I’ll be gathering reactions for the rest of the day. Check back here periodically for additions.
World Bank president Robert Zoellick said:
It’s a very welcome and an important step because we have seen the ripple effects. I compliment the leaders of the European Union for facing and making difficult decisions. Of course problems like this can’t be solved by waving a magic wand, and the implementation of the three core elements will require follow through to ensure that with the market reactions, the banks can function more effectively and to ensure that euro zone countries are able to roll over their debt.
I’m hopeful that this first important step will lay the foundation for a broader approach that will focus on helping the world economy resume growth, overcome joblessness, and support the innovations so we can get the world economy back on track.
Canadian Prime Minister Stephen Harper said:
I see as positive steps, the actions taken by our European friends just a few hours ago,” Harper said in the Australian city of Perth, where he will attend a summit of Commonwealth country leaders.
Of course, we still await the elaboration of further details and successful implementation, as we approach the G20 summit (next month).
UK Chancellor of the Exchequer George Osborne said:
We are not going to contribute to the eurozone bailout, but we are members of the IMF … We aren’t turning our backs on the IMF. The agreement last night did not say the IMF was going to put additional resources into the eurozone.
We will only contribute to resources that are available to all members of the IMF around the world, we will not contribute to a fund that is hypothecated, that is directly linked to the eurozone.
We are not going to contribute to a special purpose vehicle that is set up to attract sovereign wealth funds or the Chinese government – in other words, people with large surpluses. We’ve got a large deficit.
Holger Schmieding, chief economist at Berenberg, Germany’s biggest private bank, said:
The deal tries to fix the mistakes eurozone leaders had made in July. At the time, they had agreed to restructure Greek debt without putting up a firewall to protect Italy against contagion risks. This time, the focus was very much on Italy. The fact that there is an enhanced deal is a positive.
Leveraging the EFSF up to €1tn yields an impressive amount of money. However, we are not convinced that – in case of a severe crisis – a first-loss insurance on sovereign bonds of 20-25% would really be sufficient to entice investors to buy newly issued Italian bonds, especially in the wake of a 50% haircut on Greek debt.
In our view, the role which the ECB will or will not play remains crucial. Without ECB support, the chances of this deal putting an end to the euro debt crisis now are probably below 50%. If the ECB were to signal a willingness to act as a backstop of ultimate resort by buying bonds, the chances that the deal could put an end to the euro debt crisis would be well above 50%. The summit statement leaves the role for the ECB’s bond purchasing open.
Many details still need to be fixed, including details of the 50% debt relief for Greece (by the end of the year) and of the two precise leverage options for the EFSF (by early November).
At the 3/4 November G20 summit in Cannes, international support through the IMF and direct contributions from emerging markets can be discussed.
In the short-term, continued austerity and bank deleveraging may have negative effects on the euro area economy. However, Europe continues on the path to fiscal rebalancing and is staying ahead of the other advanced economies in this respect.
Simon Lewis, chief executive of the Association for Financial Markets in Europe said:
The recapitalising of Europe’s banks will not in itself solve the sovereign debt crisis. However, this plan is set within a timeframe that should enable them to determine how best to strengthen their capital positions in ways that treat all stakeholders fairly and allow the banks to fulfil their role in supporting Europe’s economic recovery.
Alan James, strategist at Barclays Capital, said:
The results of the summit appear to provide a framework that can offer a degree of stabilisation over the medium term if efficiently implemented, but without significant positive surprises relative to market expectations. The details and timetable for implementation of most measures remains vague.
While the official statement suggests the leveraging mechanisms could potentially multiply the firepower of the EFSF by four to five times, the efficacy of the structure is far from certain. On Greece, it remains unclear whether the €30bn from member states is new money, while even if this process is completed without further detail, there is still potential for it to be designated as a default trigger event, albeit today’s agreement appear to have reduced this probability somewhat.
On bank recapitalisation, most of the €76bn estimated need outside of Greece is likely to come from the private sector, with Spain already indicating it does not expect state aid to be required. The initial market reaction of modest relief appears appropriate, in our view, but an extended normalisation rally is far from certain without more details on implementation.
