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This is an archive article published on December 14, 2011
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Opinion Seizing the initiative for Europe

Germany and France have led the creation of a new fiscal protocol that could potentially calm global financial markets

indianexpress

MK VENU

December 14, 2011 03:53 AM IST First published on: Dec 14, 2011 at 03:53 AM IST

Humans have a natural tendency to allow a crisis to fester to a point where it threatens to engulf everyone. Corrective action typically comes at the last minute,preceded by much drama and flow of emotions. So it was with the 17 eurozone countries whose leaders brainstormed for 10 hours last Friday and decided to formally agree to much stricter,integrated budget rules for the single currency area to deal with their mounting debt crises. The intent of collectively wanting to follow tighter fiscal norms and resolving temporary liquidity problems would help improve market sentiment in the weeks and months to come. This is also critical for fast growing economies like India,whose vast infrastructure financing needs are funded substantially by large European banks that are unwilling to lend in an uncertain environment. Consequently,Europe’s fiscal stability,or even a perception that it is gradually moving towards it,has a profound impact on India’s external sector,which is suddenly looking quite vulnerable as foreign capital inflows have slowed quite sharply this year.

In substantive terms,Germany and France led the creation of a new fiscal protocol which has the potential to bring sanity to global financial markets that have been suffering periodic seizures,sending government bond markets into a tizzy. The most important decision which will soothe the financial markets is the promise to ensure that private investors holding government bonds will not be asked to take haircuts in the future. It may be recalled that private investors,largely banks that lend to governments,were asked to take a 50 per cent haircut recently on their Greek bond holdings. Since then,private investors have been extremely nervous at the thought that the same story might get repeated with bigger economies like Italy and Spain whose bond yields were soaring to crisis levels recently as investors were selling their bonds in panic. The assurance that private investors will not have to take haircuts is most reassuring for the financial sector,which lubricates the real economy.

The main provisions of the new agreement include:

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a) A cap of 0.5 per cent of GDP on countries’ annual structural deficits. By definition,structural deficit is caused by a spending item which cannot be withdrawn in the longer term,such as higher salaries.

b) “Automatic consequences”,in the form of sanctions against countries whose public deficit exceeds 3 per cent of GDP.

c) The EU’s permanent bailout facility,the European Stability Mechanism (ESM),to be fast-tracked and operationalised by July 2012.

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d) The adequacy of $666-billion limit for the ESM to be reviewed.

e) The eurozone and other EU countries to provide up to 200bn euros to the International Monetary Fund (IMF) to help debt-stricken eurozone members.

Taken together,all these measures are bound to bring some relief to the financial markets. It will also bring some stability to European banks whose health is critical for the global economy. Looked at objectively,the magnitude of the current national debt and potential structural deficits due to higher welfare spending in the future is slightly less worrisome in the EU than what exists in the United States. However,the US manages to keep financial markets calm because of its ability to take quick decisions on printing more money and injecting liquidity in the system to prevent the bond markets from going into a tailspin. This does not happen in the Eurozone because of obvious reasons. Too many governments have to agree on critical decisions to inject more liquidity to calm the bond markets. This creates a permanent feeling of crises. The new fiscal package may mitigate this perception of a permanent crisis which is refusing to subside. The promise to review the ESM fund size of $666 billion,which was seen as inadequate by many,and the decision to advance the operationalisation of the ESM to July 2012,are very significant in the context of calming the financial markets in the short run.

The timing of the new agreement is also very significant. The three big economies of the eurozone area — Italy,Germany and France — have to repay debt of nearly $700 billion,which is maturing early next year. The total debt repayment obligation by 17 eurozone economies in the next five to six months is of the order of $1.5 trillion. Since the bigger economies like France,Italy and Germany have to repay nearly 40 per cent of the total debt maturing in the next few months,one can assume that the big boys are serious about implementing the new pact and calming the financial markets.

The real shock to the financial markets was delivered a few weeks ago when the bond yields of the strongest eurozone economy,Germany,began to flare up. That was a sharp message to Germany that even if your real economy is in good shape,too much uncertainty in the financial markets can take anyone down. Perhaps this message is what has made Germany seize the leadership firmly to avoid further prevarication.

So the next three months are most crucial as the 17 eurozone economies,and others who are aspiring to join the euro,will work together to bring sanity to financial markets. The United Kingdom staying out of the pact really does not matter as it has ceased to punch the kind of economic weight that it did decades ago. Of course,sceptics are suggesting that a “two-speed” European Union will disintegrate sooner or later. Most likely,they will be proved wrong because in the weeks ahead,more big decisions could be taken by Germany and France to further consolidate the situation.

For instance,the Italian prime minister has hinted at an enhanced role for the European Central Bank(ECB),and the evolution of a common euro bond,which will be seen as far more stable,is not off the table yet. As I said at the outset,Germany and France have developed a much bigger stake in a substantive resolution of the euro crisis because the financial markets in recent weeks have started sending strong signals that continued uncertainty could take even the bigger and better economies down. This message,in a way,has galvanised the big boys into taking concrete action. Continued drift in the eurozone could also have caused serious external sector problems for emerging market economies like India — with rapidly depreciating currencies — who are net capital importers. There is now some evidence to suggest that the worst may be over in Europe.

The writer is managing editor,‘The Financial Express’
mk.venu@expressindia.com