal Reserve and Bank of England. There is no real sign, however, that either Merkel or Mario Draghi, ECB president, are moving towards this position for the ECB. Merkel also still opposes eurobonds — another possible way of defeating the bears through a massive show of solidarity. 

There is another problem: Despite Friday’s progress, buyers of peripheral euro zone debt are likely to be reluctant until investors believe that these member states can arrest their sharp decline in output and eventually return to growth. Investors know that even in a more united euro zone, the patience of richer member states towards their poorer cousins is finite. If Greece, Italy or Spain were still a burden on the euro zone in five years’ time because of economic weakness, the pressure from other member states for it to exit the union could become unstoppable. Investors know this, and will consequently demand a large risk premium for these countries until their underlying economies have stabilized, to allow for the political risk.

Responding to all these fears, most analysts regard Friday’s progress as merely one step on the road to a solution of the debt crisis. As a result, they warn that the day’s across-the-board surge in asset prices is at risk of rapid reversal.

The euro had leapt 1.9 percent against the dollar by the end of Friday European trading to $1.267, with the Eurofirst 300 index of euro zone stocks 2.6 percent higher at 1,020. The yield on Spanish 10-years plummeted 43 basis points to 6.46 percent. Brent crude oil was up 5.6 percent to $96.45 a barrel in early afternoon U.S. trading, with gold up 2.9 percent to $1,594 an ounce.

The sharp rise in a range of assets, coming after sharp falls on previous occasions when policy makers had failed to move towards a pan-euro zone resolution of the crisis, underlines the current sense among investors that devising a coherent investment strategy in these times is a tough call.

“The outcome of the euro zone debt problem is so bimodal — either a full-blown solution or a severe crisis — that this is not a scenario that lends itself to fundamentally based analysis. It’s a coin toss,” says Dean Curnutt, CEO of Macro Risk Advisors in New York, which specializes in services to hedge funds. “Many hedge funds have responded by very much paring their risk down. They don’t want to be long equities, in the euro zone and elsewhere, in case there’s a disaster. They don’t want to be short the euro in case there’s a forceful policy response designed to prop the market up.”

Related Content