The Euro Stabilisation Fund is announced and the European Central Bank is willing to buy government debt

Tonight has seen the announcement of a very large fiscal package by the European Union. At this stage there are not full details given in the Press Conference but what we have been told is  that a European Stabilisation Fund of 60 billion Euros will be  made available and will be accompanied by 440 billion Euros of bilateral loans which will be called a special purpose vehicle. In addition there is  further International Monetary Fund involvement in addition to its promise of funds to Greece. I understand that this could be worth another 250 billion Euros as the President of the meeting Elena Salgado has stated that the ratio will be two-thirds/one-third .

European leaders rhetoric 

There had been plenty of this at this meeting with talk of speculators being a “wolf pack” hunting down the Euro. The Chairwoman of the meeting Elena Salgado who is Spain’s Finance Minister said

“We are going to defend the euro,” and that “We think we have a duty for more stability for our currency. We will do whatever is necessary.” So the rhetoric was building and needed in my view to be matched by action.
Initial Market Action

The Euro has rallied against the US $. As I type this at nearly midnight UK time the Euro has strengthened to 1.2881 although it is not holding the highs it reached when the news of this announcement began to leak. Stock markets are rallying quite strongly initially with the US S& P future gaining some 2% on its Friday night close and Dow Jones futures rallying some 165 points.

Greece

One piece of action that can be confirmed is that funds to help Greece in her liquidity crisis were signed off. The IMF approved the total of 30 billion Euros to Greece as a three-year aid package and this included some 5.5 billion Euros which can be paid immediately. So that Greece’s maturing debt which is due on the 19th May looks like it can now be paid. It is also true that the euro zone is making progress on the 80 billion Euro loan package with I believe 9 governments having now signed up to this.

The IMF

This 30 billion Euro aid package is as big a package as it has ever given to an individual country. If it should be involved in offering another 100 billion Euros to the euro zone then the IMF is getting heavily involved.

Comment

There seems to be a fundamental change going on in the role of the IMF. Its role used to be as a provider of short-term liquidity finance for countries with balance of payments problems and it appears to have morphed into one which now deals with fiscal deficits. Whilst these problems often come as a pair it is a long way from always being true that they are the same problem. As the sums involved with the IMF are increasing they are being accompanied by a change in its role and I would like to repeat my question of the 26th April

 

I have a question for my readers here and it relates to the recent increase in loan capital for the IMF. This was announced to great fanfare at the April 2009 G20 meeting by the UK Prime Minister Gordon Brown. He announced it as if it was a rabbit from a hat. However there are potential implication from it, for example what would happen if some of the money was lent and the loan was not repaid? Who is then liable? Has there in any country been a debate on this? As the largest player the biggest potential burden is on the taxpayers of the United States but all G20 countries are involved and liable. This strikes me as an off-balance sheet liability for the taxpayers of the G20 nations.

 

Comment on bilateral loans

Whilst this sounds a large amount it does potentially face the problem of will countries in trouble have to contribute? For example Portugal, a country with ten-year government bond yields now over 7%, found itself in a weakening position but also having to contribute 2.2 billion Euros of bilateral loans to Greece as part of the EU aid package for her.

It looks as though there was an effort to involve the whole of the European Union in these proceedings rather than just the euro zone. However this did not go down well with the Swedes and appeared to be rejected by Chancellor Darling for the UK. So the deal has 16 countries behind it rather than 27.

If the deal is split by shares in the European Central Bank then we have a problem. For countries in difficulties will have to take their share as follows. By my maths we will see loans offered as follows.

Italy 80.96 billion Euros

Spain 53.9 billion Euros

Portugal 11.6 billion Euros

Greece 10.4 billion Euros

Ireland 7.2 billion Euros.

There are obvious problems here.

My conclusion would be that this is a short-term liquidity operation that may in the short -term address liquidity problems in the euro zone but over time it does very little to help solvency. I think that minds will become focused on the list of contributors I have put above. In the end for the euro zone to repair itself we needs some signs of economic convergence too

Further Detail

The 60 billion Euros which are the initial state in this operation will be loans to countries in a similar form in the way that loans have been made to Greece. Euro zone ministers have activated this under the terms of Article 122 of the Lisbon Treaty which I show below.

