Crisis across the Eurozone is just getting started

Allister Heath
LOOKING at the chaos in the markets and the Eurozone yesterday, it would be tempting to claim that the sovereign debt crisis is nearing its endgame. But that would be the wrong call to make. The crisis is intensifying, obviously, but political incompetence in the European Union, as well as its faulty political institutions, means that it is going to drag on and on. There will be no quick resolution, merely a prolonged, horribly slow death.

Despite Greece’s inability to meet any of its deficit targets or actually introduce promised reforms, the Eurozone insists that the Athens government won’t technically default. But EU finance ministers have rightly and belatedly decided to reconsider the absurdly low level of the haircut that private bondholders are going to face. It is currently just 21 per cent. A figure of 50 per cent is being discussed – but even that would still be too low. Something closer to 70 per cent would make more sense.

But when that eventually happens, the pressure will then become immense for financial institutions to mark down substantially other Eurozone debt held in their available for sale portfolios. Those who dismiss the credit default swap (CDS) markets – which suggest massively higher risks of default for many countries, especially in the Club Med – as meaningless because of their illiquidity have a partial point – but only a fool would entirely ignore such a key financial indicator, especially when it is accompanied by rocketing bond yields.

Belgium’s basket case bank Dexia’s biggest problem is that it has a large exposure to dodgy sovereign debt; writing it down properly will prove to be a bitter blow (hilariously, this wasn't detected by the Eurozone’s stress tests). Many French banks have also further to go in terms of writing down Greek debt (though Société Générale has very little exposure left so would be fine on that front). But the entire financial system – and that includes insurers and pensions funds – would be in trouble if they have to start writing down substantially the value of their Italian and Spanish debt.

But the Eurozone’s woes are not just due to idiotic, profligate governments or to the single currency’s internal contradictions. The massive, almost nuclear impact of the capital and especially liquidity provisions of Basel III are a crucial component of the story. While the reforms were meant to be phased in over time, worried investors are forcing Eurozone banks to speed up their implementation. Some banks are contracting their balance sheets; others are withdrawing credit lines; all are reducing their loans to other banks (which are much costlier under Basel III) and all are desperately scrambling to reduce their dependence on wholesale markets.

Meanwhile, wealth destruction will continue apace. Equity investors are being trashed everywhere, commodities are down (even gold is way off its recent peaks, partly because of margin selling), real house prices are down, emerging markets are suffering, inflation is slashing savers’ cash (a problem which is bound to worsen if and when the Bank of England launches another round of quantitative easing, possibly as early as this week) and only a few supposedly safe (in reality bubble-like) bond markets are generating good but entirely unsustainable returns for investors. The last thing everybody needs is a long, drawn-out crisis in the Eurozone, overshadowing the next 18 months at least.

Tragically, however, that is exactly what we are going to get.
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