Corruption in Italy Threatens the Efficacy of Fiscal Stimulus

Sources:

The Telegraph (U.K.):  Making a killing on contracts: how Italy's Mafia has plundered EU building funds

NYT:  Corruption Is Seen as a Drain on Italy’s South 

BBC: Italy sacks Reggio Calabria council over 'mafia ties'

US DOS: 2012 INCSR: Country Reports - Honduras through Mexico: Italy

Mafia led corruption continues to plague Southern Italy, leading to government inefficiency and a reduction in the efficacy of domestic and international infrastructural spending. 

The A3 highway has been at the epicenter of Italian corruption scandals. The highway, which spans an area from Salerno to Reggio Calabria, lies in one of the poorest regions in Italy. Located at the tip of the Southern peninsula, the area lacks high-speed rails, many other infrastructural amenities found elsewhere in the country, and has close to a 20 percent unemployment rate. The Italian government embarked on a plan to renovate the A3, along with other infrastructural projects, in 2001 after receiving funding from the European Union (EU). Since the inception of the project, construction has been completed on 169 miles of the 309-mile highway, and hundreds of people have been arrested in association with their involvement on the highway, mostly on charges of corruption and extortion. Sergio Rizzo, an author who focuses on political corruption, says that European money “did tremendous damage because the funds were used badly and, as some magistrates say, they also fed organized crime.”

             

Calabria, the region located in Italy’s Southern peninsula is dominated by the ‘Ndrangheta, an international crime syndicate. The ‘Ndrangheta has an annual income of €44 billion from a combination of drug smuggling, extortion, and public-sector graft, and while lesser know than its peers in Sicily or Naples, the ‘Ndrangheta’s reputation has increased greatly over the past decade.

            

 The ‘Ndrangheta plays a major role in public sector life in Calabria. On October 9, the provincial capital of Calabria, Reggio Calabria, dismissed all 30 members of the City Council and the mayor for suspected ties to the ‘Ndrangheta.  The move, which Italian Interior Minister Annamaria Cancelleri said was designed to prevent “mafia contagion,” came after months of criminal investigation.

             

Since 2007, over €3 billion has gone from the EU to Calabria, much of that for infrastructure projects, much of that to the ‘Ndrangheta.  While the EU has been able to recover €383 million appropriated to the A3, the potential for future fraud and mismanagement remains high. “The ‘Ndrangheta is like an octopus,” said anti-mafia magistrate Roberto di Palma, “whenever there is money, you will find its tentacles.”

             

The revelations into the corruption scandals come as the European Commission pushes for a 6.8 percent increase in its annual budget, much of that money going towards funding infrastructural projects in Southern and Eastern Europe. The A3 highways symbolizes a fear for many northern European countries that the Eurozone will develop into a welfare state where fiscal stimulus is misspent or lost to graft at taxpayers expense. While infrastructure spending can have enormous benefit, a challenge for the EU will be increasing oversight and accountability as they continue to fund infrastructural projects.

Lithuania Seeks Alternative Natural Gas Sources to Reduce its Energy Dependence on Russia

Business Recorder: Lithuania Sues Russian Gas Giant Gazprom
FT: CEE Nuclear Power: Deeper in Doubt
NYT: Chevron, Intent on European Shale Gas, Buys Lithuanian Stake
Reuters: Chevron to Prospect for Shale Gas in Lithuania
Reuters: Lithuania Gets 16 Proposals to Supply LNG
Reuters: Lithuania Terminal Calls LNG Supply Tender
SF Chronicle: Lithuanians Deal Blow to Austerity, Nuclear Plans
WSJ: Chevron Enters Lithuanian Oil and Gas Exploration 

To reduce its energy dependence on Russia, Lithuania is encouraging private companies to explore for shale gas (a type of natural gas) and actively seeking new liquefied natural gas (LNG) suppliers. Lithuania imports over 60% of its total electricity needs, more than any other European Union (EU) country. In 2009, Lithuania shut down its only atomic power plant, which was built when the country was part of the Soviet Union, due to safety concerns. To make up for this loss of energy, Lithuania began importing more natural gas from Gazprom, a Russian gas company. These imports totaled 3.4 billion cubic meters (bcm) in 2011, or 100% of Lithuania’s natural gas consumption. Countries completely dependent on Gazprom for natural gas have experienced problems in the past. For example, in the winter of 2009, the Ukrainian government entered into a pricing dispute with Gazprom. As a result, Gazprom cut off the country’s gas supply for three weeks leaving hundreds of thousands of Ukrainians without heat. This is why the Lithuanian government recently made energy independence a priority for the country.
   
According to Lithuania’s Prime Minister, Andrius Kubilius, Lithuania has 120 bcm of underground shale gas reserves that could be recovered through specialized extraction methods. In order to access the reserves and reduce its dependence on Gazprom, the Lithuanian government has been auctioning off shale gas exploration licenses to private companies. In May 2012, Minijos Nafta, a Lithuanian oil exploration company, began drilling wells in its license area around Gargzdai. In October 2012, Chevron, the second largest U.S. oil company, announced it was purchasing a 50% stake in LL Investicijos, a privately owned Lithuanian oil and gas exploration company. Investicijos holds a license to prospect for gas on a 2,400 square kilometer field near the town of Rietavas. According to Derek Magness, Chevron’s Director General of onshore European operations, the company believes Lithuania’s government will welcome Chevron’s involvement due to its desire to break free from Gazprom. Prime Minister Kubilius described Chevron’s investment as a “good sign,” and the Ministry of the Environment announced plans to auction off two more licenses to shale gas areas in 2012.
   
The Lithuanian government has also attempted to find new suppliers of LNG to reduce its dependence on Russia. Klaipedos Nafta, a state-owned operator of oil terminals (facilities for storing natural gas), is opening a new LNG storage unit in 2014 that it expects will distribute up to 4 bcm of natural gas to Lithuania each year. In October 2012, Klaipedos Nafta received bids from 16 companies offering to supply LNG to the new storage facility. Rokas Masiulis, Klaipedos Nafta’s Chief Executive, said the number of bids received was “unexpectedly high” and would help put an end to Lithuania’s dependence on a single gas supply source. The bids came from companies all over the world, including the U.S., Qatar, and Norway. Klaipedos Nafta hopes to sign one of these non-Russian companies to a ten year supply contract for 0.75 bcm of natural gas per year. In addition, Klaipedos Nafta entered negotiations with Cheniere Energy, an energy company based in the U.S., to purchase LNG in the spot markets (purchase of gas for immediate delivery at current market prices) beginning in late 2015.
   
The Lithuanian government’s efforts to reduce dependence on Russian natural gas are coming at a critical time for the country. In October 2012, Lithuania filed an international lawsuit against Gazprom seeking approximately $1.9 billion in damages. Lithuania alleged that Gazprom abused its market clout to increase Lithuanian gas prices almost 500% from $84 per cubic meter of gas in 2004 to $497 in 2012. Lithuania’s Prime Minister hopes Gazprom will ultimately agree to a settlement involving more favorable gas prices, but warned the lawsuit could drag on for several years if no settlement is reached. Although Gazprom angrily contested the lawsuit’s allegations, the Lithuanian government’s continued efforts at energy independence may provide a powerful economic incentive for the company to reach a settlement.

