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Is Europe Still in an Economic Downswing?



The International Monetary Fund (IMF) has revised its economic forecast downward to −0.6 percent for 2013,1 making it unlikely that the real economy will turn worse in the short run. But the latest euro area economic data project a gradual and surprising recovery in the second half of 2013. The second quarter numbers in mid-August are a likely non-event—if anything they will show a slightly improved outlook. The European Central Bank (ECB) is thus unlikely to change its rates before its updated macroeconomic forecast in September.

But the ECB did dole out a nonstandard goodie this month, announcing several changes to its credit risk control framework for collateral consisting of asset backed securities (ABS). Seeking to promote the ABS market in Europe, the central bank will now accept such securities that bear an A rating, rather than AAA, as collateral in its monetary policy operations, thereby accepting additional, limited credit risk on to its balance sheet in order to assist European ABS market liquidity and issuance.2 Moreover, the ECB will "continue to investigate how to catalyse recent initiatives by European institutions to improve funding conditions for Small and Medium-sized Enterprises (SMEs), in particular as regards the possible acceptance of SME linked ABS guaranteed mezzanine tranches as Eurosystem collateral in line with established guarantee policies."

This was an example of euro area quid pro quo. The ECB might accept even lower rated collateral in return for credit or fiscal guarantees from the European Investment Bank (EIB), the European Stability Mechanism (ESM), the European Commission, or national member state governments.3 Responsibility for increasing access to credit for peripheral euro area SMEs was thus put on governments and other European institutions. Unless other European institutions or member states take the initiative—highly unlikely for now—the SME credit crunch will not be fixed in the short-term. The goal, however, will not be achieved until completion of a tough, transparent, and credible bank asset quality review plus stress test in mid-2014, however.

Is there a chance that the IMF will spoil the summer calm in Europe? The IMF has a rule that any program must be fully financed 12 months ahead of time for the Fund to disburse money. In addition, financing gaps for Portugal and Greece have opened up and must be addressed. (The gaps result from delayed Troika program implementation and worse macro-economic performance.) Moreover, the IMF recently published a staff paper recalling the failure to restructure early in Greece and another paper looking to reopen the broader discussion about sovereign debt restructurings.

But the possibility that another round of losses imposed on creditors is extremely unlikely. With the global economy already slowing, few members of the IMF board will want to provoke economic instability. Despite some internal tension on the matter, the IMF board would prefer instead to continue to fudge the issue and accept the euro area political guarantees to keep troubled countries solvent and avoid financial risks to the IMF as the senior creditor.

My colleague Douglas Rediker pointed out to me how the recent IMF report on this issue is actually quite bland in its discussion of changes to the global sovereign debt restructuring framework, noting "[T]he paper does not provide reform proposals, but notes areas where further work would be needed to inform any change to the existing framework.4" This is not a settled IMF position.

But it is far from obvious that a position by the IMF favoring more losses on creditors—private sector involvement, or PSI—could force the issue. The money required to close the short-term financing gaps in Greece and Portugal is only €20 billion,5 assuming that program money already committed but not used to bank recapitalizations cannot be redirected. Sums of that magnitude are well within the financial capacity of the European Financial Stability Fund (EFSF)6 to cover. Facing a hardline IMF position, the euro area members might finance such requirements themselves, shutting the fund out of euro area crisis management.

Key euro area policymakers—in Berlin, for example—will be grateful for the finances and technical assistance provided to date by the IMF. But as the euro area stabilizes, the IMF is likely to be seen as less indispensable to Europe's crisis management. Forcing another round of PSI could well end the Troika arrangement, an outcome that is already advocated by some in the euro area. To begin with, other euro area countries will not likely accept such an IMF ultimatum. Why risk their credibility over a few billion euros? The danger of contagion from a new Portuguese PSI, which would be implemented in a country that has debts approximately equal to Italy's as percent of GDP, would be huge. The case for "Italy is next" would be obvious. Consequently, German finance minister, Wolfgang Schaüble, who pushed for the first Greek debt restructuring, has ruled out such a step repeatedly.

