Germany is forging ahead with plans to reform the euro at a time when the 16-nation common currency is once again under siege on the foreign exchange markets after a respite following eurozone agreement on a $1 trillion (£693bn) bailout package for debt-ridden partner Greece.
In addition to pushing for increased regulation of hedge funds and of the financial markets, Chancellor Angela Merkel’s government has drafted a list of proposals to revamp the European common currency. From suspending voting rights to national bankruptcy proceedings, the plan is wide-ranging.
The Chancellor started her offensive last week when the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin or the Federal Financial Supervisory Authority), slapped a ban on uncovered short-selling of eurozone government debt, prohibiting traders from buying default protection against government bonds they do not own. The move is designed to stabilise turbulent financial markets.
Merkel has also been working with her finance minister and economics minister on far-reaching changes to the treaty underpinning the euro.
According to a draft paper obtained by the respected German business daily Handelsblatt, Merkel’s government would like to see increased monitoring of member states’ annual budget proposals, the introduction of stiff sanctions for those in violation of eurozone debt rules and the suspension of voting rights in the European Council. Furthermore, Germany wants to establish bankruptcy proceedings for insolvent eurozone countries.
“A crisis like that in Greece cannot be allowed to be repeated in the currency union,” the draft paper concludes, according to Handelsblatt.
While many traders have dismissed BaFin’s move on short selling as political posturing, the situation may be more complicated.
An internal BaFin note in February said German banks held €522bn of exposure to government bonds in Portugal, Italy, Ireland, Greece and Spain. It warned of “violent market disruptions” if contagion spread beyond Greece, sparking a “downward spiral in these countries, as in the case of Argentina”.
The ban on short-selling has not gone down well with investors. Stock markets across Europe fell sharply last week just hours after BaFin announced the measure on Tuesday. The euro also lost value against the dollar but held its own against sterling.
Analysts said the action taken by the German financial regulator will test EU cohesion and pile even more pressure on the euro.
“If the market can’t vent its frustration by selling eurozone government bonds or (credit default swaps), it will sell the euro,” said Steven Barrow, a currency strategist at
Standard Bank.
There’s general unease in the markets about the reasoning behind Germany’s decision. Many analysts believe that central banks around the world will have to intervene to slow down the euro’s fall.
“German restrictions on short-selling seem set to send another shockwave across markets as investors are once again left asking questions over the resilience of Europe,” said Ben Potter, a research analyst at IG Markets.
The regulator has stopped investment banks, hedge funds and other investors from naked short-selling of eurozone government bonds and from purchasing credit default swaps on government debt unless they own the underlying bonds. The ban also extends to short-sales of 10 German financial institutions.
BaFin cited “extraordinary volatility” in debt securities issued by eurozone countries, noting that spreads on credit default swaps had widened sharply amid the crisis. Credit default swaps (CDS) provide protection against
non-payment by a borrower and have also been a popular vehicle for speculating on the probability of default.
But if the move was designed to calm financial markets, it appeared to have the opposite effect.
The euro came under selling pressure in North American trading soon after the ban, falling below $1.22 – a fresh four-year low against the dollar.
Strategists at KBC Bank in Brussels said Germany’s decision to impose the ban in isolation, despite talk of an eventual wider move by the European Union to limit short sales, added to market jitters and raised numerous questions, including whether the German government knows “something more about the situation of some institutions”.
The main issue, however, is that the German decision only serves to underline fears that euro bloc authorities have no plan capable of tackling the problem of some members’ unsustainable finances.
If the German move proves to be effective, it may well take pressure out of the CDS market but at the cost of an apparent breakdown of a unified eurozone response to the crisis.
The BaFin decision comes at a critical time for the future of the euro, which has been badly weakened by sovereign debt problems in Greece, Spain and Portugal. Speculation has grown in recent weeks that the eurozone may not survive the present crisis.
Tension in the financial markets spiked higher last Wednesday after Merkel warned that the single European currency was in danger of collapse, and that Europe faced its greatest crisis in decades.
“Every one of us here can feel that the current crisis of the euro is the greatest challenge that Europe has faced for decades, since the signing of the Treaty of Rome,” Merkel said in a speech to the German Bundestag.
“The euro is in danger ... If we don’t deal with this danger, then the consequences for us in Europe are incalculable.”
Merkel’s warning came only a few days after the president of the European Central Bank, Jean-Claude Trichet, said that Europe was facing “severe tensions” and that the markets were fragile.
For Europe’s banks, the problems are twofold. Short-term borrowing costs are rising, which could lead institutions to cut back on new loans and call in old ones, crimping economic growth.
At the same time, seemingly safe institutions in more solid economies like France and Germany hold vast amounts of bonds from their more shaky neighbours, like Spain, Portugal and Greece.
Investors fear that with many governments groaning under the weight of huge deficits, the debt of weaker nations that use the euro currency will have to be restructured, deeply lowering the value of their bonds. That would hit European financial institutions hard and may feed through the global banking system.
Britain will not be spared if the euro area is rocked by more financial difficulties.
Adam Posen, an American economist and member of the Bank of England’s Monetary Policy Committee, said Britain would be in trouble if the eurozone tipped back into recession because it is so heavily dependent on the region for trade.
“This is a huge risk to the UK. 60% of our trade is with the euro area. So we view this as a very real risk,” he told US National Public Radio.
“We’re small compared to the euro area. If the euro area goes down then that does have a huge impact on us. There’s not much we can do about it.”
Posen said that the eurozone faced low growth in the foreseeable future, which he said explained the euro’s steep fall and market volatility despite the big rescue package for Greece agreed by eurozone members earlier this month.
Posen also said he thought it unlikely that the euro system would collapse, but he conceded “it’s certainly more likely now than it ever was at any point in the previous 11 years, the 11 years the euro has existed”.
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