El Pais (English edition)
Spain’s big banks on Thursday ruled out having to tap the markets to meet the new European-wide solvency requirements being imposed.
The European Banking Authority (EBA) late Wednesday calculated Spanish banks would require an additional 26.161 billion euros to meet the new core capital ratio of nine percent of risk-weighted assets they will need to pass the stress test to be carried out by the EBA in June of next year.
The tests will include the premise of a writedown in the value of Spanish government bonds held by the banks in their books of under three percent. According to EBA calculations, marking the value of sovereign debt in the portfolios of Spanish banks will cost them 6.29 billion euros.
Of the total required of Spanish lenders, 82 percent correspond to Spain’s two biggest banks, Santander and BBVA.
Local banks, which reckon the figure they require is only 13.5 billion euros once convertible bond issues and other adjustments are included, have informed the National Securities Commission (CNMV) that they rule out capital increases or state funding to meet the new requirements. They believe they can do so by generating additional capital internally from their earnings by June of next year.
Economy Minister Elena Salgado said the banks have the capacity to obtain funds for recapitalization on their own and do not need help from the state. “Of course, state funding is available, but the banks are going to do everything possible not to have to ask for it.” Salgado was following the same line taken earlier Thursday by Prime Minister José Luis Rodríguez Zapatero.
The Bank of Spain also issued the same message. “Bearing in mind that the figures published by the EBA are provisional, with the final calculations only available around the middle of November when the definitive figures for capital and exposure to sovereign debt as of the end of September are available, from the information offered by the banks it can be seen that they intend to meet the indicated requirements though their own ability to generate capital, with the understanding it will not be necessary for the public sector to take stakes in them,” the central bank said in a statement posted on its website.
Santander and other lenders also said they can meet the new requirements without changing their dividend policies.
A deal struck by euro zone leaders on Thursday to contain the region’s dangerous debt crisis was greeted skeptically in the two countries most in the firing line, Greece and Italy, with some saying politicians were dreaming.
Italian Prime Minister Silvio Berlusconi submitted an ambitious set of reforms intended to boost growth and cut debt as part of the deal, but analysts questioned the ability of his fractious coalition to implement the plan.
In Greece, opposition politicians and citizens feared further painful belt-tightening and years of recession, showing little enthusiasm for a plan for banks and insurers to accept a 50 percent loss on their Greek government bonds.
Berlusconi’s pledges include raising the retirement age and making it easier for firms to lay off staff but few expect a scandal-ridden government with a poor track record of pushing through reforms to be able to do so while battling for survival.
“It’s hard to believe that yesterday’s intentions can really be transformed into the biggest plan of market reforms Italy has ever put on paper,” Antonio Polito wrote in the Corriere della Sera daily, pointing to coalition tensions and lack of faith in the government.
An editorial in the left-leaning La Repubblica daily described the plan as a “book of dreams.”
In a sign of the challenges Berlusconi faces, Italy’s biggest trade union CGIL responded by pledging to fight the reform plans and called on smaller unions to unite against “targeted attacks” on Italian workers.
“We’re ready to propose unified action,” CGIL secretary Susanna Camusso told La Repubblica.
The Institute of International Finance (IIF)
Dr. Josef Ackermann, Chairman of the Board of Directors of the Institute of International Finance and Chairman of the Management Board and the Group Executive Committee of Deutsche Bank AG, today confirmed his full support for the voluntary agreement reached last night between Euro Area leaders and the IIF on a new Greek debt deal.
Dr. Ackermann stated: “We are very pleased with the agreement reached. It was appropriate for all parties to move on the July 21 decisions in light of the changed circumstances. The Greek economy has weakened considerably since that time and the different parties are taking additional difficult measures to lay the basis for stabilization and renewed growth. European leaders are also doing more, and as all parties have recognized that not only the future of Greece but the future of Europe was at stake. The outcome is a good one for Greece, Europe and the investors, and we look forward to its early implementation.”
