After a couple of days where they had been quieter equity markets picked up yesterday. I mean in times of price movements and volume with traders apparently willing to ignore both the World Cup and Wimbledon tennis for a day anyway! May I just in passing tip my hat to John Isner and Nicholas Mahut who if you were not aware played over three days so obdurate were they, and actually played some 138 games in the fifth set alone. The Dow Jones Industrial Average closed down some 145 points giving us another triple-digit day which is now 17 out of the last 30 trading days. Government bond markets had some action too with Greece being yet again under pressure. As we seem to be entering another round I will look at the European Financial Stability Facility (EFSF) today. This is what was called the Special Purpose Vehicle or SPV and is the vehicle set up to be the main enforcer in her “shock and awe” strategy from May 10th. Personally after what happened last time when someone boasted of a “shock and awe” strategy i.e the opening of the Iraq war I would have avoided such an analogy as we are all aware of what then happened.
The Finance ministers of the euro zone formally established the European Financial Stability Facility (EFSF) on Monday the 14th of June. How it will operate is that it will be established with guarantees from the all the euro-zone member states except for Greece totalling some 440 billion Euros. It also now has a Chief Executive Officer Klaus Regling. It will be ready to act as soon as 90% of the “capital” of 440 billion Euros has been committed by the member states, which is likely to take some 3/4 weeks. So far so relatively simple however the EFSF plans to have a buffer of 20% which it feels will be sufficient to get it as an institution a Triple A rating from the credit rating agencies. So this means that it will in fact have some 365 billion Euros available to help any euro zone sovereign nation were to get into funding difficulties.
How will it work?
Should a nation get into trouble the EFSF would sell bonds of its own in the financial markets to finance its share of any aid/rescue package for a troubled sovereign. It plans to do this in return for applying conditions to the country concerned which will be reviewed and updated quarterly. The bonds the EFSF issues would be guaranteed by all euro zone member states proportionately to their share in the capital of the European Central Bank. The bonds could be of whatever maturity is seen as best and would not be limited by the envisaged 3-year life-span of the EFSF itself. Once the EFSF raises money through the bond issue, it would lend money to the euro zone country in trouble charging a rate of interest modelled on the one charged by the IMF and similar to the one that Greece was charged for her rescue package.
Will it be alone?
When it acts to finance a countries problems then the EFSF will be joined by the European Commission which has established a fund of 60 billion Euros for this purpose and the IMF which has promised some 213 billion Euros as part of the package. So we have a sum total of 638 billion Euros which if somewhat short of the 750 billion promised is still what might be called a tidy sum. I have reduced the contribution from the IMF from the originally promised 250 billion because I remember its President promising to help in the ratio 2/3rds to 1/3rd and so a reduction in the EFSF also reduces the IMF contribution.
1. When a policy measure does not deliver what it promises that disturbs me somewhat and this one is some 112 billion Euros short. In yesterdays comments section it was pointed out for example that the Greek Newspaper Kathimerini is running a story saying that Greece will have to issue Treasury Bills in July. If this turns out to be true it does not fulfil the promises or the arithmetic of the Greek rescue package to my mind.
2. The idea that the EFSF will issue securities or bonds when a sovereign needs help seems to assume that nation is the only problem at that time. Should it not be so then issuing such paper may be difficult or even impossible. What if several are in trouble at once or the problems are associated with financial markets being in trouble themselves? How about a freezing of the bank interbank market for example? Not exactly the time I would want to be trying to issue securities.
Those who think that this could work point out that the securities could be repo’d at the European Central Bank so that in their view there would always be a market. It strikes me that allow investors to effectively round-trip the ECB and the euro zone is not far off financial alchemy.
3. This would plainly take time just at the moment time might be short. I would imagine (given the response time to events that the European Commission has demonstrated) that the IMF would be called in to offer any urgent finance.
4. I do remember the Deputy Director of the IMF being quoted as saying that it does not hold funds for specific purposes until they are directly called on so the whole scheme had better hope that the IMF does not have other calls on its funds at the time.
5. There appears to be no mechanism for restructuring of the debt for the sovereign nation which hits trouble. The euro zone made this mistake with Greece where to my understanding if Greece should now have to restructure then the money provided by the euro zone (up to 80 billion Euros) would have to take a haircut to. To misquote a famous phrase,tell that to the Germans… A Greek restructuring is rather likely at some point in my view.
6. Countries which may be recipients are also funding this plan. If we revert to the 440 billion capital total before the margin for the Triple A rating then we get contributions from the possible candidates of Italy 81.1 billion,Spain 53.9 billion,Portugal 11.4 billion and Ireland 7.2 billion. So a call from one of these not only is a draw on the fund it reduces the potential capital available.
Asssuming it works is it enough?
The fund has capital and if all of it were to be used then it could in my view buy some time. For example if we deal with purely sovereign needs then it could finance the expected government debt issuance of the four usual suspects (Portugal,Ireland,Greece and Spain) for the next 3 years. So it has the capital to buy time,however as per the Greek rescue you then come to the question of what happens next? What if at the end of the three years they are in no better a position or even in a worse position? If you wish to shorten the timescale then adding Italy to the mix brings it to less than two.
However we also know that a lot of the current problems are banking ones which are badged as sovereign ones. Without the perceived state of her banking system there would be no particular reason for Spain to be on the list above. Then the arithmetic becomes more difficult as then one could see a scenario where say Spain could use up a lot of the capital. It is also true that Spain’s banks would affect others so one would be expecting other calls for cash as contagion spreads then it could quite easily not be enough. I notice that my tutor from the LSE Willem Buiter of Citigroup feels that to guard against all eventualities then some 2 trillion Euros would be required and that this would have the force of what US Treasury Secretary Paulson called a “bazooka”.
I suspect that I will not be alone in finding an answer of maybe somewhat uncomfortable and that the underlying philosophy of “kicking the can down the road” assumes that things improve in the three-year timescale. So to add to my suggestions I would make the facility permanent.