Ireland Considers the Benefits and Drawbacks of Additional Austerity Measures

BusinessWeek: Draghi Says No Alternative to Austerity as Economies Shrink
FT: Ireland Revises Growth Forecast Down
Herald: We got it Wrong on Austerity and Made Things Worse – IMF
IMF: Ireland Staff Report For the 2012 Article IV Consultation
Irish Examiner: €3.5bn budget Plan to Stay Despite IMF Admission
Irish Examiner: IMF Chief: Don't Sacrifice Growth for the Sake of Austerity
Irish Examiner: IMF: Failure to Act Could Tip Ireland into Recession
Irish Times: ECB 'Cannot Print Money'
Reuters: Irish Consumer Confidence Sags, More Austerity Feared
WSJ: For Ireland, More Austerity Is a Strain
WSJ: Irish Economy Skirts Recession

There is currently a debate in Ireland about whether or not the Irish government should move forward with an accelerated round of austerity measures (policies designed to reduce federal deficits through cuts in government services and/or increases in taxes). Austerity measures are used to stimulate economic growth by reducing government deficits down to sustainable levels and increasing investor confidence in government finances. Ireland, which experienced a severe financial crisis in 2007, has implemented a series of austerity programs over the last four years. Despite these efforts, the Central Bank of Ireland recently warned that Ireland’s gross domestic product (GDP) will only grow by 0.5% in 2012, 0.2 percentage points less than previously anticipated. Additionally, the Bank forecasts that Ireland’s GDP will grow just 1.7% in 2013, down from a prior forecast of 1.9%. This slowdown in growth, driven by a decrease in demand for Irish exports due to weakness in the global economy, is putting additional pressure on Ireland’s budget. As a result, the Central Bank of Ireland, the European Central Bank (ECB), and many business leaders believe it is important for Ireland to continue reducing its budget deficits through austerity measures in the short run. Others, including some economists and labor unions, believe that additional austerity programs will actually slow Ireland’s economic growth, and that generating tax revenues by increasing domestic demand is the easiest way to reduce deficits in the long run.

Ireland first initiated austerity measures in 2008 to reduce the budget deficit created when the country invested billions of dollars in its banking sector during the 2007 financial crisis. Prior to the financial crisis, Ireland’s deficit-to-GDP ratio was just 25%; however, by 2010 it had increased to over 90% and GDP had fallen by 8%. Between 2008 and 2010, the country managed to reduce its budget deficit by over €15 billion through cuts in government services and increases in taxes. To further reduce its deficits and spur economic growth, Ireland negotiated a €67.5 billion bailout agreement with the European Union (EU) and the International Monetary Fund (IMF) in 2010. This agreement required Ireland to implement an additional €15 billion of austerity measures through 2015. Ireland’s austerity efforts helped pull the Irish economy out of its recession in 2009, and reduce Ireland’s budget deficit by 4.1% between 2009 and 2011. As a result, some analysts have said Ireland has the best chance of all the bailed out countries in the Eurozone to recover from its financial crisis.

To meet the IMF’s €15 billion austerity target, Ireland must implement a final €8.6 billion of austerity measures through 2015, which includes €3.5 billion of deficit reductions in 2013. The Central Bank of Ireland recently advocated accelerating these cuts to reduce the length of time Irish companies will need to worry about the uncertain impact of future austerity measures. The Bank believes the uncertainty surrounding these measures has curtailed many companies’ willingness to invest in growth opportunities in Ireland. The Bank also believes that certain austerity measures, such as cutting public sector pay, will ultimately make Ireland more competitive. The implementation of more austerity measures in Ireland is also supported by the EU. Mario Draghi, the President of the ECB, recently commented that there is no alternative to continued austerity measures for countries receiving bailout funds. He argued that one of the original drivers of the European financial crisis was the “unsustainability of deficits and debt levels."

Unfortunately, due to the amount of cuts Ireland has already made to its budget, new austerity measures are placing increasingly heavy burdens on Ireland’s population that threaten the country’s domestic demand for goods and services. For example, future austerity measures will likely require cuts in child welfare payments and increases in payroll taxes. Other proposed austerity measures include cutting social security and health benefits, and introducing a new tax on households. Some economists and labor unions within Ireland believe these drastic measures will do more harm than good to the Irish economy, and are encouraging the government to reconsider its austerity program. Ide Kearney, an economic research professor at Ireland’s Economic and Social Research Institute, believes additional austerity measures will not improve Ireland’s struggling domestic economy given its dependence on exports to the rest of Europe. Additionally, Jack O’Connor, the leader of Ireland’s largest labor organization, believes that given Ireland’s almost 15% unemployment rate, further cuts to welfare payments might reduce the deficit in the short run, but will weaken domestic demand and prevent Ireland’s economy from growing in the long run.

The IMF also questioned the wisdom of additional austerity measures in a recent academic report that found for every €100 a government saved through an austerity program, it reduced its country’s GDP by between €90 and €170. The IMF admitted that reductions in economic growth resulting from prior austerity measures “worsened [Ireland’s levels of] poverty and inequality.” Future austerity measures are likely to have a similar effect, and media speculation about additional welfare cuts in September of 2012 already caused a 20% drop in Ireland’s consumer expectations index (a measure of the degree of optimism that consumers feel about the future of their economy). Christine Lagarde, the Managing Director of the IMF, summed up Ireland’s difficult choice between reducing its deficit through austerity and encouraging growth in domestic demand to generate tax revenues. She noted that “reducing public debt is incredibly difficult without growth” and that high debt “makes it harder to get growth.” Therefore, she said countries like Ireland have a “very narrow path” to take and must make their spending cuts at just the “right pace” in the medium term in order to sustain growth in the long term.

Ten European Union Countries Consider Implementing a Controversial Tax on Financial Transactions

BBC: Financial Transaction Tax for 10 EU States
CNNMoney: Robin Hood Tax Gains Traction in Europe
Guardian: European Financial Transaction Tax Moves Step Closer
Reuters: EU Commission Backs 10 Countries' Transaction Tax Plan
Telegraph: Financial Transaction Tax Will 'Raise Billions', Says EU Commission
WSJ: Eleven European Countries Support Tax on Transactions

A controversial proposal by ten European Union (EU) member states to tax financial transactions within their borders could help those countries reduce their deficits, but it could also reduce their economic growth and drive their banking and investment businesses offshore toward untaxed financial centers. The proposal by ten EU members, including Germany, France, Italy, Spain, Austria, Belgium, Greece, Portugal, Slovakia, and Slovenia, would impose a 0.1% tax on the trades of stocks and bonds and a 0.01% tax on the trades of derivatives (a contract between two parties whose value depends on other underlying assets). Although the tax on each individual transaction is low, the plan could produce substantial amounts of revenue for the ten countries due to the significant number of transactions completed within their borders each year. France’s European Affairs Minister, Bernard Cazeneuve, said such a plan could generate more than €10 billion per year.

Proponents of the financial transaction tax argue that increased tax revenues could help the ten countries offset their costs associated with the European sovereign debt crisis, including the hundreds of billions of euros spent on bailing out struggling banks. The tax is particularly popular with taxpayers who feel as though they have suffered due to austerity measures (policies designed to reduce federal deficits through cuts in government services and/or increases in taxes) implemented to help fund the rescue of failed banks. According to Jose Manuel Barroso, the President of the European Commission, which functions as the EU’s executive branch, the tax is motivated by “fairness” and is designed to “ensure the costs of the crisis are shared by the financial sector instead of just shouldered by ordinary citizens.” To show support for the tax, members of grassroots organizations have started to dress up as Robin Hood (a fictional character who robbed the rich to help the poor) at public rallies that are reminiscent of the Occupy Wall Street events in the United States.