Mr. Charles Dallara, IIF Managing Director, said, “This voluntary substantial reduction in Greek debt by the private sector, along with additional official support, provides an historical opportunity for Greece to revitalize its economy and reap the benefits of the difficult measures the Greek people have undertaken. We look forward to work with the Greek and European authorities to translate this framework into a concrete agreement that can deliver an early reduction in Greece’s debt and place it squarely on a path toward debt sustainability. Throughout the process we have enjoyed strong support from the IIF’s Board of Directors and from many leaders of other financial institutions.”
Wall Street Journal (no links)
- “Europe’s Not-So-Grand Plan”
Previous Grand Plans unraveled within days under the glare of market scrutiny; the best hope is that this deal buys a little more time . . . The euro zone is gambling the market will judge the sum of the parts to be greater than the whole. But there is no new money on the table, while the crucial issue of who will bear the losses of the debt crisis has still not fully been answered. That may not matter so long as Ireland, Portugal, Italy and Spain’s difficulties can continue to be treated as problems of liquidity not solvency. But that requires an urgent revival in confidence and economic growth: That may be asking too much of this deal.
- “European Banks Look to Reassure on Capital Needs”
Spanish, French and Italian banks need around €50 billion in fresh capital . . . several large banks from the countries early Thursday said they won’t have to turn to shareholders for the money, and analysts affirmed that many banks should be able to accrue capital by retaining earnings and disposing of assets.
EU banks supervisor the European Banking Authority said around 70 banks in the 27-country bloc must add roughly €106.4 billion to their capital reserves to reflect price declines in the Greek and other sovereign debt they hold, and to generally bolster capital held against their assets. Final shortfall estimates will be released next month and banks will have until the end of the year to tell domestic regulators how they plan to come up with the money.
Bank have until the end of June 2012 to improve their ratios. Many have previously said they won’t turn to shareholders, but will instead retain earnings, pursue asset sales and otherwise shrink their balance sheets. The EBA stressed, though, that banks will be limited in the deleveraging they can do, for example by cutting off business lending, in order to protect the broader economy. Banks needing new capital will also be expected to withhold dividends and bonuses, the EBA said.
[European leaders] agreed to increase the firepower of their €440bn bail-out fund by providing “risk insurance” to new bonds issued by struggling eurozone countries – a scheme designed for potential use in Italy – but they did not specify the amount of losses that would be covered by the insurance.
Both Ms Merkel and Nicolas Sarkozy, the French president, said it would increase the size of the fund “four or five times”, but a final number could not be calculated because it was unclear how much money was left in the fund. Most analysts estimate about €250bn will remain after the second Greek bail-out, putting the fund’s new firepower at more than €1,000bn.
Although the details of the deal as outlined by both European leaders and the Institute of International Finance remained vague, officials said that €30bn of the €130bn in the government bail-out money would go to so-called “sweeteners” for a future bond-swap, which would be completed by January.
Charles Dallara, the IIF managing director who served as the bondholders’ chief negotiator in Brussels, said in a statement that the net present value of bondholders’ losses had not yet been determined. He added that his consortium would need to continue to work with authorities “to develop a concrete voluntary agreement”.
“The specific terms and conditions of the voluntary [haircuts] will be agreed by all relevant parties in the coming period and implemented with immediacy and force,” Mr Dallara said.
Some elements of the package appeared to be based on optimistic assumptions. Under the terms of the deal, Greece agreed to put €15bn it aims to raise from a vast privatisation programme back into the European Financial Stability Facility, the eurozone’s €440bn rescue fund. International monitors have already acknowledged that Greece will struggle to raise the €50bn in privatisation cash it promised earlier this year, but the €15bn is supposed to come on top of previous commitments.
The deal with the Institute of International Finance is for a “voluntary” 50 per cent haircut on Greek debt on behalf of their member banks . . . I do not believe this is going to work. First, the agreement with the IIF is not binding on the banks. The IIF has yet to deliver the voluntary participation. Many banks would be better off if the haircut was involuntary, given their offsetting positions in credit default swaps. The whole point of a CDS is to ensure creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. In other words, there is a significant probability that we will end up with an involuntary agreement – which is precisely the outcome the eurozone governments, except perhaps a small group of northern countries, had sought to avoid.
