'Third Way' For Eurozone Could Provide Medium-Term Crisis Solution

by: Research Recap

Fitch Ratings expects the credit profiles of sovereigns and banks will continue to weaken and this will be reflected in their credit ratings even though Fitch does not expect any systemically important financial institution or sovereign to be allowed to default.

Whilst the public support and political will for a ‘United States of Europe’ involving full fiscal and political union simply does not exist, the costs of a break-up of the Eurozone are too great to allow – and this remains a key judgement which underpins its ratings on Eurozone sovereigns and financial institutions.

Concerns over the risk of a break-up of the Eurozone are greatly exaggerated. There is a ‘third way’ that falls short of full fiscal and political union that is not only politically plausible but which will be sufficient to prevent a ‘break-up’ and secure the long-run viability of the euro. - David Riley, Fitch’s Head of Global Sovereign Ratings.

Some of the building blocks for the ‘third way’ are already being put in place. It implies a much strengthened pan-European supervisory and regulatory structure for financial institutions; greater European oversight and coordination of domestic economic and fiscal policies with the ultimate sanction of an ‘orderly’ sovereign debt restructuring mechanism to ensure discipline on governments and lenders. To this end, Fitch believes the proposed European Stabilisation Mechanism (ESM) and the introduction of collective action clauses in government debt issued from mid-2013 is a significant step in this direction.

However, reform to the governance of the euro area is politically and technically complex and will take considerable time to put in place and to earn the trust of investors and acceptance of the public. In the meantime, the ECB has little choice but to continue to absorb more and more sovereign and bank risk on its balance sheet until and unless the EFSF is enlarged and made more operationally flexible, including potentially allowing it to borrow from the ECB as well as giving it greater operational independence.