“Where a member state is in difficulties or is seriously threatened with difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the member state,”

There is a lot of talk in the press conference of the phrase “if needed” so it appears that the ministers feel that talk again will be sufficient.

Spain and Portugal

These two countries have promised to cut their fiscal deficits but there have been varied numbers bandied about. We are promised more details on this as time goes by.

The ECB

We are told that “very significant decisions have been made” by the ECB in the past 12 hours and the spokesman has said that the ECB has taken a decision to purchase sovereign debt in secondary markets. This if it turns out to be true is the most significant of the details announced tonight. So this is a quite extraordinary night as it would appear that it is now willing to countenance a programme similar to the Quantitative Easing programmes of the UK,US and Japan. Of course it leaves Mr. Trichet having to implement a policy he claimed that he had not even discussed on Thursday!

Mistakes in the press conference

Elena Salgado announced 220 billion Euros as the amount promised by the IMF and then had to change her answer later to 250 billion so this did not look well organised and had the feel of a rush job. In addition the 440 billion special purpose vehicle does not exist yet.

Conclusion

The implications for the changes in the role of the ECB are far-reaching and are the most significant of the moves announced in this press conference. I rather suspect that the ministers involved felt that the special purpose vehicle will not need to be used which of course is a dangerous game and an error they have made before. In effect the ECB is going to monetise government debt or more simply print money.

As for the large sums suggested as loans or aid and publicised in the news media only 60 billion Euros plus presumably 30 billion Euros from the IMF would be available in any prompt time span. If you look at that it would not have been enough even to bail out a small economy like Greece. The special purpose vehicle is something of a red herring to my mind as over the timescale they stated it would take to activate they could have set up such a scheme anyway. So it is an attempt to impress people with large numbers.which is a dangerous game as markets have a habit of testing this sort of thing over time.

The IMF is putting its (or rather the world’s taxpayers) neck on the line for a lot of money.

Spare a thought for Mr.Trichet Europe’s politicians have made a liar of him again, I hope they have had the decency to say sorry!

Update 11.15am UK time

After what was an extraordinary night (albeit if you waiting for the press conference like me a long dull wait first…) now we have an extraordinary day or at least morning. There are quite a few implications from what was decided last night and I do not think that the market have got to those yet. However in time it will catch up. Let us consider the events.

Special Vehicle Programme

At this stage this does look rather like some more euro zone grandstanding. There are loads of questions as to how it will be financed and how it would operate. As I posted in my initial thoughts it does not actually contribute anything at this moment in time because if the description of how long it would take to come into operation by the President of the IMF is true then even the slow to respond euro zone  could have come up with this after the next crisis! So it is an attempt to “shock and awe” with large numbers in my view.

As to who would pay for this I would return you to my calculations above where a lot of money would be put into it by what are the weaker and indeed current problem nations in the euro zone. I still think that this part of the programme is supposed to frighten the markets so much it is never actually used and this is a dangerous and rather foolish game.

A Problem for the UK

Whilst the UK is not involved in the Special Vehicle Programme we are in the stabilisation fund and of course we are “shareholders” in the IMF. According to the Chancellor Alastair Darling our share of the increase in the fund is £8billion. His mind cannot have failed to see the potential political problems for the likely UK government in this. The Eurosceptic wing of the Conservative party will choke on its tea or coffee when this hits them! Also we have a 4.94% share in the IMF so should it be involved up to the limit announced then we would be providing loans via it of US $ 12.4 billion.

Comment

There was some talk by Alistair Darling about this money potentially being helpful to the UK as in stopping problems with our trading partners. Of course you could take this logic about anything and it yet again encourages moral hazard….

The European Central Bank

For this organisation the phrase extraordinary night barely does justice to what has happened to it .I would like to refer to my article on the 9th April where I suggested that for many of the worlds central bank the word independent could no longer be used. Well the ECB has now joined that list in my view. Indeed it is an adjunct to a fiscal policy that does not actually exist within the euro zone.

What is it now doing?