On the EFSF, the leaders reached political agreement to leverage it up to about €1,000bn. Herman van Rompuy, the president of the European Council, made a revealing comment following the meeting when he said that banks have been doing this forever. Why should governments not do so as well?
The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European financial stability facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of €210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.
Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop. This would be either in the form of an explicit lender-of-last-resort guarantee by the European Central Bank, or through a eurobond – or ideally both.
Now that is something I would consider to be a comprehensive agreement. It may yet happen, but not for a long time. The crisis, meanwhile, continues.
The deal does not, and was not intended to, have any effect on the core problems facing the eurozone. There is still an urgent need to restore growth to economies which are hamstrung by uncompetitive business sectors, and continuous fiscal tightening. Recession still looms, especially in the southern economies.
What the deal is intended to provide is adequate medium term financing for sovereigns and banks which have been facing urgent liquidity problems. On that, it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn.
All of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.
There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised.
. . . the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt.
There will now be an anguished debate on whether this restructuring can be described as “voluntary”, and whether a default will be declared in the CDS market. The euro summiteers, who frequently announce that water can flow uphill, claim that it is indeed voluntary. Common sense says that it is not.
The attention of the markets will now turn to two main issues: whether new money can be raised from China and other sovereigns outside the eurozone; and how the ECB behaves under the new leadership of Mario Draghi.
First, the Greek debt deal:
1) Greece’s debt will remain 120 per cent of GDP a decade hence, even under the 50 per cent bondholder haircut. (As the debt sustainability analysis by the Troika warned.) Does that look like a safe number to you? Say, providing a good buffer to any external shocks that Greece might face over that period? Does it look like it rules out subsequent bondholder haircuts?
2) The huge disparity between haircuts and actual debt reduction is a creature of Greece’s reliance on official loans (plus the ECB’s getting made whole on its Greek bond holdings). This deal will chuck another €100bn on the fire. Again, if a subsequent debt reduction is needed, we’re getting to the point of either completely wiping out bondholders, or official lenders have to write down.
3) Official sources will also provide €30bn of credit enhancement to bondholders in the debt swap. We don’t know what this really boils down to, and probably won’t for some weeks. It might be that EFSF collateral attached to the restructured Greek debt is offered, purely because that’s how the first swap proposal worked (and, it appears, banks really wanted it again this time round). Of course there were proposals yesterday to give bondholders cash upfront. We strongly desire to know about other possible features that we just don’t know about so far, such as the legal status of the new bonds (would they be governed under English law?).
4) How is Greece going to raise more money from privatisations? A further €15bn is targeted in the new agreement, but this is coming after the Troika already took a strange, fingers-in-ears-la-la-la approach to what is already acknowledged to be a difficult task of raising €50bn.
Four points in, and hopefully you can see that a) very critical details remain to be decided, and b) the room for manoeuvre on Greek debt might actually be decreasing with this new offer. That is, a subsequent haircut might be harder to execute (even if debt levels are still high enough to argue that it should happen).
5) Let’s get the inevitable Greek CDS question out of the way. What are the bondholders going to do, and what’s the ISDA determination committee going to determine? [Here are a couple of possibilities.] Assuming everyone agrees that the haircuts are sufficiently voluntary not to trigger a credit event — what does that mean for sovereign CDS? And indeed, for bond yields, as we pondered last week.
What we really need is evidence of whether, or how, Greece might “punish” and bind bondholders who don’t take part in the swap — providing crucial evidence for the ISDA committee. This could be anything: a clear statement of intent to service the new bonds over unrestructured debt, exit consents by the participating bondholders which bind the holdouts in some way. Again, more detail is needed. Doubtless however, a few lawyers must be leafing through the ISDA definitions for credit events this morning…
On to our second set of questions — the EFSF part of last night’s deal.
