Fariborz Moshirian

Last week’s Franco-German summit provided a foundation for deeper fiscal convergence amongst the Euro zone countries in the medium term. However, it failed to satisfy the expectations of the market which wanted to see much bolder action immediately.

The QE 2 provided ample US dollars to maintain liquidity in the market and now that this source of funds has disappeared, there are signs that European banks are seeking greater access to dollar market funds and requesting that the ECB provide them with US dollars.

The request made by the New York Federal Reserve to major banks in Europe asking them to ensure that they have adequate cash to deal with their day to day obligations in the US, in the wake of further financial turmoil in Europe, has created greater sensitivity in the market. This process has made the market nervous about the health of European banks and hence the market will focus on European banks in the coming days and weeks. This may well increase the interbank lending rate and create liquidity problems in the banking system. While some may argue that the ECB will be ready, as the lender of last resort, to ensure liquidity is not frozen, there is a limit to how much intervention the ECB can make in the market.

Indeed, there is some concern about the ability of the ECB to be able to continue purchasing government bonds from Italy and Spain over time. The ECB is acting as a de-facto Government or Treasury for the Euro zone. The ECB may continue this role if all the national parliaments of the Euro zone area do not ratify the European Financial Stability Fund’s (EFSF) mission by the end of September. However this role is unsustainable in the long term.

Both Germany and France have flagged that they do not intend to increase the funding of the EFSF from its current 440 billion Euro, as they are fearful that if they increase the amount now, the market will demand more. However, the idea of turning the EFSF into a bank and use this as a way of financing the needs of the member countries may not address the current concerns of the market. Only six European countries are still triple A rated to could ensure that the EFSF will remain a triple A fund. However, further transfers of funds from countries such as France into the EFSF may lead to France losing its triple A rating. Furthermore, the market is looking for bolder action. Merely allowing small economies such as Greece or Ireland access to the EFSF or Italy and Spain to roll over their debt in the next few years are no longer the only concerns for the market.

The Euro zone has lost its steam for generating economic growth. Greece’s economy is now expected to shrink by 4.5 this year. The German economy has slowed down. As the market is now nervous about European banks, the Euro zone leaders may have to take bolder action to either save the Euro and the Euro zone or prepare for a break down of the current monetary union.

Given Germany’s commitment to the Euro, the market is keen to see the Euro zone embrace full fiscal union and in this process allow the formation of Euro zone bonds that will be supported by all member countries. The concern is that small nations will over use euro bonds without any scrutiny, in the way they used the low interest rates of the ECB associated with monetary union, to borrow too much. However, similar to the US Federal system, Euro bonds should emerge as part of a full package that includes requiring small economies to forgo their fiscal independence and be subject to scrutiny by the EC and have a clear cap as to the amount of Euro bonds that they can use. On the other hand, larger economies may see their support and guarantee of the Euro zone bonds as a more effective way to contribute to the current financial turmoil in Europe than being forced by the market to pay more to rescue their large banks which have been exposed to the sovereign debt crisis, to provide more capital for investment, as foreign capital is fleeing the Euro zone rapidly, to spend more to stimulate the Euro zone’s sluggish economy, to spend more to stimulate their export market within Europe and be prepared to pay for a rise in the cost of capital.

The emergence of Euro bonds will create a unique opportunity for Europe to directly compete with US treasury bonds and attract much needed foreign capital to its shores. Large demand for euro-bonds may well bring its yield lower than the current German bond yield and allow for stronger economies in Europe to access cheaper capital and more investment opportunities.

German demands for an increase in the competitiveness of other member countries may not mean that they all become like the German economy. However, competitiveness could increase, if foreign capital moves back to small member countries in Europe and complement the austerity measures that are now in place in more than five countries there.

One of the underlying causes of the financial turmoil is a leadership crisis in Europe. Bold leadership on the part of Germany and France would not only address the current sovereign debt and banking crises but would also ensure that both Germany and France emerge economically stronger, and that capital will flow back into smaller economies. This will result in more consumption and spending in the Euro zone which will ultimately benefit Germany’s exports and German workers’ jobs over time.

Professor Fariborz Moshirian  is a Professor of Finance and Director of the Insitute of Global Finance at UNSW.

A version of this opinion piece appeared in the Australian Financial Review on the 25 August 2011.