Rescue plan falls flat with debt markets

The early take on the euro rescue plan is as straight-forward as the plan was vague: It is probably not going to work. Two numbers tell the tale: 1.77, the number of percentage points in excess of German debt that the supposedly AAA-rated euro rescue fund had to pay to borrow Monday; and 6.67, the percentage yield on Italian 10-year bonds.

Neither of those numbers fits in well with the plan announced last week to recapitalise banks, bail out Greece, erect a firewall around the larger weak economies and produce credible plans for fiscal and economic improvements.

Put simply, those numbers are telling us that the market and debt investors do not believe the plan will work in its current form. And little wonder. It is just days later, and the Greek government has fallen, Prime Minister Silvio Berlusconi of Italy is under siege and the much-hoped-for support from outsiders like China has failed to materialise.

When the rescue fund, the European Financial Stability Facility, tried to sell €3 billion, or $4.1 billion, worth of 10-year debt Monday, it just managed to scrape up the cash and had to pay much more than it had in the past. In some ways, that is no surprise; the rescue plan was vague about crucial details of how the fund would be structured and how it would employ leverage.

Hopes that China and other emerging powerhouses would step up and support the plan have so far gone exactly nowhere.

Accumulated trouble

Not only did President Hu Jintao of China leave France after the Group of 20 summit meeting without committing, but the head of the Chinese sovereign wealth fund went so far as to attack European “sloth”.

“If you look at the troubles which happened in European countries, this is purely because of the accumulated troubles of the worn-out welfare society,” sovereign fund China Investment Corp chairman of the board Jin Liqun, told Al-Jazeera television. “The labour laws induce sloth.”

As if that were not enough, British Prime Minister David Cameron recently said that the Group of 20 had withheld extra commitments to the International Monetary Fund because of a lack of faith in the plan.

“The world sent a clear message to the euro zone at this summit: Sort yourselves out and then we will help, not the other way round,” Cameron told the British Parliament.

All of that is before we get to the high level of political instability the crisis has wrought.
Greece is pulling together a temporary technocratic government, but meanwhile, larger problems come to the foreground. While it is undoubtedly a good thing if the Arab Spring has jumped the Mediterranean and spread to Italy, the fact of Berlusconi’s weakness, welcome as it is for so many fundamental reasons, only underscores just how difficult it will be to make the moving pieces of the plan fit.

Berlusconi, under pressure to step down to clear the way for change, refused to cooperate, even as Italian borrowing costs hit critical levels, with two-year Italian yields hitting a euro-era high of 6.31 per cent. That is perhaps worse than the rise in 10-year yields and is very similar to what happened to other euro zone peripheral countries before they were shut out of the bond markets.

It is not clear that even the fall of Berlusconi will solve Europe’s problems, though it may temporarily drive Italian borrowing levels down. The huge jump in Italian rates since the bailout was announced indicates instead that Italy, seeing the deal given to Greece, has less reason to resolve to change its ways.

At the same time, Italy’s vulnerability calls into question Europe’s ability and willingness to make a truly huge transfer of wealth southward from Germany.

The logic is self-reinforcing: the bigger the prospective crisis, the less reason Germany, has to stick with the euro and the more reason it has to stand tough against things like the suggestion that it put its gold reserves to work backing the rescue fund. The two things to watch now are the Swiss franc and signs of deposit flight out of Italy, Portugal and Spain.

Depositors in Italy, for example, have good reason to wonder whether they should not hedge their bets by pulling out of banks there, on the small chance that the crisis might lead to Italy’s expulsion or Germany’s flight. Some of that money would head for the tunnels into Switzerland, so any signs of reviewed strengthening in the Swiss franc should be closely monitored.

Europe is going to need some unaccustomed luck in coming weeks. The rest of us ought to hope it gets it but should perhaps prepare for the increasing chance that it will not.