6) Is China going to stump up for the EFSF SPV? Sarkozy is calling Hu Jintao at midday on Thursday to speak to him about this, and Klaus Regling, the head of the EFSF, is travelling to China on Friday. But even if China agrees, there could be some complications.
7) How will the EFSF bond insurance plan pan out, particularly in terms of existing bondholders? Last night’s statement said that “providing credit enhancement to new debt” would be included. What form of enhancement in particular? The statement mentions investors can “purchase” insurance. This is very sketchy but this seems to exclude Spain or Italy buying collateral off the EFSF (a la Brady bonds) and handing them over to investors as a free gift with every bond issue. Rather, it sounds like investors buy credit protection. To put it all another way, it sounds like the EFSF sells protection (or “CDS”).
How likely is it that we’ll see the level of fiscal integration alluded to in the agreement? A commitment to “consultation of the Commission and other euro area Member State before the adoption of any major fiscal or economic policy reform plans with potential spillover effects,” sounds like a big deal, and a sign of some determination to get at the root of the problem (or, one of them) by really deepening fiscal integration.
Or, it could just be aspirational hot air.
But is it a good deal? This was, after all, the third “comprehensive solution” devised by the euro zone so far this year. With each “unprecedented” effort, the problem has only worsened (see chart 1). Sadly, this latest deal promises to be no more enduring. At best, it will buy time before the next round of panic. At worst, it may push the euro zone into catastrophe.
The next paragraph from the Economist refers to the following from the Euro Summit Statement:
“The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the Greek debt. Therefore we welcome the current discussion between Greece and its private investors to find a solution for a deeper PSI. Together with an ambitious reform programme for the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks. The new programme should be agreed by the end of 2011 and the exchange of bonds should be implemented at the beginning of 2012. We call on the IMF to continue to contribute to the financing of the new Greek programme.” [My emphasis]
The bond exchange is billed as “voluntary”, but it is not clear that the International Swaps and Derivatives Association (ISDA), a trade body, will agree. If it judges that a “credit event” has taken place, then payouts will be triggered on credit-default swaps (CDSs), insurance contracts against default on government bonds. This is something that the governments and the ECB had been determined to avoid, fearing it would lead to financial catastrophe, rather as the bankruptcy of Lehman Brothers did in 2008. There is no clarity about who the biggest issuers of default insurance on Greece are. The net exposure on Greek CDSs is thought to be less than €4 billion, though this is likely to be unevenly distributed, with some banks big winners and others big losers.
The ISDA today updated its Greek Sovereign Debt Q&A:
“The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts. In addition, it is important to note that the restructuring proposal is not yet at the stage at which the ISDA Determinations Committee would be likely to accept a request to determine whether a credit event has occurred. “
Bankrupting the banks?
Even if the euro zone succeeds in avoiding CDS payouts, this could prove a Pyrrhic victory. If losing half the face value of a bond does not amount to a default, what does? Undermining the value of CDS insurance could deeply distort the market. If banks or other investors lose faith in their ability to hedge risks, they will be tempted to cut back on risk or demand higher yields. So, perversely, sparing a CDS payout on Greece could push up the borrowing costs of other countries.
That said, the danger of contagion is real. If holders of Greek bonds can incur losses on what they once thought were safe investments, what of holders of Italian or Spanish debt? The initial deal on Greek debt in July was followed in August by the dumping of Italian and Spanish government bonds.
One of the obvious channels of contagion is the banking system. So the 27 governments of the EU—both in and out of the euro zone—agreed to force banks to take on more capital to reduce the risk of collapse. The new recapitalisation package will oblige banks to reach a minimum core Tier-1 capital ratio of 9% (somewhat higher than current requirements) by the middle of next year, after recalculating the value of their bond holdings at market prices. That would mean writedowns of Italian and Spanish bonds and gains on German and British ones. This will push much of the burden of raising new capital onto Spanish and Italian banks while leaving British and German ones largely unscathed.
