Gloom over the future of the euro zone is starting to lift after months of crisis, with policy makers sounding increasingly confident that the worst is over. There are still plenty of risks. Economic growth is fragile, governments must keep the political will to impose austerity steps for years to come, and small banks in the hardest-hit countries remain unable to borrow in the markets, making them dependent on the European Central Bank for funds. But in the past several days financial markets have reacted positively to details of planned stress tests on European banks, while sales of Spanish and Portuguese government debt have seen strong demand. European bank shares have rallied almost 10 percent and the euro hit a seven-week high versus the dollar.
“This has been the most difficult six months in the history of the European Union,” European Commission President Jose Manuel Barroso said this week. “There has been a stress test on the EU and on our ability to work together.” But he made clear that he believed Europe had come through that test, and his political rivals in the European Parliament, the European Socialists, for once appeared to agree with him. “The speculative attack against the euro has been slowed down. The speculators are seeing the EU is protecting its currency,” Socialist leader Martin Schulz told the assembly.
A major factor worrying markets in the first half of this year was the difficulty which euro zone states had in agreeing on how to stave off debt defaults by countries on the southern periphery of the region. The political and ideological differences between governments have not all been resolved. But most aspects of an emergency mechanism to handle the crisis are now in place, and the EU has at least started efforts to address the long-term causes of its debt crisis. A 110 billion euro ($140 billion) bailout of Greece, agreed in early May, is buying time for Athens to reform its finances. The launch of a European Financial Stability Facility, which could borrow up to 440 billion euros to help struggling countries, has been delayed by the resistance of tiny Slovakia, but strong diplomatic efforts seem likely to overcome that obstacle this month. While there is scepticism about how accurate the EU’s stress tests of its banks will be, the unprecedented decision to test 91 institutions and publish results for individual banks suggests the bloc is more serious about confronting the problem than it was just weeks ago. The 27-country EU has also set up a task force to review its budget rules, tighten fiscal discipline and increase economic policy coordination. ECB President Jean-Claude Trichet signalled on Thursday that he felt these measures were beginning to restore markets’ confidence, saying the central bank might lean towards cutting back further its emergency programme of buying government bonds. French Economy Minister Christine Lagarde told U.S. broadcaster PBS on Wednesday that the worst was over. We are in the middle of the beginning of the end. The crisis has really hit its peak,” she said.
SPREADS STILL HIGH
Prices in several key markets show investors are still nervous. The Spanish 10-year government bond yield remained a very high 198 basis points above the equivalent German yield on Friday, not far from a peak of 239 bps hit in mid-June; credit default swaps for weak euro zone states, used to insure against the risk of a debt default, have not come down much. That is because many investors still think a debt restructuring by Greece or conceivably other euro zone states is likely in the long term — perhaps in a year or two, when policy makers judge markets have recovered enough for a restructuring to occur without destabilising the whole region. Another fear is that countries in the south of the euro zone could slip back into recession this year as austerity measures bite. This would weigh on the economic recovery of the whole zone, though strong German data this week suggested it might not end the recovery.
Referring to the global financial crisis, Trichet said on Friday: “Events over the past few months have made it clear that it is still too early to declare the crisis over.” Discord between France and Germany could yet stand in the way of agreement on significant changes in the EU’s budget rules, enshrined in its Stability and Growth Pact. But ahead of regular talks on Monday between the 16 euro zone finance ministers, the mood in EU policy-making circles is clearly much more upbeat than it was before most of the ministers’ meetings this year. The European Policy Centre think tank noted this change in mood in a report after the most recent summit of EU leaders on June 17. “For the first time since the start of the year, there was no immediate crisis overshadowing their discussions, they were able to stick to the pre-planned agenda and finish the one-day meeting without going into overtime,” it said. “After a string of emergency meetings over the last few months…this came as a huge relief.”