$1-trillion aid surprises markets

The only amount that is actually committed in the Europe rescue package is 60 billion pound from an EU emergency fund

The earlier $150 billion euro zone/IMF package for Greece had not reassured the financial markets about the willingness of eurozone members to do all that may be necessary to restore Greek finances to a more stable level. There were also worries about whether the Greek disease would spread to other EU economies - Portugal? Spain? Ireland? The euro remained under pressure and the eurozone sovereign bond yields and credit default swap spreads did not soften.

Last Monday's much bigger $1-trillion (750 billion pound) rescue fund, jointly sponsored by the EU and the IMF, surprised the financial markets by its size, and seemed to reassure investors of Europe's determination to put its house in order - at least initially. Global equity markets and the euro reacted positively.

The mammoth fund was the result of a customarily long EU meeting over the weekend. Surely, the long-term future of the euro and, indeed, the EU itself must have played a role in the negotiations.

After all, the EU leaders know how much Europe has gained through economic interdependence and integration - for the first time in more than two centuries, there has been no major conflict in Europe for the last 65 years, in no small measure due to European economic integration.

However, the markets' initial positive reaction seemed to undergo a change from the very next day.

Global equity and bond markets turned jittery and the euro softened, as the details of the funding got analysed and the whole exercise seemed to amount to less than what it first seemed.

The only amount that is actually committed is €60 billion from an EU emergency fund; of the balance, 440 billion pound would be raised in the bond market, as and when necessary to assist a member country, with the bonds guaranteed by the remaining eurozone members.

And, these guarantees are going to need parliamentary approvals in these countries. The balance of 250 billion pound is to come from the IMF, but its actual availability would depend on country-specific negotiations and conditions. The IMF contribution is more an expression of intent, and not a contractual commitment. (Was not the IMF's increase in resources agreed by the G20 meant for emerging/developing economies?)

A more concrete move came from the European Central Bank, which now stands willing to buy eurozone government bonds, without insisting on investment grade ratings.

While the package may still help in providing liquidity to countries facing problems, bigger issues remain: Can democratic governments enforce the fall in living standards needed to restore some balance in the external account in the southern countries, and reduce dependence on capital inflows? Will the deflationary measures not increase unemployment and output at least temporarily, thus worsening the fiscal deficits and debt-servicing problems? How will the financial markets react to any failures to meet fiscal targets? What about the impact of a possible double-dip recession in the world's largest economic bloc, namely the EU, on the global economy? Too many questions with no clear answers. One can perhaps be more certain in expecting that the euro's status as the alternate reserve currency has clearly been damaged.

In last week's article, I had commented on the divide between the north and the south within the eurozone as far as their current account balances are concerned. Is it a corollary of the cultural differences between the two groups? One can clearly see the cultural divide between the north (Austria, Germany, the Netherlands, Scandinavian countries) and the south (Greece, Italy, Spain, Portugal, etc.), with France somewhere in between: the division between the frugal, hardworking, Calvinist, better-governed countries of the north with surpluses on current account and the spendthrift, less disciplined, fun-loving, Catholic countries of the south, with deficits on the current account. The latter group of countries is also known for relatively poor governance, lax tax collections, etc. The political opposition in Germany to participating in the rescue package for Greece was, at least, partly rooted in the cultural divide. Why should the hard-working, honest German taxpayer bail out the lazy Greek? (Germany forgets that the deficits in the southern countries have created and sustained a lot of jobs and output growth in Germany.) The political opposition to the package in Germany remains strong as witnessed in the May 9 state election results. In any case, the provisions of various EU treaties have had to be interpreted with great flexibility and creativity before the package could be tied up. There are chances that it could be challenged in the German Constitutional court.

The fact is that growth and capital inflows can hide a lot of sins - fiscal deficits, public sector wage increases unlinked to productivity, tax evasion, overvalued exchange rates, large deficits on current account, etc. - for a while. But these are not sustainable. Surely, there are some lessons for India in the Greek tragedy - as also in the way CDS triggered the crisis, a point I will come back to later.