The criteria are suspiciously kind to France. Its banks have been battered in the markets in recent months, and the government is alarmed by the prospect of losing its AAA credit rating. The recapitalisation will be reckoned according to bond prices on September 30th, when French ten-year bonds were still yielding 2.6%. Since then the price has fallen, and the same bonds are now yielding 3.1%. In all, banks will have to come up with €106 billion in extra capital. That sounds like a lot, yet it is at the lower end of many estimates, largely because it will not include a “stressed” scenario that models the impact of a recession. That may be a mistake, given the slowdown in Europe’s economy.
A far bigger mistake is in the plan’s timetable. Banks are being given almost nine months to reach the targets, ostensibly to allow them to raise capital themselves through cutting dividends or bonuses and selling shares. Yet few investors are willing to buy bank shares, cheap as they may seem, given the perceived risks of a series of sovereign defaults in Europe. This means that the burden would fall first on national governments and then on the increasingly stretched resources of the European Financial Stability Facility (EFSF), Europe’s main bail-out fund.
Given too much time, moreover, there is the risk that banks will, in fact, shrink their balance-sheets to bolster their capital ratios. Their first strategy will be to trim economically essential but capital-intensive businesses such as trade finance or lending to small businesses. Huw van Steenis, an analyst at Morgan Stanley, reckons that European banks may go on a “crash diet” and cut their balance-sheets by as much as €2 trillion by the end of next year. They may also sell government bonds of peripheral countries, worsening the bond-buyers’ strike that afflicts Italy and Spain.
Capital is only one issue facing banks. A second is their own ability to borrow. The ECB can step in for short-term funding, but long-term markets are frozen. European banks have, to all intents and purposes, been unable to issue bonds since the start of July. Governments could reopen the market by guaranteeing bonds issued by banks, but they are wary of putting their own public finances at risk; this was the path that led to Ireland’s ruin. In any case, few investors would trust guarantees from Italy or Spain.
All this suggests that an essential part of shoring up Europe’s banks is to restore faith in government bonds. That means protecting countries, such as Italy and Spain, that are solvent but have lost the confidence of bond investors. Even fundamentally solvent countries can quickly go bust if their borrowing costs rise too fast.
This is where the EFSF comes in. It was designed to protect smaller peripheral states. European policymakers insisted it should have a gold-plated AAA credit rating, lowering its costs but limiting its capacity. It is now too small to shield the bigger economies. The EFSF can lend €440 billion (see chart 2). But given its commitments to Ireland, Portugal, Greece and, perhaps, the recapitalisation of the banks, it may have as little as €200 billion for future contingencies. And yet in the next three years Italy and Spain will have to refinance about €1 trillion-worth of bonds, not counting additional borrowing to finance their deficits.
Countries guaranteeing the EFSF’s funds do not want to increase their burden, not least because some cannot afford to do so. France’s AAA rating is already at risk. What is more, France and the EFSF are like tottering drunks holding one another up. If France is downgraded, the EFSF will be close behind.
How to conjure a bigger EFSF without more taxpayers’ money? The answer is “leveraging” through financial engineering of the sort that helped cause the global crisis in the first place. “If you want leverage, you can always find it,” says one senior policymaker disdainfully. “Just get two or three investment bankers in a room.” Herman Van Rompuy, the president of the European Council, who chaired the summit, sounds even more cavalier. For centuries, he says, banks have taken deposits and used them to multiply money.
The favoured option is to get the EFSF to insure government bonds, acting, in effect, as the issuer of the much-maligned credit-default swap. By guaranteeing to take, say, the first 20% of any loss on government bonds, the EFSF could, in theory, support €1 trillion-worth of Italian and Spanish debt.
A second option is to set up SPVs, or Special Purpose Vehicles. These would seek to attract funds from private investors or sovereign-wealth funds in Asia and the Middle East, again by offering to take the first losses in sovereign defaults. In effect they would be creating something that looks a lot like the collateralised-debt obligations (CDOs) that became infamous during the subprime crisis. How much leverage each vehicle would take on, and which countries they might apply to, are questions that still have to be resolved over the next few months.
