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Thursday, June 28, 2012

A great way to run down a bailout fund?

Ahead of the summit today the proposals for the EFSF/ESM to start purchasing sovereign debt began rearing its muddled head again, with some indication that this is actually one of the few things that could be agreed at the summit. We hate to be party poopers but as we have already noted (at length) this is a confused idea and will likely provide little help relief to those countries embroiled in the eurozone crisis. Below we outline some of our key concerns with the plan:
  • The capacity will be tested: this role was previously filled by the ECB. Markets know that the ECB can provide an unlimited backstop and will rarely test its resolve in keeping yields down. However the EFSF only has around €250bn left, while the ESM has a lending cap of €500bn (as we have shown though this will also not be fully operational for some time). In any case markets are likely to test the resolve of these funds, meaning they may spend more than is needed and may be less effective than the ECB was. 
  • Will deplete the funds of the EFSF/ESM: further to the point above, the money in the bailout funds will be severely depleted reducing the capacity for them to fully backstop countries which may need full bailouts. Particularly a worry if Portugal needs a second bailout, Greece a third and Spain possibly a full one on top of its bank rescue package. 
  • Subordination: if ESM purchases bonds other debt of the recipient countries will become junior. This increases market jitters. Would be less of a concern if these purchases solved any of the issues but they only simply delay them at best.
  • Secondary market purchases: if the buying is on the secondary market, the benefit is limited in terms of countries actually being able to issue debt. Still rely on domestic markets and the sovereign-banking-loop in problem countries may become more entrenched. 
  • Primary market purchases: if done in primary market, then this will be a direct transfer between countries and could lay the groundwork for debt pooling, something which could cause political outcries across northern Europe
  • Risk transfer: holders of peripheral sovereign debt will likely see this as an opportunity to sell off their holdings at a higher than expected price, shifting risk to the eurozone level. 
  • De facto Eurobonds: the funds will issue bonds to raise money to buy debt off struggling countries. Building on the two points above, this means that investors will sell national debt and buy European backed debt, again essentially creating a de facto European bond and debt union. 
  • Conditions: must come with clear conditions otherwise could be self-defeating (removes incentive to reform). Furthermore, if, as is currently the case, countries must enter an adjustment programme to allow the EFSF/ESM to buy its bonds, there could be significant stigma attached (again reducing the benefit).  It could also mean other countries picking up the slack if a government does not properly implement its own fiscal policy (however, without a clear say on the spending programmes).
All in all then, a very mixed bag. At best this plan could provide some temporary relief to high yields but the side effects could be large and frankly these funds just aren’t big enough to fulfil this role (and their other roles) on a consistent basis. Besides, even if some time is bought they are still yet to outline to what end it would be used – better then to agree on this before starting to run down the one of the few backstops still in place to the eurozone crisis.

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