Opponents of the financial transaction tax, including the U.K., Sweden, the Netherlands, and many other EU members, believe the tax will slow economic growth in Europe, even if just confined to ten countries. A treasury official for the U.K. said the tax could negatively impact the EU’s “real economy” (manufacturing and service production). Many financial transactions are made through pension accounts held by manufacturing companies, and imposing financial transaction taxes on these manufacturers could lower their profitability, which in turn could lower their demand for new workers. Matthew Fell, the Director for Competitive Markets at the Confederation of British Industry, believes a tax on financial transactions could also slow economic growth by making it more expensive for businesses to raise money through the issuance of new debt and equity shares to investors. Businesses typically rely on these share sales to fund their expansions and growth.

Other opponents of the transaction tax, including banks and financial lobbyists, believe the tax will drive financial transactions out of the ten countries covered by the plan and into untaxed financial centers. The European Commission has downplayed this notion by arguing that the tax would apply to both parties in a transaction. For example, an American bank purchasing shares of a German investment fund would still need to pay the tax even if the trade was made in New York, an untaxed financial center. In responding to this argument, a deputy director for the Bank of Italy recently told the Italian parliament it would be easy for the bank to avoid paying the tax by simply moving its investment trading operations to another country. The Swedish government agreed with that assessment based on its experience attempting a similar tax in the 1980s, which ultimately resulted in the loss of transaction activity to other untaxed financial centers.

Although the financial transaction tax proposal would only take effect in ten countries, it still must be approved by a majority of all the EU nations and the European Parliament. Given the small minority of countries supporting this plan, its passage is far from certain. A similar proposal by the European Commission for an EU-wide transaction tax was soundly rejected by a wide majority of EU members last year. However, it is unclear if that majority will block the current proposal due to the economic boost it could provide to countries not enacting the tax. For example, the U.K. soundly rejected last year’s proposal for a transaction tax within its borders and questioned the wisdom of the current proposal, but said it would not block the current proposal’s passage. This support is likely due to the fact that London, as one of the top financial centers in the world, would benefit greatly from an influx of transaction activity seeking to avoid taxation.

Europe Attempts to Avoid Negative Long-Term Consequences of High Youth Employment Rates

European Commission: Youth Opportunities Initiative 
Euro Observer: Youth Unemployment Risks 'Social Disaster' 
WP: As Youth Unemployment Soars, France Offers to Let Companies Hire Young People on its Dime
WP: Unemployment Rate Remains Above 11 Percent in Euro Zone
WSJ: In Europe, Signs of a Jobless Generation

Out of concern for the long-term negative consequences related to youth unemployment, the European Union (EU), along with member state governments and a consortium of private businesses have adopted plans to put young people to work in Europe. In July 2012, the unemployment rate in the EU reached 11.3%, signifying 18 million Europeans were out of work. This was the highest level of unemployment in the EU since the euro was adopted in 1999. European companies have hesitated to invest and hire new workers due to weak consumer spending, triggered in part by government payrolls cuts, higher taxes, and volatility in the financial markets. European companies have also hesitated to expand their work forces because strict European labor laws make it difficult to lay off workers during tough economic times.

While the overall unemployment rate in the EU is high, its youth unemployment rate is even higher. In July 2012, the unemployment rate for workers under the age of 24 reached 22.5%, up from an already high 21.3% one year earlier. However, this increase was not uniform across the EU. The youth unemployment rate actually decreased in ten EU member states during July and increased greatly in several countries located in Europe’s economic periphery, including Greece and Spain. During July, the youth unemployment rate reached 53.8% in Greece and 52.9% in Spain, the highest levels in the EU.

A prolonged high youth unemployment rate has many long-term negative consequences for workers and businesses. A person’s job skills and work experience begin to fade rapidly after about six months of unemployment. This means that the longer a person is unemployed, the harder it becomes for that person to find a permanent job at a competitive wage. The EU’s challenging labor markets have already forced many out of work youth to accept part-time and temporary jobs for low wages. However, the International Labor Organization (ILO) believes that if a person accepts such work early in his or her career, that person will have a more difficult time finding permanent employment with proper advancement opportunities later on. The negative impact from working in these low-level positions can hamper a person’s career for up to 15 years according to Ekkehard Ernst, Chief of the ILO Employment Trends Unit. Businesses can also be hurt by sustained youth unemployment in the long run. As unemployed youth move abroad in search of better job opportunities, companies in countries with high youth unemployment rates will eventually be unable to find qualified workers to fill vacancies.

To prevent these long-term negative consequences, the EU, a group of private businesses, and several member states have adopted plans to put people to work. The EU already contributed €3 billion to education and apprenticeship programs designed to reduce youth unemployment in Greece, Ireland, Italy, Latvia, Lithuania, Portugal, Slovakia, and Spain. The EU also recently proposed a Youth Guarantee program, which would help young people find employment or training opportunities within a few months of losing their jobs. Private businesses are also trying to reduce youth unemployment. A task force at the Business-20 Summit, a gathering of global business leaders, called for companies to increase their apprenticeships and internships by 20% over the next year in order to put young people to work. Several companies have already responded. For example, Starbucks recently launched a twelve-month apprenticeship program in the U.K. Finally, individual governments are trying to reduce youth unemployment within their borders. For instance, the Italian and Spanish governments have proposed tax breaks for businesses that hire young workers. In addition, the French government recently proposed to pay up to 75% of the salaries for young workers hired by private companies during the first three years of their employment. France hopes the plan will put 150,000 new young people to work over the next two years.

Despite the best efforts of the EU, private businesses, and individual member states, youth unemployment is likely to continue to be a problem in Europe going forward. Due to the continuing problems associated with the European financial crisis, the ILO forecasts that over the next five years the youth unemployment rate in the EU will decrease only slightly to 21.4% from 22.4% today. Such a prolonged period of youth unemployment could produce a “lost generation” of young workers who suffer long-term career setbacks. It could also negatively impact long-term business productivity and competitiveness in the countries experiencing the highest rates of youth unemployment today. 

Fiscally Cautious Countries Hesitate to Join Eurozone Amid Fears of Future Bailouts

Bloomberg: Bulgaria’s Stability Will Attract Investment, Barroso Says
Bloomberg: Lithuania to Adopt Euro when Europe is Ready, Kubilius Says
European Commission: Enlargement Website
European Commission: Economic and Financial Affairs Website 
WSJ: Bulgaria’s Lesson for Euro-Skeptics
WSJ: Bulgaria Shelves Plan to Join Ailing Euro Bloc

Fiscally cautious European Union (EU) member countries, including Bulgaria, Lithuania, and Latvia, have recently postponed plans to adopt the euro as their official currency due to concerns over future bailouts for weaker members. There are 27 member countries in the EU, 17 of which have adopted the euro (the Eurozone). The remaining ten countries, with the exception of the United Kingdom (U.K.) and Denmark (who both “opted-out” of the euro), are expected to replace their national currencies with the euro when their economies meet the Eurozone’s  entrance criteria. This criteria includes debt-to-GDP (gross domestic product) ratios below 60%, deficit-to-GDP ratios below 3%, stable exchange rates, low consumer price inflation, and low long-term interest rates.

