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Tuesday, September 27, 2011

A non-starter?

In today's City AM, we give our take on the idea that was floated over the weekend to top up the EFSF, using the fire power of the ECB:
THERE was quite a bit of excitement in the media and financial markets over the weekend. The hot news was that Eurozone leaders, on the sidelines of the G20 summit, forged a new grand scheme to save the embattled euro. The plan, we were told by some, would be announced “within days”. Alas, details are still thin on the ground and talk of an imminent deal looks wide of the mark. So what’s the fuss about? The key proposal would see the Eurozone’s undersized bailout fund, the European Financial Stability Facility (EFSF) topped up through a complicated scheme involving the balance sheet of the European Central Bank (ECB). This would increase the fund’s lending capacity to around €2 trillion, allowing it to contain a Greek default, by providing a much needed backstop to Italy and Spain, as well as covering the recapitalisation needs of Europe’s banks. EFSF funds would be used to cover the first 20 per cent of any losses the ECB makes on purchases of government bonds or the recapitalisation of European banks. The proposal gets good marks for creative thinking, acknowledging that an orderly Greek default is the preferred option and attempting to address Europe’s unhealthy banking system. Unfortunately, the proposal is also a non-starter.

Firstly, the plan would require a radical reworking of the EFSF framework, since it is not designed to be leveraged or be subordinate to the ECB in terms of covering losses. Remember, following a deal agreed in July, most of these countries are still scrambling to get a more moderate boost to the EFSF past national parliaments, which are becoming increasingly resistant to what they see as a potential blank cheque.

Secondly, using the ECB’s balance sheet to top up the EFSF would further expose the former to even more risky debt. As of August this year, the ECB was leveraged around 25 times with an exposure of around €510bn to the peripheral Eurozone economies – with much of this debt being of very dubious quality. It faces potentially hefty write-downs should a Eurozone country actually default (it remains unclear how these losses would be covered).

In theory, the ECB has an unlimited capacity to lend, and can even do so to some extent without triggering inflation, due to control over future money supply. But this is where politics kick in. By effectively merging its balance sheet with that of a government-run institution, the EFSF, the ECB would fully enter the domain of fiscal policy. This is critical for a number of reasons. The ECB’s freedom to act without political influence affords it the trust of financial markets, and allows it to effectively transmit monetary policy, including managing inflation expectations. It was on this premise that the single currency was sold to the German electorate in the 1990s – the ECB was going to be the heir to the trusted Bundesbank. As former European Commission President Jacques Delors once famously observed, “Not all Germans believe in God, but all Germans believe in the Bundesbank”. In contrast, a growing number of Germans now view the ECB with growing suspicion, as was seen in the dramatic resignation last month of Juergen Stark, the German representative on the ECB’s executive board, allegedly over the bank’s decision to start buying Italian and Spanish government bonds. One step further, and German support for the entire euro project could start to diminish.

This links with another crucial question: who, exactly, is in charge? The advantage of using the ECB as lender of last resort for the Eurozone is that it can act quickly without seeking a democratic mandate from voters, which is a slow process. Combined with its capacity to massively expand its balance sheet, this is one of the reasons why the ECB is, in theory, the one institution that can move markets. But since it hinges on EFSF loans, the proposal discussed over the weekend would presumably still be subject to approval by each member state (and various national parliaments), meaning that we would be stuck with the same political bottlenecks as now.

There are also, it should be said, familiar economic risks involved. Leveraging the EFSF’s lending capacity, which is mostly backed by six triple-A states, could negatively impact on the credit ratings of the member states, most notably France (through contingent liabilities). This could lead to a vicious circle, with the rating of the EFSF suffering a corresponding blow.

Not much of a surprise then, that politicians and central bankers in triple-A countries have lined up to criticise this proposal, with Bundesbank president Jens Weidmann saying: “If [the EFSF were to finance government bond purchases] through the central bank, it would be monetary state financing. Whether you do it directly or whether you do it via the detour of a special purpose vehicle makes no difference economically.”

What’s positive about the apparent change in mood over the weekend is that Eurozone leaders are beginning to realise that without a restructuring of Greece’s, and possibly some other country’s debts, and proper recapitalisation of European banks, there’s absolutely no way out of this crisis. But proposals need to be rooted in political, legal and economic reality. Otherwise, the huge gap between what markets demand or expect, and what politicians can deliver, will grow ever wider – and the rollercoaster ride will continue.

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