Is Europe About to Collapse? Not if It Restructures Sovereign Debt

05/09/2011 02:04 pm ET | Updated Jul 09, 2011
  • Georges Ugeux Chairman and CEO, Galileo Global Advisors and Adjunct professor at Columbia Law School

Recent news from the European side of the Atlantic is not good. With €270 ($400) billion in bailout plans for three relatively small European countries (Greece, Ireland and Portugal), more than half the resources of the European Financial Stability Fund (EFSF), the easy task is done.

The rescue of Portugal was announced last week and included severe measures that will put the country in recession for most of the next three years. As a precondition for this action, the IMF and the European Union required an approval by both the majority and the opposition. The Parliament approved it.

The Greek situation remains the most worrying. With 2-year yields at 25%, Greek sovereign bonds are worse than junk. Standard & Poor's just downgraded Greece from BB to B, making the situation even worse.

Two main challenges lie ahead.

The first one is the relative fragility of Spain. The restructuring of the banking sector is aiming at the second-tier institutions, mostly the Cajas de Ahorros (local savings banks). It should be manageable since Spain did not enter the financial crisis with an excessive sovereign debt level. A meaningful bailout of Spain, if it were to happen, would exhaust the EFSF's intervention capability and require a substantial increase to its publicly announced €750 ($1,150) billion. While Italy has some fragility within its banking sector (mostly the Cassa Popolare di Milano) it might avoid such a treatment. A bailout of Italy would have to be six times as big as Greece's. It would purely and simply create a collapse of the European financial system.

The second one is the social element: so far, despite demonstrations on the street, the austerity measures have started to be put in place. Surprisingly, the trade unions, after violently expressing their opposition to the austerity measures that were aiming at the workers and pensioners, eventually surrendered to the obvious. That support, however, is fragile. There is a non-insignificant risk of European social unrest that could rise to the level of some of the Middle Eastern unrest.

Those two fronts are therefore as essential as they are delicate to handle. The freedom of maneuver is limited. There is, however, something that is not quite right in the European bailout. It is the refusal by the European Governments, the European Central Bank and the countries concerned to even envisage a restructuring of their sovereign debt. Ever since the IMF started helping countries in difficulty to face similar situations, restructuring of the sovereign debt was on top of the agenda. Why would Europe not go through the same exercise?

The answer lies in the immense power of European banks on their national Governments. Some of them have balance sheets representing a multiple of their country's GDP while the largest U.S. bank only reach a fraction. Most financing in Europe goes through the bank balance sheets. Since banks are important holders of European sovereign debt, including those of the countries in crisis, a restructuring of the debt would require them to take a write-off on their core holdings of these bonds. So far, they hold those securities at... their nominal value. This will be accepted by Europe for its "banking stress tests" and therefore, they will be meaningless.

Restructuring is also a way to share the pain with the public at large. This is where the social fear, the limits of the EFSF and the structural banking fragility meet. Without an immediate restructuring of sovereign debt of the ailing countries, the European bailouts will only be the burden of their citizens and crush consumers and growth. Without a serious debt restructuring, all Europe is doing is buying time and worsening the problem.

It is now at the mercy of any confidence crisis that could erupt in the markets as it did last Friday when the absurd notion of Greece leaving the Euro erupted. Europe is on a tightrope. It can explode at any moment. European Governments and authorities know it. They are consciously running the risk of their own collapse, and a world crisis as a consequence.