Ending direct IMF influence on crisis management in the euro area would, moreover, not go unnoticed in other regions of the world. Countries in future crises might well try to rely on strictly regional initiatives, rather than face an almost preemptive IMF call for PSI when long-term debt sustainability is in doubt. Thus by insisting on more PSI in the euro area soon, the IMF risks marginalizing itself on global policymaking and crisis management.

Finally, any gains from more PSI in Greece or Portugal would be negligible. Most of their debt is held by domestic banks, the official sector or, in the case of Greece, in long-term and low yielding previously swapped securities. New haircuts cannot achieve any material financial difference at this point. This would be even truer if softer versions of PSI, such as maturity extensions of outstanding privately held bonds, were imposed.7

The issue of "moral hazard"—punishing reckless lenders and protecting taxpayers—has not disappeared, of course. But its importance is less because of the relatively modest financing gaps for countries in the third or fourth year of recession. Political concerns over moral hazard in the euro area are outweighed by the risks of contagion and limited financial gains from such an action. Because Portuguese program compliance has been generally good, and Greek compliance improved, moral hazard concerns are less urgent. Spain and Italy present different considerations. For one thing, Spain is not like in an IMF program country. It has market access and—without much difficulty—€60 billion available from its €100 billion bank rescue in 2012. In addition, the Partido Popular (PP) has an absolute majority in parliament. Despite corruption and party financing scandals, Prime Minister Mariano Rajoy faces no dramatic political problems in the short run. The opposition Socialist Party (PSOE) under Alfredo Perez Rubalacaba lacks the votes to force the prime minister to resign and, in any case, is in disarray and fearful of early elections. Despite a financing scandal, the PP will not likely abandon Rajoy, at least in part because so many of its leaders are implicated in corruption and the party thus has no obvious successor available. Rajoy and the PP have little choice but to stay the course and hope for recovery before the 2015 election.

Irrefutable legal evidence of Rajoy being on the take could bring him down, but such a discovery seems unlikely despite leaks in the Spanish media. If such evidence existed, we would have known by now. And Spain does not have a tradition for independent judicial activism by investigative judges. Few Spanish officials and bankers have faced legal sanctions from their role in the Spanish crisis. Ultimately, Spain's political elite will likely choose to keep Rajoy.

In Italy, the coalition under Prime Minister Enrico Letta seems dogged by political instability, the norm in Rome. Fights will continue over whether, how or when to repeal the infamous property tax imposed by former Prime Minister Mario Monti, and the shenanigans over the deportation of the family of a Kazakh dissident. But early elections also seem unlikely because President Giorgio Napolitano will not call for them until completion of a new election law and election of a new leader for the Democratic Party.

Meanwhile the Italian Supreme Court upheld former Prime Minister Silvio Berlusconi's conviction to four years in jail for tax evasion, corruption, and false accounting on August 1. Because of his age, Berlusconi may escape jail. But the Supreme Court has kept open the possibility of his being banned from public office for three to five years. The Senate must now decide whether he is fit to remain a member of Parliament.

Were the Supreme Court to ban Berlusconi from public office, there will likely be a period of horse-trading to determine his role in his People of Freedom (PdL) party, which would face an uncertain future without its founder at the helm.

In sum, European politics may be entertaining this summer but will continue in relative economic and market stability ushered in by Mario Draghi, president of the ECB, a year ago. Pax Draghi will likely persist.


1. Year-over-year growth forecast. The IMF in line with the 2H recovery projects positive 0.3 percent Q4/Q4 growth.

2. The ECB at the same time made several other minor revisions to its overall collateral framework and haircuts, which reduces the amount of eligible collateral. Consequently, the ECB notes that "These measures taken together have an overall neutral effect on the amount of collateral available."

3. National member state guarantees will likely be made off-balance sheet so as to not add to their Maastricht criteria debt/deficits levels.

4. Page 6.

5. Note that potential future debt relief required for Greece will be considerably larger.

6. The EFSF not the ESM will in all probability cover financing requirements of these existing programs.

7. It is of course always possible that say the Portuguese government can implement swaps of domestically held securities with government-linked counterparties, but such transactions hardly qualify as PSI.

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