Global support shows euro zone rescue means business

By Mike Dolan – Analysis

LONDON (BestGrowthStock) – The scale of global backing for last weekend’s trillion dollar euro zone rescue operation made it one of the most ambitious and aggressive market interventions of the last thirty years.

The involvement of the United States, the economies of the Group of Seven and the Group of 20, the International Monetary Fund, the 16-nation euro group and the European Central Bank showed this was not just another regional twist in a protracted crisis.

As Greece’s debt crisis threatened to infect the rest of the euro area and go global, the response needed to be global too.

There was a line drawn in the sand, a commitment to do whatever it takes and plans to urgently remedy the root cause of the market mistrust — budget cuts and better coordination.

“It’s the most important and impressive policy response to a potential global crisis that I’ve seen since the Plaza Accord,” said Jim O’Neill, Chief Global Economist at Goldman Sachs, referring to 1985’s successful pact between the United States, Japan, West Germany, Britain and France to weaken the dollar.

The dollar lost 50 percent against Japan’s yen by 1987.

After Monday’s initial market shock at a 750 billion euro EU/IMF package to underpin euro government debt markets and the ECB’s unprecedented bond-buying spree, market players naturally searched for holes in the plan.

After the seven percent surge in European equities (.FTEU3: ) on Monday and up to a halving of debt market premia on blighted Greek, Portuguese and Spanish bonds paused and hesitated on Tuesday before resuming with more measured gains on Wednesday.

The euro’s exchange remains lower than Friday’s levels, although that was more to do with the effective easing of monetary conditions engineered by the ECB’s bond buying than a judgment of the debt rescue package per se.

BONDS NOT CURRENCIES

But even though Monday’s operation was aimed at unruly bonds rather than currencies, unlike most prior G7 market forays, it still bore all hallmarks of those agreements.

Yet as celebrated as the Plaza Accord has become, last weekend’s action probably owes more to the international accord to support the ailing euro in September 2000; or the G7/G20 pledge not to allow other systemically important banks to go bust after Lehman Brothers’ tumultuous demise in 2008.

“The euro FX intervention model of 2000 is exactly the right way to think about this,” said Goldman’s O’Neill.

In September 22 2000 central banks in Europe, Japan and the United States acted together for first time in five years and intervened to drive the euro higher after it hit an all-time low below 85 cents two days earlier, a fall of nearly 30 percent since its January 1999 launch.

At the time the precipitous decline of the euro threatened to destabilize world markets and the United States, led by then Treasury Secretary and now White House adviser Lawrence Summers, was as keen to stabilize the situation as the Europeans and they acted the morning before a G7 finance ministers dinner in Prague.

After the initial shock, currency markets attempted to push the euro back lower within 48 hours, but the ECB continued its heavy and regular unilateral euro-buying interventions for at least six weeks afterward. The euro/dollar exchange rate was 50 percent higher within two years.

FIRST BASE

The immediate task this time was to cap prohibitively expensive borrowing rates to manageable levels for the most affected euro members and assuage growing investor unease about the risk of sovereign insolvency and default spreading across the world in the wake of Greece’s messy and delayed bailout.

The alarm bells rang to mobilize the G7, the G20, the IMF and for extraordinary EU and ECB action when the crisis spilled over to interbank lending on fears of another wave of bank asset writedowns and insolvencies akin to the worst moments of the 2007/2008 credit crisis.

Given that G20 governments had already committed to whatever was necessary to prevent that banking crisis and recession becoming a global depression, it learned from previous mistakes. If no systemically important bank was going to be allowed to fail, then no sovereign would to be allowed to default either.

For the ECB, the decision to buy euro zone bonds was a controversial new departure but it did shift the goalposts for financial speculators who had become increasingly emboldened betting against member governments’ bonds.

In this regard, its move mirrored the EU’s decision in 1993 to counter a year of constant speculation against currencies held in narrow trading bands within its Exchange Rate Mechanism by exploding those band widths more than sixfold. The euro was successfully launched six years later.

“By implementing this bold programme the ECB has now eradicated the sovereign liquidity crisis and avoided the global economy returning to the dark days of end 2008,” said Jacques Cailloux, European economist RBS. “This weekend’s historic decision is a sign that the ECB continues to mature. It is now one of the “grown up” central banks in the world that can afford to take bold actions without losing credibility.”

The battle will likely take more than couple of days or a couple of weeks. Investors will question the progress on fiscal reform of euro area institutions and promised austerity plans.

“A sustained solution probably lies with a combination of fiscal consolidation and debt restructuring coupled with monetary stimulus in the form of full-blown QE (quantitative easing. This would bring needed currency weakness,” said David Shairp, global strategist at JP Morgan Asset Management.

“The sense of crisis may have passed but the underlying problems remain.”

But if history is any guide then the Brussels agreement of May 2010 may mark a turning point.

Investing Analysis

Global support shows euro zone rescue means business