However, on September 3, 2012, Bulgaria, which joined the European Union in 2007, indefinitely postponed its plans to join the Eurozone. Although the country remains one of the region’s poorest member states, its current debt-to-GDP ratio of 15.3% is one of the lowest in Europe. Although Bulgaria’s leadership anticipates meeting the criteria necessary to join the Eurozone by 2013, the government has decided to keep its own national currency (the lev) for the time being. Bulgaria’s Finance Minister, Simeon Djankov, attributes this decision to the uncertainty of future bailouts, such as those for struggling countries like Spain and Greece. Djankov commented that, “The public rightly wants to know who would we have to bail out when we join?” He went on to say that if his country joined the Eurozone, the lack of fiscal discipline among the region’s weaker members to reduce their deficits and debts could negatively impact Bulgaria’s relatively strong economic growth rate.

Bulgaria’s announcement follows decisions made in August by the Lithuanian and Latvian governments to postpone their own plans to adopt the euro. Lithuania and Latvia, who both joined the EU in 2004, expect to meet the criteria necessary to join the Eurozone by 2014. However, Lithuania’s Prime Minister, Andrius Kubilius, stated that the country would not adopt the euro until there is a stable situation in the Eurozone and it is clear the group is ready for expansion. Similarly, Latvia’s Prime Minister, Valdis Dombrovskis, also backed away from switching to the euro in 2014. Dombrovskis attributed Latvia’s decision to the Eurozone’s failure to control member countries that choose to violate rules on budget deficits, debt, and inflation. If Eurozone countries do not bring their deficits and debts under control, the need for more bailouts would hurt fiscally conservative countries like Latvia.

The decisions by Bulgaria, Lithuania, and Latvia are not evidence that EU member countries find a single, common currency undesirable. Rather, the decisions reflect concern about their liability for future bailouts of weaker countries, and the uncertainty surrounding the Eurozone’s resulting move toward tighter financial integration among members. Bulgaria, Lithuania, and Latvia’s desire for a common currency is demonstrated by the fact that these countries currently tie the exchange rates of their national currencies to the euro. This allows the countries to experience many of the benefits that come from participation in the Eurozone’s monetary union, while avoiding many of the problems associated with bailouts and the loss of control over their own financial decisions.

Corporate Bond Issuances in Europe’s Economic Periphery Face Challenges

Bloomberg: Santander Defies Spain Woes to Sell First Bonds Since March
FT: Peripheral Corporates Eye Bond Sale Window
MarketWatch: Cash-rich Mull Spanish, Italian Corporate Bonds
Reuters: Bond Comeback No Easy Feat for Spanish Corporates
Reuters: DBRS Downgrades Spanish Banks After Sovereign Rating Cut
WSJ: Beware a Corporate-Bond Reversal

Some corporations headquartered in Europe’s economic periphery, which includes Spain and Italy, have experienced difficulties issuing corporate bonds since the first quarter of this year. Other peripheral companies have recently been able to issue corporate bonds, but at much higher interest rates than in the past. Corporations typically issue interest-bearing bonds (bonds that periodically pay interest) to investors in exchange for money. They use this money to refinance existing debt, fund operations, or invest in growth. However, uncertainty surrounding the European sovereign debt crisis has limited investors’ demand for these types of bonds throughout much of 2012.

Investors’ hesitation is due in part to the increased likelihood of downgrades in sovereign debt credit ratings. Countries, like Italy and Spain, issue debt to investors and private credit rating agencies, such as Moody’s and DBRS, publish ratings assessing the investment quality (risk) of that debt. They also rate the debt issued by private companies. A rating agency might downgrade a country’s debt to “junk” status (the lowest grade) if it believes a country will default on its debt (be unable to repay debt or make interest payments). This downgrade will negatively impact the ratings for corporate debt issued in that country. This is because rating agencies often link the debt rating of a company to the debt rating of the country where it is headquartered.  For example, DBRS recently downgraded Spain’s debt to an “A (low)” rating due to its poor economic outlook. As a result of this downgrade, DBRS automatically downgraded several Spanish banks to an “A” rating, one notch above Spain.

Due to their higher risk of default, junk bonds must pay a higher interest rate to investors than investment grade (non-junk) bonds. A downgrade to junk status is problematic for corporate bonds because many investment fund managers are prohibited by fund prospectuses (legal agreements with investors) from investing fund resources in more risky assets, such as junk bonds, despite their higher interest rates. These fund managers must instead focus on less risky and more liquid, or easily tradable, investment grade bonds. According to Bank of America Merrill Lynch, there are approximately €200 billion of investment grade corporate bonds traded in Italy and Spain. If these countries are downgraded to junk status, there would likely be too few investment funds willing and able to invest in junk bonds to absorb this amount of downgraded corporate debt.

Thankfully, many companies in peripheral countries have plenty of cash on hand to operate in the near term without issuing new bonds. However, if investors remain mostly unwilling to purchase new corporate bonds due to the risk of sovereign downgrades in the coming months, it could cause several problems. First, peripheral companies will eventually need to issue new bonds to successfully refinance existing debt. Second, credit rating agencies worry companies without the ability to issue new bonds could run out of money to pay off existing debt and fund future operations. Thus, in order to keep strong debt ratings, credit rating agencies require companies to prove they still have the ability to issue new debt to bond investors. Finally, if companies in Europe’s periphery have trouble issuing new bonds, or can only issue bonds at relatively high interest rates, it could make them less competitive in the long term. These companies would have higher overall interest costs and less ability to expand and grow than companies headquartered in Europe’s economic core—e.g., Germany.

Although they are in the periphery, some Italian and Spanish corporations have recently benefitted from increased investor demand for their bonds. Spurred on by the European Central Bank president Mario Draghi’s remarks that he would do “whatever it takes” to support the euro, some investors are turning to corporate bonds issued by large, financially stable corporations in peripheral countries to put their growing cash holdings to work. For example, Italian bank UniCredit SpA issued €750 million in bonds on August 14. In Spain, Banco Santander SA raised €2 billion from the sale of bonds on August 21. These were the first transactions of their kind since the first quarter of 2012 in either country. Throughout the rest of 2012, analysts expect corporations in Europe’s periphery to issue as much as €10 billion worth of bonds.

Despite the recent increase in investor demand, even financially strong peripheral companies are paying significantly higher interest rates on debt today than they were one year ago. This also is primarily due to the risk of sovereign downgrades in the near future. For example, many investors and analysts fear Italy or Spain could be downgraded to junk status as early as this month. The fear of a sovereign downgrade for Spain is one of the reasons investors demanded Banco Santander pay them an interest rate on the bonds it issued in August that was 1.4 percentage points higher than on bonds the bank issued in March. Given these high interest rates, it is unclear if other financially strong companies in Europe’s periphery, including Spain’s Telefonica, will take advantage of the increase in investor demand and issue bonds in the near future, or wait for more favorable market conditions to return.

U.S. Economic Growth Slows Down

Sources:
FT: U.S. Consumers Cautious on Spending
FT: U.S. Factory Orders Increase in May
FT: U.S. Factory Output at Three-Year Low
FT: U.S. Manufacturing Activity Drops Sharply
NPR: “This Is Not Good”: Factories Show Signs Of Slowing
WSJ: Factory Slump Reaches U.S.

