Euro zone sees light at end of tunnel, pitfalls remain

BRUSSELS: There are no calls for celebration, no desire to relax in
the corridors of Brussels but some officials believe the euro zone has
turned a corner, sharpening the focus on longer-term reforms and
structures.
Despite a messy bailout of Cyprus, markets are calm,
Ireland's rescue program is on track and Greece and Portugal, while
still in recession, hope for a slow recovery next year.
Slovenia's
banks are a concern, but one that policymakers are confident they can
deal with. And although Malta's banking system is vast compared with its
economy, it is not structured in the same way as in Cyprus. The same
goes for Luxembourg.
Spain's bank restructuring appears to be working.
"All
the skeletons are out of the closet," said one senior official who has
spent much of the past three years working on the crisis. "There are no
more major issues in the pipeline."
It is a line of thinking shared by European Central Bank policymaker Yves Mersch, who said on Wednesday he did not expect another country to "slump further".
The
relative calm has given officials in Brussels breathing space, and the
signs are that several countries, including France and Spain, could be
given an extra year or two to meet their budget deficit goals. The
policy of austerity remains, but the pace of fiscal consolidation will
ease.
Yet none of that means the bigger issues underpinning the
crisis are resolved. While the existential threat may have passed, the
need to implement tough and unpopular structural reforms remains, and
plans for tighter oversight and control of banks via a 'banking union'
are not even half-way there.
"With Cyprus, we have hit the lowest
trough of the crisis," said Peterson's Jacob Kirkegaard of the Peterson
Institute for International Economics, a think tank in Washington.
"Although
we might be down here for a little while longer, due to risks of an
aggravated euro-area credit crunch, there is light at the end of the
tunnel. Cyprus is now focusing minds on the structural repair of the
euro area, such as banking union."
Although the renewed
confidence is principally down to the European Central Bank's promise to
support the single currency whatever it takes, it has allowed Brussels
to soften the orthodoxy of budget austerity - despite the misgivings of
Germany.
"The pace of fiscal consolidation is now slowing down in
Europe," Olli Rehn, the European commissioner for economic affairs,
told the European Parliament on Thursday. "We have the room to make
fiscal policy with a more medium-term view."
Other taboos are
being broken. In the bailout of Cyprus, losses were forced on large bank
depositors, opening the way for a similar approach elsewhere. The power
to impose such losses will be written into EU law, reducing the risk
that taxpayers will have to foot the bill.
"The one thing that
Cyprus did was to partially remove the direct linkage between the
sovereign and the banks by bailing in the depositors and bondholders,"
said Tony Stringer, a government debt analyst with credit-rating agency
Fitch.
But the euro zone has to keep a delicate balance. On
Thursday, Rehn said structural changes were in part responsible for
affording the euro zone extra flexibility, but he underscored the
importance of sticking to promised reforms.
"The banking union is essential to reverse the process of financial fragmentation in Europe," he said.
If it unravels, confidence could just as rapidly disappear.
GENIE OUT OF BOTTLE
Many
dangers lie ahead. First off, most member states still have to fully
implement tough reforms to rehabilitate their economies by raising
productivity, cutting labor costs and overhauling their pension systems,
even as they are dropping deeper into recession.
That painful process of reform is going to take years to complete, with the risk that it will be rejected by voters.
Secondly,
the botched initial attempt to impose losses on small savers in Cyprus
could gradually erode confidence, prompting depositors to withdraw money
if they fear a similar "bail-in" elsewhere.
"There is clearly a
risk that when you make a proposal that insured deposits can be bailed
in, you have let the genie out of the bottle," said Stringer. "It is
then difficult to convince people that this option will never be
considered."
Thirdly, the controls on capital movement in Cyprus have cast a cloud of uncertainty over Europe.
"If
you cannot access or transfer euros in Cyprus, it will call into
question whether there is a fragmentation of the currency," said
Stringer. "It's difficult to argue that a euro in Cyprus is the same as a
euro in Germany."
But perhaps the biggest risk, as in the past,
is that Europe's political will to change could falter. That is
especially true when it comes to establish a banking union, including
ECB supervision as well as an agency and fund to close bad banks. It is a
concern at the forefront of officials' minds.
As the sense of
crisis has eased, Berlin has cooled to the idea for fear that it could
be left on the hook for reckless lending in other countries. Without
German support, the whole scheme will falter.
Finance Minister Wolfgang Schaeuble
put a brake on plans in mid-April when he said banking union needed a
change to the EU treaty, a cumbersome process most member states want to
avoid.
CALM
Yet despite those concerns, and in contrast to earlier chapters of the financial crisis, financial markets remain calm.
Borrowing
costs in Ireland, where yields on the government's 10-year bonds shot
above 8 percent before the country was bailed out in November 2011, are
now down to 3.8 percent.
Benchmark yields in Italy and Spain are
also far below their peaks, indicating a much lower level of perceived
risk by investors, despite the continued political uncertainty in Italy
and the possibility that Spain may need further support.
Another
sign of confidence is that banks in southern Europe rely less on the ECB
for funding, according to central bank data. That trend continued after
the Cyprus bailout, signaling that they are finding it easier to raise
funding normally.
"The lack of market reaction illustrates that
investors are convinced that the euro isn't going to break up," said
Kirkegaard of the Peterson Institute.
Over the longer term, as Europe wallows in recession and voter resentment hardens, however, the mood could darken.
"Forecasts
for economic recovery, including our own, keep on getting pushed back,"
said Fitch's Stringer. "First it was 2011, now 2012 and then 2013. The
big worry is that Europe will suffer a lost decade, as Japan has done."
Francesco
Papadia, the former head of the European Central Bank's financial
market operations and one of the inner circle around former ECB President Jean-Claude Trichet, understands the risks in the delicate balancing act to sustain confidence.
"The mess in Cyprus was horrible," he said. "I'm surprised that the market has taken ... events so much in its stride.
"But
if Italy says we'll run our own finances not Brussels or Merkel says
forget about banking union, for example, then tensions could come back
with a vengeance." - Reuters