The European Financial Stabilty Facility is taking shape: will it be enough?

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 EFSF

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.

Problems

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.

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9 thoughts on “The European Financial Stabilty Facility is taking shape: will it be enough?

  1. I’m just posting this on here because it’s the latest post. I’ve just read something from Angus Tulloch, investment manager of First State Asia Pacific Leaders, which provides another piece of the jigsaw: China is putting up its prices. Tulloch takes the view that equities globally only look good value because of low cash and bond rates. Inflation will lead to interest rate rises and so…

    One thing that has been a benefit of Chinese imports is that commonly bought consumer goods (electricals, clothes, actually practically anything) has kept inflation down. If you consider Chinese bought goods as being part of the shopping basket of many working households, i.e. wage goods, then for a given technology the purchasing power of wages in the UK and around the world has been maintained without affecting profitability.

    So this is another direction from which the squeeze is being felt.

    • Hi Thanos
      In her current situation as a recipient of aid it would not be logical or sensible. Indeed one might question as to whether some of the other countries can “afford” the aid.

      There are a lot of issues which could come up if this organisation starts to issue bonds and lend money so in some ways it is good for Greece she is outside it.

  2. If the EFSF reaches the point of issuing eurobonds, it will be a Quantum Leap in the use of seigniorage to create money.

    The EFSF is a form of hierarchical economic governance leadership, that if it actually reaches the 90% required participation, and issues Eurobonds, creates a federal debt union that unifies the participating member states into a region of global governance.

    The EFSF in exercising seigniorage would be a stunning development as it would be an agency acting as a government to issue global debt, that is debt that be a world-wide financial instrument. Its seigniorage would actually impinge upon and reduce the seigniorage of sovereign nation states. If and when the EFSF issues eurobonds, then an agency would have seigniorage equal to that of sovereign nation states, and would establish it as a sovereign governing power.

    Issuing more debt to resolve existing debt provides only temporary monetary triage; fiscal restraint and austerity would be much better for the nation obtaining assistance.

    If and when the eurobonds are issued, the participating nations will have lost their national monetary sovereignty. People living in the participating states will no longer be citizens of sovereign nation states, rather they will be residents in a region of global governance, one of ten called for by the Club of Rome in 1974.

    The issuance of eurobonds by the EFSF not only creates a hierarchical and unified government in the Eurozone, but it also depreciates the AAA sovereign debt rating of Germany and others. Issuing more debt to assist in a debt crisis, monetizes the sovereign debt of all participating countries. This is inflationary and destructive to the value of the sovereign debt of the participants.

    The required 90% participation level may not be reached as Slovak Premier Waiting for New Cabinet on EU (EFSF) Fund, report Radoslav Tomek and Meera Louis in Reuters June 18, 2010 article.

    And Martin Santa in Reuters article Slovaks Risk EU Safety Net Delay By Failing To Sign Off write that Slovakia rejected on Friday June 18, 2010 calls to sign Europe’s 750 billion euro stability programme, a necessary step for the financial safety net to go ahead, amid political wrangling. Slovakia’s rejection could jeopardise European finance ministers’ plan for the facility to be operational by the end of June.

    If the EFSF comes into existence and issues eurobonds, it would be a stepping stone, that is an assisting step to achieving European Economic Governance, which is the vision of Jean-Claude Trichet. RTTNews reports in article ECB’s Trichet: Europe Needs Quantum Leap To Strengthen Economic Governance, that Europe needs to make a quantum leap in strengthening the governance of economic policies and surveillance, European Central Bank President Jean-Claude Trichet said.

    Should the EFSF arrive to point of using seigniorage to issue eurobonds, it would be a stepping stone to the end time seigniorage system presented in Bible prophecy which foretells that the Sovereign, Revelation 13:5-10, will be complemented by the Seignior, Revelation 13:11-18, who directs the 666 credit system, Revelation 13:17-18, which is the seigniorage system whereby one will be given the charagma, or mark, necessary to conduct commercial activity.

  3. Having read the BoE Financial Stability Report today on the state of UK banks in this context, can you consider giving a heads-up on the Irish situation where we have a particular exposure.

  4. Hi Shaun (and, as always, thank you for another informative article),

    I have a few things regarding the agreement for the package for Greece, as was presented in Kathimerini of 5 June, 2010 (in Greek):
    http://news.kathimerini.gr/4dcgi/_w_articles_economy_1_05/06/2010_403378
    I haven’t seen an English version. Selected points (relevant to issues raised here) are:
    #2. The Eurozone countries have priority over other bondholders for repayment of the loans in the package.
    #4. If any country’s constitutional court finds the treaty in violation of the country’s constitution, and the violation cannot be remedied, then the loan from that country is rescinded.
    #6. Greece may not restructure its debts for the duration of the loans from the Eurozone. If Greece does not pay any of its debts on time, then the other countries have the right to sue.
    #7. Greece forgoes any rights to national assets if the debt cannot be repaid — no current or future asset is immune.

    A comment regarding #7, Germany (as had been reported in the Greek press) was insisting on collateral guarantees in order to agree for the loan.

    I am not sure whether the same rules will apply for any other countries that might need the SPV, or Greece got a special deal.

    js

  5. Hello again,

    Another related issue to austerity packages and pension benefits is appearing across several countries.
    In Romania, the constitutional court found that some of the cuts included in the austerity package are illegal.
    http://www.businessweek.com/news/2010-06-25/leu-sinks-to-7-month-low-on-romanian-austerity-legal-challenge.html

    In Greece, the government is pushing a wide-ranging reform of the retirement system (which is insolvent among other things) and the bill is supposed to come up for a vote in the parliament — it is part of the agreement for the eurozone package. However, concerns have been raised by the conference checking on the constitutionality of the proposed reforms.

    Similar situation in several States in the USA, as reported in last week’s Economist. The states (which are, em, broke) are trying to roll back the benefits in the state retirement systems. The roll backs are being challenged in court.

    Perhaps massaging the CPI might not be such a bad idea after all. I don’t think it’s unconstitutional, right?

    js

    • Hi John
      Yes you were well ahead of the international news pack. If they saw it I would suspect that they rejected it after all the headlines saying that Greece’s borrowings were covered for the next 3 years. The euro zone and IMF have handled this rather badly in my view but let’s face it the euro zones response to Greece’s problems has had a litany of policy errors and mistakes.

      I have also been looking into the inflation issues that you raised. I rechecked the data to make sure my memory gave you the correct answer on hedonics and yes it did. They came into the RPI figures in 2005 for laptops and mobile phones and were in response to some moves made in the US on Alan Greenspans watch. I have not read every document yet but there appears to have been no further moves. The latest issue (from last year) is a possible change in the rate of interest used to calculate mortgage costs in the RPI but this too has met some resistance (rightly in my view).

      In the meantime we have had the move to CPI for indexation of some assets in the UK. This is in my view quite a retrograde step for more reasons that I have explained so far and I will return to this subject. Just one example of this is that the Office for National Statistics is a little more vague about hedonics and CPI than it is for RPI so there is still an element of watch this space…

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