In the beginning of July, the U.S. government released reports showing signs of economic growth slowing down in the country. First, U.S. manufacturing shrank in June for the first time in three years. The Institute for Supply Managements (ISM) said that its index of manufacturing activity fell from 53.5 in May to 49.7 in June. A reading below 50 is an indication of contraction—a decline—in the economy. Anything above 50 signifies an expansion of the economy, or an increase in the level of economic activity and of goods available in the marketplace. This is the lowest reading on the index since July 2009, a month after the recession officially ended. Manufacturing accounts for 12% of the U.S. economy and has been at the forefront of the country’s recovery.

There are many reasons for the contraction in U.S. manufacturing. Americans have cut back on spending which has led to lower demand of manufactured goods. In addition, Europe’s economy is in a recession, which has hurt U.S. exports, because Europeans are buying less goods in general and thus less American-made goods. A recession is a general slowdown in economic activity occurring when the country’s gross domestic product (GDP) declines for two or more consecutive quarters.. It also appears that U.S. manufacturing is likely to stay weak for the next few months as the ISM’s new order index plunged from 60.1 to 47.8. The new order index reflects the levels of new orders of goods and products from customers of manufactured goods. Although this measure is traditionally volatile, such a sharp decline could signal a downturn in the demand for U.S. products overseas. It is the first time this index number has fallen below 50 since April 2009, when the economy was in a recession.

The fewer amount of new orders in manufacturing has left many businesses concerned that U.S GDP growth will further decline. This fear stems from the recent decline to a 1.5% GDP growth rate in the April-June quarter from a 1.9% rate found back in the January-March quarter. U.S. businesses are also concerned about Europe’s financial crisis and the possibility that U.S. lawmakers will not extend a package of tax cuts at the end of the year. Thus, U.S. companies are cutting back on manufacturing and purchasing as well as not increasing their hiring to prepare for a downturn of orders from Europe and higher taxes. Another concern of U.S. businesses is that European manufacturing has remained at its weakest level in three years and continued to decline in the month of June. Meanwhile in other parts of the world, a recent survey shows that China’s industrial sector expanded at its slowest pace in seven months.

U.S. consumer confidence decreased to its lowest level of the year at 73.2% in June, which was another reason for the slowing in manufacturing. Consumer confidence is an economic indicator, which measures the degree of optimism that consumer’s feel about the overall state of the economy and their personal financial situation. In a recent survey given to 5,000 U.S. households, it showed that consumers are concerned about slowing job growth and increasing unemployment. The unemployment rate in June was at 8.2% up from 8.1% in April, with the U.S. economy adding only 69,000 jobs in the month of May and only 80,000 in June. The sharp drop in the ISM index will not help the situation, as it will trigger speculation that the U.S. economy may fall into recession.

In an effort to kick-start the economy, the Federal Reserve extended “Operation Twist,” in which the government sells short-term bonds while buying long-term bonds. The aim of the program is to lower long-term interest rates. By selling shorter-time bonds and using the money from the sale to purchase long-term bonds, the government will increase demand for the longer-term bonds, which in turn will drive up the price of those bonds, and lower the rate of return (yield) of such bonds. The relationship between bond price and yield is inverse, thus as bond prices increase, yield decreases.

Additional signs that America’s economy is feeling the impact of slower growth in China and continued unrest in Europe could cause the U.S. central bank to take more aggressive action , including purchasing financial assets (such as bonds and stocks) as a way to inject more money into the economy. Injecting more money into the economy means that banks will have more cash to lend to each other, to companies, and to any consumer making a large purchase like a car or house. The fall in manufacturing will be of concern to Barack Obama’s re-election campaign as well as his rival Mitt Romney.

Spain Introduces New Reforms to Clean Up Its Banking Sector

Sources:
Bloomberg: Spain Imposes 30 Billion Euros of Provisions on Banks
FT:  Spain in New Bid to Clear Property Assets
Guardian:  Spanish Banks to Face New Scrutiny as Fears Rise
Reuters:  Lack of New Cash Disappoints in Spain Bank Reform
WSJ:  Spain Tries a New Cleanup

On Friday May 11, 2012, the Spanish government introduced new reforms to clean up its banking sector. The Spanish government has struggled to correct its banking crisis, which occurred in 2008 with a property bubble burst—rapid increases in the value of real estate properties to the point of unsustainable levels and ultimately lead to a drastic drop in value. These new reforms mark Spain’s fourth attempt to correct its banking crisis in the past three years and come only a few days after the government part-nationalized the country’s fourth largest bank, Bankia, by claiming a 45% stake. The country’s past reform attempts were likely unsuccessful because Spain’s approach of making gradual changes to its banking sector was not enough to offset the receding economy and falling property values.

The Spanish government imposed two main reforms. First, banks must set aside an additional €30 billion in provisions to cover potential bad loans—provisions, also known as loan loss reserves, require banks to increase their capital. Banks must meet certain capital/asset ratios (also known as capital requirements). For instance, if a bank needs to write-off unpaid loans (assets), then the bank must increase its capital in order to meet the specified capital requirements. Thus, Spain increased the bank's capital requirements to ensure that the banks would have sufficient capital in the event of loan write-offs.

Spain’s provisions cover 45% of a bank’s real estate assets when added to the €54 billion provision increase mandated this past February. The Spanish government decided to allow banks one month to develop a plan to meet the extra provisions. The government also decided to offer five-year loans with a 10% interest rate to those banks struggling to find capital. If a bank fails to pay back these five-year loans, then the loan converts into shares. Therefore, if the bank fails to pay, the government becomes a part owner of the bank.

The second reform is to hire two independent auditors to value the banking sector’s assets. The Spanish government agreed to hire independent auditors after its recent takeover of Bankia. This is because past auditors refused to sign off on Bankia’s accounts when they discovered discrepancies over the value of foreclosed properties and the value of junk loans—loans with a high risk of default. Thus, Spain likely hired independent auditors in hopes that their outside perspective will reveal other discrepancies similar to those discovered in Bankia’s accounts. While the auditors have not yet been identified, Spain’s Economy Minister Luis de Guindos ensured that the auditors have “maximum international prestige.” The hiring of independent auditors with such “international prestige” ensures credibility and confidence in Spain’s banking reform efforts.

Although the International Monetary Fund (IMF) managing director Christine Lagarde welcomed and praised these reforms, others remain skeptical. Many economists, including Columbia University’s Xavier Sala-i-Martín, believe that the €30 billion increase is not enough. Instead, some economists propose that an increase of  €50 billion is necessary.  Other economists worry that the reforms and the nationalization of banks like Bankia will leave Spain with greater debt in the future. This is because the five-year loans Spain offered to banks to finance the required provisions as well as Spain’s nationalization of Bankia could leave the country without reimbursement of its loans to banks and with a large ownership share in failing banks that have little hope of turning a profit. Even investors are skeptical as shares in Spain’s top three banks, which include Banco Santander, BBVA, and Banco Popular, all fell in response to the announcement of the new reforms.

The European Commission recently forecasted that Spain would fail to meet its imposed budget deficit target next year, which is 5.3% of its gross domestic product (GDP). Instead, the European Commission projects Spain’s budget deficit to be 6.4% of its GDP. This suggests that Spain’s austerity measures—policies of drastic cuts on government spending and/or increases in taxes—are not as effective as originally thought. However, these projections do not account for Spain’s newly introduced banking reforms. The Spanish government views the banking sector as a key component to the country’s overall economic recovery and is hopeful that these reforms will help the country meet its future targets as well as restore the banking sector that has continued to struggle since 2008.

