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Wednesday, June 20, 2012

Are the rumours of a new(ish) eurozone backstop true?

The press have got very excited over suggestions from European leaders at the G20 meeting in Los Cabos, Mexico, that they will activate the EFSF to buy eurozone government bonds from the secondary market in an attempt to reduce borrowing costs for Italy and Spain - a function which the fund has always had but has never been used (since the ECB has filled this role with its bond buying programme). Berlin has already moved to deny this, but there could be truth in it - not least because it's legally possible but also because we've seen over the past few weeks that the ECB has refused to buy bonds despite the persistent rise of Spanish borrowing costs. It has become increasingly clear that Spain cannot withstand these interest rates for long - something needs to  be done.

If true, this could prove a important change. Despite always being possible, bond buying from the EFSF has up until now only been theoretical. When it comes to the unenviable task of backstopping Spanish and Italian government debt, the ECB has now officially passed the buck to eurozone governments. Over the last two years, the ECB has effectively managed to manipulate government bond yields by buying a limited amount of government bonds – some tens of billions a month at its peak (although with mixed success). In August last year, for example, the mere willingness of the ECB to buy Italian government debt may have prevented a full-scale run on that country as political uncertainty ran wild. But there’s a key difference between the ECB and the EFSF – while the former has deep enough pockets to move markets, the EFSF’s lending capacity is inevitably limited, meaning that making it into a lender of last resort for a country the size of Spain (let alone Italy) could prove risky. The ECB could stand behind Spain and Italy with, at least in theory, the ability to massively expand its balance sheet and thereby quarantine these problem countries. But the EFSF only has €250bn left to lend – to top up its lending capacity, it will need to pass 17 hostile national parliaments, which ain’t gonna happen anytime soon.

This is to say that, if the buck has indeed been passed from ECB to the EFSF, then the Eurozone’s firewall just became a lot weaker - many have rightly previously questioned its capacity to purchase bonds and fund lending programmes to struggling countries simultaneously. Furthermore, the EFSF treaty states that secondary market intervention can only take place at the request of the recipient country and will come with some conditions (although probably not a full reform programme). Clearly this will come with significant stigma (once you go down the path of any external aid it is hard to return, as Spain is now finding out), while it is hard to imagine a country signing up to extra conditions just to manage its secondary bond market (especially since the ECB was previously doing this without any clear conditionality).

There are additional questions over what this means for the permanent eurozone bailout fund, the ESM, which is meant to be up and running this summer. Presumably, it will have to take over this bond buying role once it comes into force. The same problems apply here as do with the EFSF, but the ESM is also senior to other debt, meaning that as it buys up debt of a country other holders of this country's debt become subordinated - this can result in further market uncertainty making it counter productive. Ultimately, if the ESM is to serve as a lender of last resort in any way, it almost has to be equipped with a banking license in order to allow it to lend and borrow freely, without being hostage to national parliamentary politics or very limited in size. Giving the ESM a banking license is a hot potato in Germany, but will Berlin have any choice if the markets start to question the firepower of the fund?

On the current path, presenting the EFSF/ ESM as lender of last resort – for Spain in particular – but without equipping it with the cash to actually allow it to fulfil this function, could set the stage for a showdown between markets and the funds - in that scenario we can only see one winner.


Rollo said...

Just a boring repetition of the old story: promise an ESF, and promise to borrow some money to lend it; then invent a permanent ESM and promise to borrow some money to lend to it; then add both together to double the pretend firewall. Who is going to lend these people the money to lend to each other? We will see a 'dead cat bounce'. We will continue to see the same cat being bounced again and again. But the fundamental problem, that of these states being unable to survive in the Euro; while the Euro is too low for Germany, will live on.

Rik said...

Some remarks:
1. If I am not mistaken there is in one of the treaties a provision that could make the ESM seniority also applicable for EFSF (for loans after ESM treaty signing or ratification).

2. The problem is that bondbuying is likely the fastest way to go through your rescuing capacity. What you want is that the financing can be rolled over (plus the (plus temporary gap till there is a balanced budget is financed).

This can be done much cheaper by a moratorium and a PSI for Italy and Spain probably only changing the term structure of the existing bonds might be enough.
Which gives only the government deficit to finance. Rather marginal.

Look at what happened before in this crisis and see how much capacity (ECB direct and indirect (LTRO) plus rescue packages was needed to achieve this result. Huge Target2 increase, EFSF is already used for 2/3, ECB >200 Bn bondbuying, plus more in collateral for LTRO and normal.
Iso a leveraging of the capacity as earlier proposed we have effectively had a leverage of the rescue amounts because of all this.

3. As you say ESM is simply much too small to save Italy and Spain especially if you use your capacity in a very inefficient way.
This way you run into a banklicense.
And with that if that rescue fails (as it imho likely is anyway) all EZ countries are basically toast including Germany.