The ECB according to its website will.

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.

What does this mean?

It will buy government bonds and by this it means government bonds of the countries in trouble so for example Greece, Spain Portugal and Ireland. To this extent it is very similar to Quantitative Easing. However there is a crucial twist or addition and that is it does not want to monetise the debt so it will sell other securities at the same time to neutralise the effect of this. These securities are most likely to be German government bonds. So this is a credit risk programme rather than a monetary one.

This means that the ECB will be filling its coffers with low quality assets and selling high quality ones. As it already had the lowest threshold for collateral out of the world’s central banks one can now safely say that it will soon have a quality mismatch between its assets and its liabilities of a frightening dimension. You could put this as a type of sub-prime central banking. Indeed there are many similarities between the ECB’s new role and what those (nasty) commercial bankers were doing a few years ago. You take low-quality debt repackage it under the name of the ECB and low and behold as if by magic it is now high quality!

What is the effect of this?

In terms of euro zone government bond markets then yields for the countries in trouble have fallen heavily this morning as the ECB has already begun to buy them. On the other side of the coin German bond yields have risen above 3% for the ten-year bund as the ECB is presumably selling those.

The remaining credibility of the ECB will be falling as fast as those peripheral bond yields. Why going forward should anyone believe what it says?

Other Moves

These too are very significant but are more forms of monetary policy minutiae. In essence they are reinstatements of policies used to respond to the “credit crunch” and so we are returning to late 2008 in this respect.

1. The ECB is resuming long-term refinancing operations with full allotment for both 3 month and 6 month maturities.

2.To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. This starts tomorrow May 11th.

Conclusions

Rather than the monetary expansionary version of QE the European Central Bank is giving us a credit risk version. It is a relatively innovative way of doing things and will sterilise much of the inflationary impact. However the price is that the ECB will have an asset book of low quality and will loan out high quality assets. This is risky in my view.

If you look at the rally in bank stocks then again this bail out can be seen as another bail out of the banking sector. Indeed as Europe seems to have acted with a lot of firepower overnight it makes me suspect if you put yourself in their shoes and wonder what has made them change their modus operandi then there is one likely conclusion. A bank or more than one bank was likely to go broke.

An irony of this situation is that by contributing to extreme market volatility the euro zone has constructed a situation which is very similar to one you might construct if you sat down and tried to construct one to break a hedge fund or two. If you think of what happened when this happened last time with Long Term Capital Management…….

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13 thoughts on “The Euro Stabilisation Fund is announced and the European Central Bank is willing to buy government debt

  1. Thanks so much for the posts and the analysis Shaun. Very enlightening and much appreciated.

    With the ECB printing money and a new role emerging for IMF, shouldn’t the Chinese and the Russians be on board? And perhaps India and Brazil as well? Some time ago China was making noises for an international reserve currency other than the dollar. Could the new IMF role be part of such a move?

    js

  2. Shaun many thanks for your diligent works and unsociable hours.

    Do I smell a global inflation strategy?

    • Actually I got pulled into it as the Press Conference was five hours late! Having waited for it I kept waiting….
      The impression I got was that there must have been arguments amongst the members and that the deal was put together right at the end as Elena Salgado was not really on the ball…

  3. Hi Shaun et all,

    new export data from Germany showed it grew an amazing 10.7% last march. Imports grew 11%. The estimated trade surplus in april is 13.3 Billion Euros, compared to an estimated 12.1 Billion. Link: http://www.rtl.nl/(/financien/rtlz/nieuws/)/components/financien/rtlz/2010/weken_2010/19/0510_0945_duitse_export_groeit_onverwacht_snel.xml

    Is this the first effect of a weak Euro kick-starting the stronger Euro nations economies into higher gear? Could the real economy overtake the currency speculations? I mean, producers are starting to make some real money now from the currency situation. I have been reading cheerfull stories from exporters in the Netherlands as well. Business is sudenly booming because they can sell at much lower prices.

    I am wondering if this will have some effect later on?

  4. I’m wondering what the individual effects of inflation might be in each country under the Euro. Greece has had traditionally higher inflation compared to the EU average, and in fact April has been announced to be at 4.9 % (!).