Portugal Becomes First Eurozone Country to Ratify EU Fiscal Pact

BBC: Portugal First to Approve EU Fiscal Pact
EU Business: Bailed-out Portugal Takes Lead in Ratifying EU Budget Pact
FT: Portugal Ratifies European Fiscal Treaty
WSJ - Portugal Approves EU Pact

On April 13, the Portuguese Parliament became the first country to approve the European Union’s new Fiscal Pact. Both main political parties supported the Pact while three left-of-center parties wanted the treaty to go through a public referendum. The Pact sets forth strict new rules and penalties for countries running excessive deficits and debts. Under the Pact, member countries’ deficits must not exceed 0.5% of the country’s gross domestic product (GDP), debt must be below 60% of GDP, and countries must add balanced-budget rules to their constitutions or national laws. The European Court of Justice has the power to impose fines on the member countries to ensure that they adhere to these rules.

Currently, the Portuguese Parliament is discussing whether it will add the balanced-budget rules to its constitution or instead pass a law that can be overturned by a two-thirds majority vote. The ruling party favors the limits to be set in the constitution, while the Socialists (the second-largest party in the parliament) are in favor of the second option. Likewise, the parliament is also considering whether it should pass pro-growth clauses to offset the negative effects that would arise from the tough austerity measures (spending cuts and tax increases) the country will have to impose to bring the debt and deficit within the Pact limits. Many other European leaders share this desire to spur growth while reducing deficits, including French Presidential candidate Francois Hollande who has pledged to pass such growth provisions if he wins the election in May.

By ratifying the Pact, Portugal aims to demonstrate to the European Union and investors that the country, which received a €78 billion ($102.86 billion) bailout, is committed to bringing down its deficit and debt. As of December 2011, Portugal’s government debt was 90.6% of GDP and its deficit was 5.2% of GDP—well above the limits set out in the Pact. Although Portugal is not expected to immediately abide by the debt and deficit limits (the European Commission will establish the time frame for compliance based on Portugal’s individual economic situation), the country faces a tough road ahead as it imposes austerity measures to comply with the Pact. Economists expect the Portuguese economy to contract by 3.3% this year and unemployment to rise to nearly 15% as there has been a sharp fall in internal demand in the country due to the lower wages and increased taxes.

Fitch Upgrades Greek Debt Amidst Debt Writedown

Sources:
Bloomberg: Greece has Rating Upgraded by Fitch
Boston Globe: Greek Debt Upgraded, but Outlook Still Grim
Business Day: Fitch Lifts Greece out of Default Territory
Eurostat News Release: Euro Area Government Debt Down to 87.4% of GDP


On Tuesday March 14, credit rating agency Fitch upgraded future Greek bonds from a “restricted default” to a B- rating. Fitch is the first of the major ratings agencies to upgrade Greek debt. The main reason for the improved outlook is the recent debt write-down, or “haircut,” accepted by 83.5% of private investors holding Greek bonds. The haircut will result in private debt holders taking investment losses of more than 70%, which includes both lost interest and principal, and will cut Greece’s debt burden by $159 billion—about one third of Greece’s total debt. Fitch also assigned a “stable outlook” for Greece, meaning it is not expected to change Greece’s rating again in the near future.

The B- rating applies to all future bonds Greece issues. Unfortunately, a B- rating qualifies as junk status, meaning Greek debt is not viewed as a stable investment in the international markets and regulations prevent some institutional investors from purchasing junk bonds. Foreign-law bonds, which are not governed by Greek law and therefore were not forced to agree with the Greek 70% haircut, maintained their C rating based on the uncertainty surrounding their debt write-down settlement scheduled for April 11.

The debt write-down is a positive sign for Greece. First, the haircut was a central aspect in the Eurozone and IMF deal agreeing to provide $226 billion in bailout funds over the next few years. That total includes amounts not yet disbursed from the initial Greek bailout, along with $170 billion in new bailout funds. Second, the write-down significantly decreases Greece’s debt-to-GDP ratio. Currently, the Greek debt-to-GDP ratio stands at approximately 160%, but an IMF report claims that the write-down paves the way for the ratio to fall to 116.5% by 2020 and 88% by 2030. However, that same report notes that the country’s debt-to-GDP ratio could remain as high as 145% in 2020 if Greece is not financially disciplined.

Even amidst the debt upgrade, international debt experts warn that Greece’s recovery is still a long way off, meaning employment and economic growth will be slower than expected. While the debt writedown paves the way for the immediate disbursement of bailout funds, Greece must continue to meet fiscal targets every three months set by international creditors to receive future bailout funds. While the debt haircut greatly decreases Greece’s current obligations and led to a ratings upgrade, the financial future of Greece remains very unclear.

Spain Set to Breach Deficit Limits for 2012

FT: Spain Defies EU Over Deficit Rules
NYT: Spain
Telegraph: Spain Planning to Breach EU Budget Targets
WSJ: Euro-Zone Ministers Press Spain for a Deal on Deficits

Earlier this month, Spanish Prime Minister Mariano Rajoy announced that the country would not be able to meet its intended budget deficit target for this year. The country had previously set a fiscal deficit target of 4.4% of gross domestic product (GDP) in an effort to reassure Eurozone leaders and investors of Spain’s commitment to tougher fiscal measures. However, due to Spain’s current economic situation, Mr. Rajoy expects this year’s fiscal deficit to surpass the set target and reach 5.8% of GDP.

According to Mr. Rajoy, Spain’s current economic situation makes it difficult for the country to implement further austerity measures (spending cuts and tax increases) needed to meet the 4.4% of GDP deficit target. The Spanish government already passed a €15 billion austerity plan in December 2011 to reduce the deficit. Further tax increases and spending cuts could seriously hurt growth and make it even more difficult for the country to bring its fiscal deficit down. When taxes increase, demand falls as consumers have less income to use to purchase goods. The decrease in consumption causes companies, faced with less revenue, to lay off workers, thus increasing unemployment. Spending cuts such as lowering wages and reducing unemployment benefits can also dampen demand.

It is not feasible for Spain to meet its deficit target since the nation’s 2011 budget deficit was higher than the previous government forecasted. The actual 2011 deficit was 8.5% of GDP compared with a target of 6%. Since the deficit for the previous year was higher than what the government forecasted, the measures taken to bring down the deficit would not be enough to bring down the deficit to the set target. In addition, the current government has predicted that GDP will shrink by 1.7% this year, compared with the growth predicted by the previous government when the original deficit target was agreed. Growth helps to combat deficit as the government will have higher revenues from tax collection. Thus, this slowdown in growth will make it even more difficult for the country to bring the deficit down.

The news of Spain’s higher-than-expected fiscal deficit caused Eurozone leaders to increase pressure on the country to lower its deficit. On March 12, Eurozone finance ministers reached an agreement with Spain for the country to make additional efforts to cut its budget deficit by an additional 0.5% of GDP this year. Mr. Rajoy has stated that despite that higher deficit, Spain will continue to work on achieving the goal of a 3% deficit in 2013, which would bring the country into compliance with European Union law.