Many wonder why any investor would put money into such vehicles when they can buy bonds directly at a discount or get the insured version. One reason may be that the direct-insurance version may breach “negative pledge clauses” in contracts governing some bonds. These prohibit countries from doing anything that would set holders of new classes of debt above those of the old.
A difficulty with the leverage scheme is that those insuring the debt of euro-zone issuers would themselves be grievously weakened if a neighbour defaulted. How credible can their insurance policy be? “We have really struggled to find investors who want to buy the ‘part-insured’ government bonds, for fear the insurance is so highly correlated to the risk,” says a banker.
An even bigger problem is that levers can work both ways. Leverage may enlarge the size of the fund, but it can also concentrate greater risk onto the sovereigns that guarantee it. If the EFSF were simply to buy the debt of a vulnerable country such as Italy, it would expect to get back more than half of the money even if there were a default with a relatively high haircut of, say, 40%. If, on the other hand, it promised to cover the first 20% of losses on the bonds, then a haircut of just 20% on the value of the insured bonds could wipe out all the money pledged by the EFSF as insurance. So instead of assuaging market fears, leveraging may yet become a mechanism that transmits panic and weakens the sovereigns, above all France. That is why, in practice, the EFSF could probably support Spain or perhaps even Italy, but not both.
Debtor, save yourself
The new weapons for the euro zone come with a political price: closer monitoring of national budgets and economic policies, particularly in the case of states that need the greatest help. After a dressing-down from Mrs Merkel and Mr Sarkozy at the first summit, Italy’s prime minister, Silvio Berlusconi, came back with a long letter setting out his promises to reform the economy (see Charlemagne). In December European leaders will consider whether they need to change the EU’s treaties to allow more integration. And there is pressure for greater harmonisation of taxes. But even if a re-engineering of the euro zone is possible, such measures are for the longer term, to avoid a repetition of the crisis in the future. The priority must be to deal with the present.
The euro’s crisis boils down to this: national treasuries do not have enough spare cash both to guarantee outstanding debt and maintain their own credit ratings. Even mighty Germany cannot stand alone behind the whole euro zone.
Some hope that more money can be found from non-European creditor countries, such as China, by convincing them to invest in SPVs. Or perhaps the IMF could do more, particularly if China increases its contribution to the fund. But even if the Chinese were game, this raises a serious political question: does the euro zone want to be so obviously in hock to China just as it is fretting about Chinese firms buying up European ones? “If the Chinese are going to chuck money into an SPV or the IMF there will be a price,” says a European diplomat. “The Chinese want two things: one is greater voting rights in the IMF, the other is market-economy status.” Such status, which is granted by the EU, would make it harder for the trading block to impose anti-dumping duties on imports from China.
There is a better answer: use the unlimited liquidity that only the ECB can provide by dint of its power to print money. The ECB could credibly stand ready to buy debt of a country like Italy. As such, it would be treating a sovereign almost as it would a bank suffering a run. The danger is that this will stoke inflation. Germany, in particular, has a deep aversion to anything that looks like printing money, an orthodoxy forged in the experience of the Weimar Republic’s hyperinflation.
The ECB guards its independence, but has not entirely kept to these rules; it has already gone into the markets to buy distressed bonds, ostensibly to ensure that a country’s bond yields do not stray too far from the interest rates the bank sets. Having seen off France’s attempt to get the ECB to lend to sovereigns indirectly, through the EFSF, Germany removed even a passing exhortation for the ECB to keep buying bonds from the summit communiqué. “We have no demands and we have nothing to request,” said Mr Van Rompuy.
In private, though, most hope the ECB will not withdraw from bond-buying. Its incoming president, Mario Draghi, who takes over from Jean-Claude Trichet on November 1st, has signalled his willingness to buy bonds to ensure the transmission of monetary policy. “The blanket prohibition against directly lending to governments is a complete idiocy,” says Willem Buiter, chief economist at Citigroup, and a former member of the Bank of England’s monetary-policy committee. “That is what central banks do. Just because it can be mismanaged does not mean you have to throw the tool away. You can drown in water, but it does not mean you cannot have a glass when you are thirsty.”