While markets ponder the risk of a new recession in the United States and the likelihood of a third round of quantitative easing the European crisis quietly heads to a hard reckoning.

Earlier this summer the political classes headed for the beach after agreeing the second Greek bailout package and revamping some of the competences of the EFSF (without however expanding its size), leaving completion of the process by parliaments for later.

In the meantime Finland signalled that its participation will be conditional to agreement by Greece to secure collateral. The collateralization of Finnish participation rapidly induced emulation in Austria and Slovakia with others likely to follow. Estonia suggested that collateral arrangements should apply to all creditors involved to ensure equal treatment. Greece’s finance minister declared that this problem is for the EU to solve.

Not only will collateralization reduce the availability of funds but, more importantly, it will -at best- bog down negotiations, and eventually unravel the whole process. The devil is often in the details.

While creditors debate the issues another potent issue threatens.
Greece, which has failed to comply with its earlier obligations to the first bail out agreement will again at the end of the third quarter miss its targets for expenditure cuts, tax collection and privatizations are still nowhere on the horizon.

Continued Greek failure to comply and increasing conditionality and reluctance on the side of a growing number of potential lenders are a combination for almost sure disaster.

The chain of events that are likely to lead to Greek bankruptcy is likely to unfold already this autumn.

The fallout of a Greek debacle will have to contend with two major consequences: a further enhancement of the risk of ‘contagion’, chiefly affecting Italy, Spain with potential tremors to be felt in Paris also, and the almost certainty of a European bank crisis.

Over the last year European banks’ exposure to Greek debt has been reduced and its latency is now probably in the realm of the manageable (at a cost). The real issue today is what happens if Spain and Italy are also engulfed.

Banks in Europe hold € 98.2 billion of Greek sovereign debt, but according to the European Banking Authority they also hold € 317 billion of Italian government debt and € 280 billion of Spanish bonds.

If debt write downs become necessary the current perimeter of the EFSF (€ 400 billion) will clearly be insufficient.

As of the 23rd of August we are already well into the early stages of an implosion of European credit markets. Bank stocks are hammered on the markets, the junk bond market has already frozen for all new issues, banks are hoarding their cash at the ECB and increasingly reluctant to lend to each other, credit default swaps are soaring.

Leading European politicians are not even at the stage of recognising their lack of leadership and, worse, their failure to understand the chain of events. The political drift now makes disaster all but unavoidable. The question is how much.

European banks have already virtually shut down the interbank market as they avoid lending to each other for fear of counterparty credit risk Lehman style. As a result the ECB alone stands as the recipient of Banks excess funds and the virtually sole source of their liquidity.

Greece is likely to fall out of the Eurozone, although nobody knows how this will be done and no provisions were ever devised for such a case. The real question is can Spain and Italy be spared the same? Much will depend on the still unseen strategy that can be adopted, if one ever emerges. If past performance is any guide the ability of Europe’s political leaders to rise to the occasion is at best questionable.

If a late strategy to manage the dislocation of the Eurozone were to be devised priorities need to be established: Greece, unfortunately, will need to be left pretty much to its own self inflicted drama. Governments need to urgently backstop the banking system by extensive further guarantees and inevitably a large commitment to recapitalize them drastically. This, deplorably, will be left for later when more extensive damage will be seen. Sovereign debt in banks balance sheets needs to be closely marked to market in order to offer a more transparent view of the costs. The EFSF will, when its authority to do so will eventually be ratified, be able to contribute to backstop balance sheets in the banking system. Again this will certainly come at a later stage and will require that the means of the EFSF will need to be expanded. The European Central Bank, whose own balance sheet has already grown by over 70% since early 2010 will probably need to be recapitalized if it is to cope with the potentially massive dimension of its intervention in sovereign bond markets and continue to provide unlimited liquidity to the banking system.

The Eurozone, if it survives the impending challenges, will at least be a reconfigured entity grouping more homogenous countries with stronger commitment to fiscal discipline and debt sustainability. It will then have to face again the challenges that come from the place it will probably still want to claim in world markets.

A. Ferreira
23rd August 2011