    Unless I’m very much mistaken, this means that prices rise while general buying power is being diminished, eh?

    Considering both “large” political parties here at the moment get less than 50% combined in opinion polls (they used to be 80%+ in several elections), I sense that until the next elections are held here, we’ll see political steps being taken in “a different route” compared to the one that led us to this hellish 2010.

    Let’s wait and see…

    • Hi Ioannis

      I just thought I would ask what the current state of play in Greece is as regards popular sentiment. Uk news is a little coalition government obsessed over here but I did notice that a bomb went off in Athens yesterday. Was that particularly significant?

  5. Robert Peston on the bbc (http://www.bbc.co.uk/blogs/thereporters/robertpeston/2010/05/eurozone_crisis_is_postponed.html) is saying that any Greek debt bought by the ECB will be offet by other, presumably German, debt being sold by the ECB.

    Which begs the question – does this mean the Greeks can now issue as much debt as they like, and it will be simply bought up?

    Does worse fiscal behaviour by a government mean that their debt is more likely to be bought up by the ECB and does this imply a serious moral hazard?

    Would Bund yields rise as a result, which dumping Bunds on the market would surely imply, and would European yields normalise toward a single figure? If German taxpayers get wind of the fact that their own borrowing costs, and taxes, have risen as a result how will they react?

    How long can this scheme go on for before the ECB runs out of good bonds to sell?

    I would imagine that a more likely scenario is that, just as the BoE declared an intention to reverse QE at some point and then promptly went very quiet on the subject, the ECB promise to sell as many bonds as they buy will also be forgotten.

  6. OK. Well the 11:15 update answered some of my questions – Bund yields clearly will rise, and Eurozone yield curves will indeed move towards each other.

    But the other questions still remain.

    What if the ECB did run out of Bunds to sell? Germany could be persuaded to go on a spending spree, creating more Bunds in the process, and pulling German competitiveness down.

    Provided the German electorate cannot work out where the inflation is coming from, and do not mind unemployed Spaniards and Greeks turning up on their doorstep to build ill considered public buildings, the ECB might get away with it, and the debt will effectively be monetised.

    • We may have to wait and see as to how they sterilise this operation. One ECB member has been quoted as saying that they can sterilise their bond purchases with activities they were already doing. Apart from contradicting their stated plan this is something of an oxymoron to my mind. But so far it looks as thought their stock of bunds is safe so there is no current danger of running out!

  7. “It is a relatively innovative way of doing things and will sterilise much of the inflationary impact. ” I wish I had your optimism Shaun! I fear the net result of all of this will be much increasing Eurozone inflation, which may well now get out of control. This is particularly so because they have now destroyed any vestige of true independence which the ECB once seemingly had.

    It is all a matter of spending what you actually earn. Socialists just cannot understand that simple premise; for them, it is always a matter of spending what they want to spend for what they want to do. Even when their credit card is maxed out they will still not accept that their spending has to reduce to get back to a position of balance. Until an economic correction is forced upon them by disaster they just will not face the real issues and constraints?

  8. Shaun I like your analysis that the ECB will finance this leg of The Response by selling the quality of its book. Like Jonathan I wonder how much of this “ammo” they have and are willing/able to “spend”, and how the next leg of the game might look when the Bunds-on-the-books run out.

    • I would suspect that they have not thought that far ahead and wonder if this was not an emergency measure to bail out one or more banks packaged as a scheme for the general euro zone. In terms of ammo I wonder if they will run short of this in the areas of credibility and trust before Germany runs out of bunds! How quickly the ECB went from not discussing QE to constructing its own version….
      I suspect that many will not believe the official stories but these things take a while to impact and anyway those that want to sell will let the rally take its course so that they can get a higher price.
      As to real change where exactly will we get economic convergence out of this? And a rallying Euro was one of the causes of the current crisis so todays Euro rally is illogical but as I have said before markets can be irrational and illogical in the short-term.
      Also the ECB’s asset book was already quite poor and we may be about to see how far a central bank can push this measure. I notice that some of the ECB members voted no to this part of the deal.

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