Ireland to Hold Vote on European Fiscal Pact

Sources:
FT: Ireland Calls Vote on European Fiscal Pact
Guardian: Ireland Set for Referendum on Eurozone Fiscal Treaty
Spiegel: A Decisive Moment for Ireland
WSJ: Ireland to Hold Referendum on EU Treaty

On Tuesday February 28, Ireland’s Prime Minister Enda Kenny announced that the country would hold a referendum on the recently-agreed-to European Fiscal Pact. The Pact sets tough deficit limits as well as strict enforcement mechanisms to prevent Eurozone countries from accumulating large amounts of debt. Under the Pact, member countries’ deficits must not exceed 0.5% of the country’s gross domestic product (GDP), debt must be below 60% of GDP, and countries must add balanced-budget rules to their constitutions. Within the next three months, at least twelve Eurozone countries must ratify the Pact for it to come into effect, but not all countries must follow Ireland’s lead and hold a referendum.

Under the Irish constitution, a public vote is necessary to ratify any significant transfer of decision-making power to the European Union (EU). However, Ireland’s past experiences have shown a suspicion towards further European integration. The Irish people have twice rejected EU treaties (in 2001 and 2008), only to approve them in second referendums after certain concessions in the treaties were made to appease Ireland’s voters. Thus, European leaders are concerned that the referendum will not pass. If Irish voters reject the Pact, the most immediate result would be that the Irish government would lose access to financial assistance from the European Stability Mechanism (ESM)—the Eurozone’s bailout fund, according to a provision of the Pact. Further, if Irish citizens vote “no” it could lead to uncertainty in financial markets as investors lose confidence in Ireland and the Eurozone’s ability to create more binding and enforceable fiscal rules.

Nonetheless, Prime Minister Kenny is optimistic that the Irish people will reaffirm their commitment to the Eurozone. There is a general consensus among economists and observers that Ireland still needs external assistance from the “Troika” (a group comprised of the European Commission, the European Central Bank and the International Monetary Fund in charge of monitoring the economic situation in distressed countries) and the ESM for its economic recovery. Thus, the referendum will show whether the Irish people are willing to cede additional decision-making powers to the EU or, as in the past, certain concessions in the Pact will need to be made to win their support.

Greece Acts to Prevent March Default

Sources:
BBC: Greece MPs Pass Austerity Plan Amid Violent Protests
FT: Greece Passes Vote as Violence Erupts
Spiegel: Violent Clashes as Parliament Passes Austerity Bill

On February 12, Greek lawmakers approved a series of tough austerity measures aimed at clearing the path for a second rescue package worth €130 billion. The measures are part of the conditions set forth by the European Union (EU) and the International Monetary Fund (IMF) in providing Greece with the bailout package. Greece needs the rescue package to make its next payment on its debt, which is due on March 20. Without such aid, the country will default on its debt. Such a “messy” default could endanger the Eurozone’s financial stability and even lead to dissolution.

European leaders set two conditions for Greece to receive the €130 billion aid package. First, all Greek political party leaders must agree to the austerity and reform program designed by the “troika” (a group composed of the European Commission, the European Central Bank and the IMF in charge of monitoring the economic situation in distressed countries). To satisfy the first condition, Greek leaders passed an austerity package providing for €3.3 billion ($4.35 billion) in budget cuts this year, including 15,000 layoffs in the public sector, €300 million in pension cuts, and a 20% cut to the minimum wage from €751 to €586 per month. However, for those under the age of twenty-five, the minimum wage will be cut 30%, which means living on €525 a month. The plan also states that public sector salaries will be frozen until unemployment drops from its current 20.9% to 10%, and the government will liberalize labor laws to make it easier for employers to lay off workers.

The second condition of the €130 billion aid package calls for Greece to negotiate with its private bond creditors (which currently own about €200 billion in Greek debt) to take a “haircut” (loss) of at least fifty percent of their claims. The goal of this is to ensure that the country’s debt, which currently stands at 163% of GDP, will fall to 120% by 2020. As part of the bill passed on February 12, Greece will provide a bond swap for private creditors that will cut the value of their bond holdings by about seventy percent. In a bond swap, creditors will exchange their current Greek bonds for new bonds worth seventy percent less than the exchanged bond. Thus, by enacting measures to satisfy both conditions, economists expect Greece to receive the bailout package.

Europe Seeks Chinese Support

NYT: China Considers Offering Aid in Europe’s Debt Crisis
Spiegel: Merkel Seeks Euro Zone Investments from Beijing
WSJ: Wen Rejects Fears China Is Out to 'Buy' Europe

Last week, during her visit to China, German Chancellor Angela Merkel sought to persuade the Chinese government to increase its investment in Europe. China has approximately $3.18 trillion in foreign exchange reserves, putting the country in a strong financial position to make significant contributions to help alleviate the European debt crisis. European leaders want China to purchase bonds from economically weaker countries in the Eurozone. An increase in Chinese bond purchases could help restore investors’ confidence in Europe as it would signal that a financial powerhouse (China) believes that European leaders are on the right path to overcoming the crisis. China already has been acquiring bonds from the economically stronger European countries.

Chinese officials are currently examining whether the country should increase its participation in Europe by investing in the region’s two rescue funds—the existing European Financial Stability Facility and the newly created European Stability Mechanism. In addition, Prime Minister Wen Jiabao also stated that China is considering working with the International Monetary Fund (IMF) to channel contributions to Europe. In other words, China would lend funds to the IMF, which in turn would relend the money to European countries in need. This lending scheme would effectively transfer a significant portion of the risk of any European debt default to the IMF—allowing China to shield itself from the risk of lending to unstable European economies. It would not be the first time countries have used such a lending approach to aid Europe. In December 2011, Russia lent the IMF $20 billion to assist Europe, while Britain is also currently considering sending more money to the organization to help with the region’s troubles. Lending through the IMF is attractive to these countries because of the conditionality and oversight powers of the institution. An IMF loan is provided under an “arrangement” which specifies conditions and measures that the country must implement to receive the entire loan. The country receives the loan in installments and the IMF oversees the implementation of the conditions before each installment is disbursed. Thus, the IMF ensures that European countries are implementing the necessary measures to combat the crisis.

It is in China’s best interest to help Europe overcome the debt crisis. Europe is China’s largest export market and China imports the vast majority of its technology from Europe. However, due to the European crisis, Chinese exports have decreased. As instability in Europe worsens, the demand for Chinese goods will continue to decrease with consumers further cutting down on spending. Lower demand will in turn negatively affect the Chinese economy—which relies heavily on exports to Europe. Thus, by aiding Europe in its debt crisis, China is also helping its own economy by maintaining a stable import and export sector.

Europe Agrees on Tougher Fiscal Measures

Sources:
Economist: “A Deal, But to What End?”
EU: Treaty on Stability, Coordination and Governance in the Economic and Monetary Union
Washington Post: Britain, Czechs snub Europe’s fiscal pact but won’t forge an alliance of critics
WSJ: Europe Tightens Fiscal Ties

On Monday, European leaders agreed on a new fiscal plan to combat the region’s debt crisis and restore investor confidence in the Europe. The plan sets tough budget and deficit limits as well as strict enforcement mechanisms to prevent Eurozone countries from accumulating the large amounts of debt that have put the entire region in jeopardy. As of now, twenty-five member countries have agreed to sign the treaty, including all seventeen Eurozone nations and eight other European Union (EU) countries. The United Kingdom and the Czech Republic are the only two EU countries that have yet to approve.

