Racing Against the Eurozone's Butterfly Effect
BRUSSELS -- In late August, Christine Lagarde, the newly appointed managing director of the International Monetary Fund, called for “urgent recapitalization” of European banks in order to cut “the chains of contagion” emanating from the euro crisis. The same day, Jean-Claude Trichet, governor of the European Central Bank, swiftly dismissed concerns about a liquidity problem in Europe. But Mrs. Lagarde had said out loud what many central bankers were discussing in private: the exposure of European banks to Greek sovereign debt might trigger a liquidity shortage throughout the European Union that would have worldwide repercussions. Under this feared chain-reaction scenario, few analysts expected the French-Belgium bank Dexia to be the first victim. Indeed, the bank had received €6 billion in aid in 2008, and its assets were estimated in early October of this year to be 96 times its €5.4 billion exposure to the Greek debt. Above all, it had easily passed the European Banking Authority’s (EBA) stress test last July. On September 23, discarding any reason for concern, the governor of the Belgium Central Bank assured the public that Dexia Belgium was “not in trouble.” It did not take long for this to be proven false. In mid-October, the French, Belgian, and Luxembourg governments were forced to dismantle Dexia. After a 14-hour board meeting, it was decided that the Belgian state would take complete control of the bank’s depositary activities in the country, at price tag of €4 billion, and that France would set up a new municipal-lending entity, another of Dexia’s activities, to be jointly owned by the Banque Postale and the Caisse des Dépôts et Consignations (CDC). Finally, a “bad bank” would be created, to hold Dexia’s bad debts, backed by a split €90 billion guarantee (Belgium: 60.5 percent, France: 36.5 percent, Luxembourg: 3 percent). It all went very quickly.
But, in the end, the bank did not collapse; it was dismantled. Its nationalization in Belgium showed governments’ readiness to intervene promptly in the banking sector. And despite initial fears, there was no major bank run, no dramatic spillover. It simply worked. While being pressured by growing public indignation, as well as ongoing discrete preparations for a probable Greek default, EU leaders demonstrated their determination to make difficult decisions at the national level when most needed. But such an isolated reaction is not sufficient to exit the crisis. When EU Council President Herman Van Rompuy postponed the EU Summit last week to this coming Sunday, he wanted time “to finalize our comprehensive strategy on the euro area sovereign debt crisis covering a number of interrelated issues.” The ambition of the summit was set: agreeing on a comprehensive plan to solve the crisis. The blueprint, being drafted by France and Germany, converges positions on reducing Greece’s debt, stopping contagion, and protecting European banks, and is designed to pull other eurozone member states toward more intervention and coordination. It is this same fully coordinated action that European Commission President José Manuel Barroso has called for in proposing to increase bank capital requirements to 9 percent in the EU. Indeed, Europe has done much more than it is generally given credit for in a short period of time.
Since Mrs. Lagarde chastised Europe, the ECB has bought €160 billion of Greek debt, and it will offer unlimited liquidity at least until July 2012. Dexia was rescued. France and Germany agreed on the principles of bank recapitalization. The markets and the euro plunged and rose again. And support for a change in the governing EU Treaty is seriously being considered. Yet, more is needed. G20 finance ministers, who gathered in Paris in mid-October, urged the EU to “decisively address the current challenges through a comprehensive plan” on October 23. And, according to U.S. Treasury Secretary Timothy Geithner, “When France and Germany agree on a plan together and decide to act, big things are possible.” No pressure! Dexia’s dismantlement proved that the risk of contagion is real, but, also, that such contagion can be contained by a subtle dosage of government intervention. This is not surprising, at least in Europe. Following Fitch’s downgrades of four European banks, and warnings over potential failures of revised regulatory stress tests by the EBA, coordinating bank recapitalizations of up to €300 billion across the EU is a natural step forward. But this is just a tactical move and should not be hailed as a grand strategy sufficient to exit the crisis. By setting critical deadlines, by playing the “EU survival” card every two weeks, policymakers are raising the stakes, artificially boosting belief in an immediate solution to the crisis. Bank recapitalization is not a solution per se. It is a means to restore some stability while knowingly taking the risk that new restrictions on banks may hamper private investment.
As German Finance Minister Wolfgang Schäuble rightly has warned, although a package of policies should be agreed upon on October 23, “providing cover for uncertainty in financial markets,” a permanent solution is unlikely to be produced at the summit. In response to this statement, which was backed by German Chancellor Angela Merkel’s cabinet, stocks fell sharply worldwide. The past year has demonstrated that artificial deadlines to survival cannot be met on both sides of the Atlantic. And why should they when policy adjustments are needed daily? It is unlikely “big things” will be decided this weekend. But time is short. The eurozone butterfly’s wings are fluttering faster and faster. And that’s one economic forecast no one can accurately predict.
Guillaume Xavier-Bender is a Program Associate with the Economic Policy Program of the German Marshall Fund in Brussels.
The views expressed in GMF publications and commentary are the views of the author alone.