As indicated by the fact that I haven’t added to this series of posts since the start of the year, the recent decoupling of the US equity market from events in Europe has made me complacent. I figure that the best way to prevent myself from paying (figuratively and literally) the consequences of overconfidence is to make sure that I once again pay very close attention to the goings-on “over-there.”
The FT’s Wolfgang Münchau is upset with the IMF for earmarking 91% of its definitive commitments to programs in Europe. He says “no” to these two questions:
- Would an increase in IMF funds to bail out the eurozone be justified?
- Should non-eurozone countries participate in raising new capital?
Here’s his case:
It is not necessary because the eurozone has the financial capacity to help itself . . . Considering that the eurozone is economically unconstrained, and among the richest regions in the world, the request to involve the IMF in hypothetical future rescue operations is morally reprehensible. What is happening here is that eurozone member states find it hard to commit additional funds to the rescue operations, and find it politically more expedient to channel resources through the IMF as a way to bypass national parliaments.
But there is an even more important argument in my view. The way the eurozone member states have been dealing with the crisis has increased the chances of a catastrophic outcome. An extension of the IMF’s commitments is very likely to support current policies.
[...] The eurozone’s cumulative policy errors are turning a liquidity squeeze into a solvency crisis. And herein lies an acute risk for the IMF. If Italy were to become trapped in a long recession, the probability would increase significantly that it would not be able to repay its debt, currently at 120 per cent of GDP. News reports from Italy suggest that the IMF is about to forecast a two-year recession for the country, which could well lead to an increase in the debt-to-GDP ratio at the end of that period. Italy’s future solvency is entirely dependent on market interest rates and the prospect of a return to strong and sustainable economic growth. I struggle to think how this can be accomplished without a fiscal union and much greater burden-sharing.
There are additional technical arguments that would favour more cautious IMF involvement. Mario Blejer, the former governor of the central bank of Argentina, argued recently that the IMF’s preferred creditor status could become a problem, as an IMF loan would automatically subordinate every other bondholder. The probability of a default on those defaultable bonds is thus significantly higher. Furthermore, the situation could become so acute that the IMF’s seniority might fail, which in turn would endanger its capacity to lend at low interest rates.
There are several proposals on the table for how to involve the IMF in a clever way. But they all are subject to the same problem. Any outside liquidity assistance would encourage the eurozone to proceed with policies that are aggravating the crisis.
Evidently, Münchau was responding to IMF chief Lagarde, who today said that the Fund was ready to help the eurozone and was seeking to increase its lending resources by up to $500 billion. She went on to say that the IMF estimates that in coming years, additional global financing of potentially $1 trillion could be needed.
She then said that there are three imperatives are needed to fully restore confidence: stronger growth, larger firewalls, and deeper integration. Regarding the second of the imperatives, Lagarde called on European policymakers to create a larger firewall. Without it, she stated, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal funding costs―a development she warned would have disastrous consequences for systemic stability.
The FT reports that, soon after Lagarde’s address, Germany appeared to soften its longstanding resistance to increasing the eurozone’s rescue funds (to €750 billion) in exchange for strict budget rules in a new fiscal compact.
According to German and eurozone officials, Angela Merkel is prepared to let the existing European Financial Stability Facility, which has about €250bn in unused funds, run in parallel with its successor, the €500bn European Stability Mechanism, the launch of which has been brought forward to July.
In return the German chancellor wants eurozone heads of government to sign up to rules to cut budget deficits and public debt that are much tougher than those currently foreseen by eurozone governments.
The most recent version of the fiscal compact would allow governments to breach deficit limits in “periods of economic downturn” – a phrase criticised by the ECB as an “escape clause” that could lead to “easy circumvention” of what are meant to be cast-iron rules.
On a positive note, US money market funds have begun moving back into European bank paper, a sign that central bank efforts to backstop key institutions are improving risk appetite.
This past week, the funds were buyers in increased issuance of French and Spanish banks’ commercial paper, according to bankers. Notes issued by US banks with foreign parents rose $6bn to $152bn and foreign domiciled bank notes outstanding rose nearly $3bn to $133bn, according to figures from the Federal Reserve.Last year, money market funds were sellers of many European banks’ short-term commercial paper as worries grew about the repercussions of a possible European sovereign default. That was a critical factor in market anxiety, as the highly rated funds’ $2.7tn in liquid assets are a key source of dollar funding.
Money market funds bought French bank paper with maturities as long as one month, as well as small amounts of Spanish bank paper, according to bankers. The funds also bought longer-dated UK, Dutch and Scandinavian bank paper, up to six-month maturities.
The move comes despite France losing its triple A-rating but after a series of strong auctions for Spanish and French sovereign debts and hopes that Greece will reach agreements with creditors to avoid a default in the spring.