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.
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.
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.
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
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.
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.
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.
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?
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.
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…….