The new “fiscal compact” treaty states that member countries must maintain their structural deficits (deficits over a prolonged period of time) either balanced—meaning deficits cannot exceed 0.5% of the country’s gross domestic product (GDP)—or in surplus. In addition, the pact will require governments to reduce their total debts to 60% of GDP or below over time. If a country’s debt-to-GDP ratio is significantly below 60%, it will be allowed to have a deficit of up to 1%. At this time, the Stability and Growth Pact (which currently controls the deficit and debt limits of countries in the European Monetary Union) limits annual budget deficits to 3% of GDP and government debt to 60% of GDP. However, the SGP has shown to be ineffective in its enforcement mechanisms, as countries have been able to accumulate large amounts of debt and reach deficits well above the 3% limit without consequences.

Another important aspect of the new fiscal plan is that if a country deviates significantly from the agreed limits, a correction mechanism will be triggered automatically. The European Court of Justice will have the power to impose fines of up to 0.1% of GDP to countries that have excessive deficits, which means, for instance, that Italy could have to pay fines as high as $2 billion. However, countries will be allowed to deviate from the set limits in exceptional circumstances such as during periods of severe economic decline.

The treaty will likely come in to force on January 1, 2013. However, countries are not expected to immediately abide by the rules. Instead, the European Commission will establish the time frame under which governments need to comply on a case-by-case basis to take into account each country’s economic situation.

IMF Urges More Drastic Action in Europe

FT: Lagarde Calls for Bigger Eurozone Firewall
IMF: Lagarde Calls For Urgent Action So 2012 Can Be ‘Year of Healing'
WSJ: Lagarde Says Europe Must Boost Firewall


On Monday, IMF Managing Director Christine Lagarde called for quick action on the part of Eurozone leaders to implement policies designed to promote growth, increase the size of Europe’s bailout fund, and further integrate the Eurozone. The warning comes as the region faces a depression similar to the one that occurred in the United States during the 1930s if the crisis is not contained.

Lagarde stated that, with the Eurozone economy slowing down drastically, there is a risk that growth in the region will fall by 1.6% in 2012. This downturn could make it more burdensome for already distressed European economies to meet their debt obligations. Less economic growth means governments collect less tax revenue (as consumer demand decreases, companies lay off workers leading to less available income to be taxed) which in turn cuts the government revenue necessary to repay debt. For this reason, Lagarde urged the European Central Bank (ECB)—the entity in charge of monetary policy for the Eurozone—to take stronger measures to stimulate economic activity, such as lowering interest rates. Lower interest rates stimulate business investment by making investment projects more profitable to start as the cost of financing such investments is cheaper. With a reduced cost of investment, businesses purchase more goods, build new factories and warehouses, and employ more people. All this new activity creates more income for both businesses and people, which stimulates the economy. Likewise, banks need to establish guidelines aimed at preventing a dramatic worsening of the crisis. For example, implementing better regulatory oversight systems will ensure that banks always have enough capital reserves to be able to sustain themselves when risky investments fail. This change will ensure that banks have enough money to continue to continue lending to consumers and businesses even if they sustain losses. Finally, Lagarde urged countries to tighten their finances quickly by implementing policies directed at reducing government spending and raising taxes.

Additionally, Lagarde stressed the importance of European leaders increasing the bailout fund currently in place—the European Financial Stability Fund (EFSF). Without a larger fund, countries such as Italy and Spain that are currently solvent (capable of repaying their debt) would not be able to continue meeting their financial obligations if the crisis worsens and these countries need a bailout. Lagarde suggested merging the EFSF into the European Stability Mechanism (ESM) as well as doubling the ESM’s resources to approximately €1 trillion. Doing so would help prevent defaults and the negative consequences that may go along with them. Also, by boosting this “firewall” fund, Europe will be able to help banks in the region raise their cash levels without cutting down on lending since the fund can provide financing to banks as well.

Lastly, Lagarde called for greater fiscal integration in the Eurozone. Currently, member countries retain complete control over their fiscal (taxing and spending) policies, while the European Central Bank is in charge of monetary policy for the entire region. However, the current crisis has exposed the ineffectiveness of this system. Although European leaders are currently in talks to implement a “fiscal compact” to limit countries’ budget deficits, Lagarde believes there also needs to be a more cohesive fiscal policy among the countries. To achieve this goal, she calls for the creation of euro bonds---bonds that are backed by all by all the countries in the Eurozone. The euro bonds would make nations’ debt a shared burden while at the same time giving investors more confidence in the region as there is a lower risk on bonds guaranteed by the entire Eurozone.

Eurozone’s Bailout Fund Suffers Credit Downgrade

Sources:
FT: S&P Downgrades Eurozone Bail-out Fund
Reuters: Rescue Fund Downgrade Raises Pressure on Euro Zone
WSJ: S&P Cuts Rating on Europe's Bailout Fund
Telegraph: S&P cuts EFSF bail-out fund rating: statement in full

On Monday, the credit rating agency Standard & Poor’s lowered the credit rating of the Eurozone’s bailout fund, the European Financial Stability Facility’s (EFSF), one notch from its top AAA rating to AA+. The downgrade comes, in part, as a result of S&P’s decision on January 13th to lower the AAA ratings of France and Austria—two of the fund’s guarantors—as well as the Eurozone’s inability to adequately contain the region’s debt crisis. The fund still retains its AAA rating from credit agencies Moody’s and Fitch.

The EFSF’s main function is to safeguard financial stability in Europe by providing financial assistance to Eurozone countries. To do so, the EFSF issues bonds or other debt instruments on capital markets to raise the money necessary to lend to struggling Eurozone governments. The fund is backed by guarantees from Eurozone countries and derives its credit rating from the ratings of those countries. To maintain its AAA rating, the EFSF’s bonds could only be guaranteed by AAA rated countries. However, following the lowering of the ratings on France, Austria, and several other countries, the EFSF bonds are no longer fully supported by the guarantees of only AAA rated countries.

The credit downgrade of the EFSF could potentially lead to higher lending costs for countries borrowing from the EFSF. This is because the fund’s lending capacity would now have to be reduced (as there are fewer AAA guarantors) or the remaining AAA countries (such as Germany) would have to agree to increase the amount of their guarantees. However, Germany has already rejected raising its contribution to the fund, leaving the EFSF to attract investors by promising to pay higher premiums (return for the investor, but additional cost for the borrower). Nonetheless, last Tuesday, the EFSF managed to successfully sell its full target amount of €1.5 billion ($1.9 billion) of six-month bills at a yield of 0.2664% compared to a yield of 0.222% when it was rated AAA, signaling that robust demand still exists for ESFS debt.

Lastly, in an effort to increase the bailout fund’s lending capacity and effectively deal with the debt crisis, Eurozone leaders have accelerated the implementation of the European Stability Mechanism (ESM) (which will replace the EFSF as a bailout fund) to July 2012. The ESM differs from the current EFSF fund in that it is funded through paid-in capital provided by Eurozone countries, instead of just guarantees as with the EFSF. Also, the ESM would have a lending capacity of 500 billion euros—much larger than that of the EFSF. Thus, the ESM should offer lower lending costs since investors should be more willing to purchase bonds that are backed by capital rather than guarantees. In any event, the downgrade of the EFSF will make it more costly for troubled economies in the Eurozone to get financial aid and harder for the region to contain the debt crisis.