Today, leaders of the European Union are at a crossroads with regard to economic governance. They can choose to go down the path of 'more Europe" or that of more 'nationalism'. And indeed it appears that under duress from social resistance to reform (specifically to fiscal austerity measures), EU leaders are being tempted down the path of no action or delayed action, possibly resulting in the break up of the Economic and Monetary Union on account of lax fiscal policy discipline.
Alternatively, EU leaders could gather the political will necessary to implement fiscal consolidation, develop and put to immediate use an economic programme of sustainable and manageable growth, in a last ditch bid to save the Monetary Union.
The situation in the euro area countries is more difficult than that of the rest of the EU, as fiscal imbalances in countries that are part of the Monetary Union can lead to much more severe consequences than those outside the union. For example, if a country within a monetary union sees investors fleeing as a result of a down-grading of government bonds, that country’s government may lose control over the liquidity required to roll over its debt (the interest rate on its bond is pushed up by the markets, the government bond becoming subject to speculative attack), while already having no control over the exchange rate of the common currency. If severe, this situation can lead to bankruptcy of the state, unless the Central Bank acts as a lender of last resort and investors are reassured that the country will receive the necessary liquidity, and undertake the required reforms in order to re-establish its solvency.
And indeed, this is what has been happening. Lack of adherence to the Stability and Growth Pact in the EU has put a number of countries at risk. The outburst of the sovereign debt problem has thus become the driving force for EU leaders to fill the gap in the EU architecture, and strengthen economic governance and coordination among its Member States.
Caught in a challenging economic situation caused by the recent financial and economic crisis, and seeing the EU project falling apart in front of their eyes, the EU authorities did start working on a ‚more Europe’ solution by channelling their efforts into putting the EU economic governance in order; which has yielded a number of positive results:
- the framework of the EU-2020 Strategy provides national EU governments with a sense of direction for the European entity;
- the European Semester of policy coordination helps line up each EU Member State’s country-specific annual objectives before they are adopted at home.
- should an EU Member State deviate from the set course of action, they become subject to the enhanced Stability and Growth Pact (SGP) rules, the so called „six-pack” of legislative proposals.
- should an EU Member State faces serious liquidity or solvency concerns, it will be able to turn to the European Stability Mechanism (ESM) for financial support and the economic stabilisation and consolidation programme.
However, while EU leaders have been negotiating on the common solution (since September 2009), the unfolding sovereign debt crisis has been sending waves of unrest into the financial markets, pushing the 10-year government bond spreads of several euro area countries sky high, making it even more costly for the troubled governments to meet their debt obligations.
In theory, greater economic coordination, if respected and fulfilled in a timely fashion by all parties involved, will help bring about greater economic stability and alignment across the economic policies implemented at national level. Such an approach will contribute to a favourable environment for banks in the European Union to conduct their primary role of financial intermediation between lenders and borrowers and thus oil the wheels of the economy. However, to be successful, the enhanced SGP should be adopted in a timely and responsible manner, and be supported by a complete and all-encompassing commitment from all EU Member States. This is why these six legislative proposals need to be agreed upon under the Polish EU Presidency in order to be finalised as soon as possible.
From the banking perspective, turbulence experienced in public finances over the past 18 months, has been directly affecting the stability of those banks exposed to the risk of national sovereign debt.
In practical terms, owing to the fact that government bonds are generally treated as the safest possible investment in the bank funding structure, a number of banks exposed to government debt face the risk of having their liquidity positions undermined and their liquid assets downgraded. Chart 3, based on the figures of the Bank for International Settlement (BIS), depicts the fact that recently downgraded US government bond rating carries implications for the European banks’ consolidated foreign claims to the amount of around USD 753 billion. The recent speculation about a possible downgrade of French government bond rating would send a wave of unrest to European banks as their consolidated foreign claims amount to over USD 150 billion.
Such a destabilising event increases the cost of funding for banks, and, depending on the degree of diversification of the banking system’s assets, may in turn cause shortage of liquidity. As the lender to the European economy, the banking sector is tightly linked to the well-being of the producers of goods and service providers. This is why it is so important for the economy in general, and more specifically for banking, that economic policies are sound and – since we subscribe to a monetary union – coordinated and respectful of the SGP rules.
The problem of a stronger national sentiment, dominating over the need to move towards a common European goal, remains an obstacle in the negotiations on the Package of Six Legislative Proposals in the Council. The tendency of European leaders to agree on a solution at the very last moment makes those solutions very costly and politically weak. This undermines the already fragile confidence of the financial markets in the solid growth prospects, so very much needed for the European economy to forge on, out of the post-crisis anaemia. While politicians are making up their minds on the final touches of the ‚six-pack’, the European Central Bank, as the lender of last resort, has been holding the fort. But although the ECB has a stronghold in terms of government bond purchase programmes, it too has its limits, and if politicians take too long, it might just be too late to save the Monetary Union.
Adviser, European Banking Federation
This article is written in the personal capacity of the author and does not necessarily represent the views of the EBF