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Friday, October 21, 2011

The UK and the Eurozone cannot afford another non-solution from this weekend’s summit

Over on Conservative Home we highlight that this weekend's (and now next week's as well) EU summit is important for the UK and not just the eurozone:
In addition to dealing with important EU issues at home, the UK government will face a huge challenge at this weekend’s EU summit – it will have the chance to act as the voice of reason amongst the cacophony of empty promises and grand gestures. Make no mistake, the eurozone crisis and the policies aimed at solving it can and do affect our economy. As our recent briefing highlights, under a Greek and Portuguese restructuring and accounting for the market prices of Irish, Spanish and Italian debt (a worst case scenario), the necessary recapitalisation of UK banks could total between £21bn - £45bn – that some of this would need to come from UK taxpayers should be enough to convince anyone of the gravity of the situation.

Certainly, there is no shortage of suggestions that the UK government could make to eurozone leaders. Let us start with their plan to use the EFSF, the eurozone’s bailout, to insure some part of peripheral sovereign debt.

The thrust of the plan is that €440bn worth of EFSF funds would be used to offer a guarantee of 20% on new, mainly, Italian and Spanish sovereign debt, therefore leveraging the coverage of the fund five times. This creates a circular situation where countries such as Italy and Spain are guaranteeing their own debt, making the extra insurance almost worthless in the case of a default (exactly when it is needed). The UK government could also point out the irony in the fact that, despite making insurance of sovereign debt the foundation of their latest eurozone ‘solution’, the same leaders have just imposed extra unnecessary financial regulation on the use of credit default swaps (a valid form of default insurance).

There’s also a worrying comparison to be made between the origins of the financial crisis and many of the solutions which the eurozone is now considering. European leaders seem to have settled on ‘leverage’ as the answer to all their problems. The logic that it’s easy to institute and will ‘never really be called upon’ rings of the financial instruments that helped create the financial crisis. Furthermore, putting a fund which will hold an abundance of similar assets exposed to the same risks and will create huge unfunded liabilities at the heart of an already unstable and divisive monetary union is asking for trouble.

Given the UK’s exposure to the crisis and the knock on effects it could have on its economy, the government cannot give its support, even tacitly, to such flawed proposals. A failed solution to the eurozone crisis could have just as many negative effects for the UK as no solution at all. Increasing liabilities and continuing to shift debt around the eurozone (mainly from the private sector to the public sector) has not only failed, but looks to be the predominant cause of the growing political unrest in many eurozone countries.

As our recent briefing points out the only viable short term option for the eurozone remains a debt restructuring in Greece and Portugal and a full recapitalisation of European banks. The UK government has another opportunity to grasp this, it would do well to take it, otherwise we could end up with yet another non-solution to the crisis, which not only the eurozone but also the UK can no longer afford.

1 comment:

Anonymous said...

Banks can't be recapitalized until the sovereign debt issue is resolved. Without knowing future actions and accompanying costs, shoring up the banks makes little sense.

Markets are practically shouting (via bond yields) that they assume a default for Portugal, Spain & Italy, regardless of what editorials or politicians think.