4. Seen 4. probably stratgic for Germany simply draw a line in the sand and not give in to reneg 9as we see with Greece that increases amounts necessary considerably.

Rik said...

Another point.
Imho a bankinglicense combined with no prior German parliamentary approval for any buying looks clearly against the German constitution.
The result would be other countries/ESM without German approval deciding what they do. This is according to the wording of the earlier case unconstitutional.
Furthermore lending becomes basically perpetual which is in its own right also dubious.

Not so much the seniority will be a problem. Of course it lowers the recoveryrate for everybody else. But simply the fact that we are talking 3 Tn debt of which 2.0-2.5 in bonds and similar. ESM capacity nowhere near enough.
Basically ESM will have to buy until almost all bonds are public. The more you buy the lower the recovery-rate will be. Somewhere (and pretty soon as you multiply the funds needed and not the capacity this way, see earlier remark) the ESM capacity will be used.

christina Speight said...

I totally agree with Rollo above but Rik's first has the snag that arbitarily and unilaterally to alter agreed terms would itself cause chaos!

The point is these funds have NO MONEY - they consist of Commitments and promises. The totals include promises from Ireland, Portugal, Greece, AND ITALY AND SPAIN. So it will turn out to be all smoke and mirrors as 5 countries which have run out of money lend one another money that doesn't exist and in the process increase their own indebtedness.

Is this supposed to pass for sensible economics? I could weep at the childish naivety of these eurocrats.

Bugsy said...

Reminds me of a certain bird that eventually disappears up its own rear orifice.

Denis Cooper said...

There could be a clever dodge around the problem that the EFSF doesn't actually have much money to buy Italian and Spanish government bonds, and that's not to pay for them with money but with EFSF bonds.

As I understand the last Greek bailout involved the EFSF providing most of the "aid" in the form of bonds rather than money.

So for example the Spanish government would sell its IOUs, bonds, to private investors, probably in the main Spanish banks, and the private investors would then exchange those Spanish government IOUs for EFSF IOUs, and the private investors could go to the ECB and use those EFSF IOUs as collateral to borrow euros, the ECB's IOUs.

If all went well, in the end the Spanish government would pay out on its IOUs held by the EFSF, which could then pay out on its IOUs held by the Spanish banks, which could then repay the ECB the euros they borrowed.

On the other hand if all did not go well then the Spanish government would not be able to pay out in full on its IOUs held by the EFSF, and then the governments of other eurozone states would have to make up the shortfall so that the EFSF could pay out in full on its IOUs held by the Spanish banks so that they could repay the ECB, which would no doubt repeat the claim that its statute does not allow it to take any losses.

Given that some of the distressed eurozone governments have already been taken off the list of guarantors for EFSF bonds, while others if left on the list might not be able to pay their share if it all went wrong, it could end up being quite expensive for taxpayers in the countries left standing.

Rik said...

@Denis Cooper
1. Using EFSF bonds is only a partial solution. It could work technically, but it is simply no real money.
And partly markets see that as a problem already. Yields on EFSF are considerably higher than one would expect them to be on basis of the underlying guarantees.
This is one of the reasons Germany is trying to move things to the ESM. The major other ones likely the seniority issue and the fact that if the EFSF is used to full capacity it likely de facto means a higher total capacity (and more risks for Germany).
This is clearly a major concern with a lot of investors. Risk is not solved it is simply moved from a to b.
A related problem being that no real structural changes are made only anti-cyclical and relatively small ones as well.
The Spanish reform of the labormarket is roughly similar to one now proposed in Holland. Where if implemented would lead to not even a 0.5% rise in GDP, according to the report attached (made by the people that want the reform, so it is very unlikely to be a too low estimate). Do they really think that this will close a 30% uncompetitiveness gap.

2. Interesting other point, is the German Constitutional case this week. Basically stating that the way information is provided to German Parliament is totally inadequate. Meaning that Germany will most likely be an even better source of info than it is now. Well that is next to the leaks. Which also have improved (got less)has to be said.

weayl said...

A model for fiscal union

1. Replace national VAT and corporation tax systems with single European system, with one European rate and one set of rules. All European companies will have single VAT declaration and corporation tax declaration for all Europe.

2. Income from these taxes go directly to a central European fund.

3. The European fund redistributes this income to member states according to pre-defined ratios.

4. The European fund guarantees all member state debts.

5. In return for the guarantee, a "commission" is deducted, according to debt and/or defecit levels of member states. Higher debts=higher deducted commission.

6. Pre-defined maxium debt levels are defined for all member states.

7. Where member states exceed pre-defined debt levels, redistributed VAT and corporation tax revenue will be automatically "withheld" and used to neutralize debt until restored to agreed levels.