The communiqué of the latest ECOFIN (November 28th), called to reassure markets before the start of a new trading week, will have - at best - a short-lived knee-jerk effect after three weeks of turmoil in bond, equity and currency markets.
Let us examine the two main questions relating to the Irish bail-out and the “Permanent European Stabilisation Mechanism”.
The Irish Package:
Out of the total € 85 billion, €17, 5B is contributed by Ireland itself (levy on the pension reserve). The balance of € 67, 5B will be shared equally (€22,5B) between the IMF, the ESFM (EU budget guaranteed facility) and the EFSF (EMU several guarantee mechanism) together with the UK, Sweden and Denmark.
The package is split into two components: €35B for Irish banks and €50B of budgetary assistance.
Out of the €10B to be made available immediately to recapitalise the Irish banks, €5B will be provided by Ireland, €1,67B by the IMF and the EFSM respectively and the remaining €1,67B by the EFSF, the UK, Sweden and Denmark.
While it can be expected that the three non EMU participants will contribute “bilateral loans” financed out their own resources, the EFSF will be called to make its “market debut” for an amount of between €1 and 1.5B.
This initial issue of the EFSF will be followed with great interest in several respects: in particular, it will set the stage for its future issues in circumstances that are, unfortunately, far from ideal:
a) The small amount of the issue will limit its liquidity in the secondary market inducing a “premium” which might prove difficult to reduce at a later stage. It will also establish future references for the “spreads” with other European sovereign issues (Bunds, OAT, OLO, etc.) as well as with other “Community” guaranteed issuers (EC, EIB). The complexity of the EFSF mechanism may create confusion and induce higher “funding costs” than warranted.
b) The EFSF Framework agreement clearly defines the “several guarantee mechanism”, enhanced to provide AAA “security” for bondholders (as long as EFSF total outstanding debt remains limited to a fraction of the available facility). It will be of great concern, to the guarantors and prospective bondholders alike, to understand the “ranking” of the EFSF’s “on lending” to Ireland in comparison with the loans granted by the IMF (which are privileged), the EFSM, and the bilateral loans of non EMU Members?
c) It should be born in mind that, should the EFSF mechanism be, once again called upon to provide assistance to another EMU member (Portugal/Spain), the structure of the guarantee mechanism will be altered because the “requesting” country no longer contributes its share to the guarantee mechanism of future issues (this also decreases the overall amount of the Facility). This “instability” of the guarantee mechanism will at some point lead to a reconsideration of the AAA rating of the EFSF (unless otherwise enhanced) and will significantly impinge of the marketability of its “non fungible” securities.
d) The open controversy concerning the “adequacy” of the EFSF’s size, between those who, like the ECB’s Axel Weber, recommend an immediate “doubling” of its size and those, like Eurogroup President Jean-Claude Junker and President Barroso, who affirm that the Facility is amply sufficient to meet foreseeable requests for assistance, adds additional uncertainty which is likely to further rattle markets.
In conclusion, the size of the Irish bail out is very probably adequate to meet the country’s immediate and medium term funding needs. However, one should remember that, in the minds of its designers, the EFSF was meant “never” to be activated, based on the hope that its considerable “nominal” size would be sufficient to deter what was euphemistically referred to as “speculative attacks”. This hope has been dashed and with it, the “technical” flaws imbedded in the system are surfacing. This is why, as is discussed hereunder, the necessity for a new “permanent” mechanism has become a central preoccupation of the authorities.
The Permanent European Stabilisation Mechanism:
It is very hard to understand how it is possible for the Ministers of Finance to claim at the end of the November 28th ECOFIN meeting that they have made “decisive progress” in establishing a permanent stabilisation mechanism. This kind of “irresponsible” declaration is bound to be severely tested by markets, after an initial sigh of relief, once investors become even more disenchanted with issues of EMU sovereign debt.
A first “contradiction in terms” flows from the nature of a “mechanism”, which is, by essence, a well defined “framework”, and the affirmation that each situation requiring intervention will be judged on a “case by case” basis. In sporting terms this is called “kicking the ball off limits”!
Another major area of uncertainty pertains to the statement that “participation” of the “private” sector in a restructuring request is to be limited to cases of issuer “insolvency” and to investors in issues sold after 30/06/2013. This creates in turn a series of new ambiguities:
The first concerns the determination of a “solvency” crisis as opposed to a “liquidity” crisis. It could be argued that a sovereign State is not “insolvent” as long as it has available “marketable” assets (see on this point the conditions imposed on German Länder when requesting “Federal” support described in the recent Bruegel paper on its proposals for an ECRM).
The second relates to the definition of “private sector” which, depending on the context, is sometimes referred to by the Authorities as being composed of “banks and institutions managing collective funds” and sometimes as “all bondholders” who purchased bonds covered by Collective Action Clauses” (CAC) which are supposed to become “mandatory” for sovereign debt issued after 2013.
While, CACs certainly facilitate the “renegotiation process” with a given set of bondholders in case of insolvency, they by no means address the questions of “pari passu” treatment of all bondholders holding similarly “ranked” securities or “acceleration clauses” in case of default. Nor do they reduce significantly the risk of “speculative attacks” against an issuer once the investors “smell blood”.
It should be quite obvious that if, as part of the CAC, one wished to include the possibility of the differentiation in treatment between “new” and “old” “private” bondholders, any new issue after 2013 containing such a provision would command a substantial discount to all then outstanding debt, aggravating considerably the cost of future debt (re)financing or even inhibiting it altogether. The introduction of CAC clauses which would include such a “differentiated” treatment would therefore directly contribute to creating the insolvency that one wishes to avoid. Announcing such intent would have “immediate” consequences on the market appraisal of all of an issuer’s outstanding debt. It would be like announcing a “devaluation” three years in advance! No wonder that markets are not satisfied by the ECOFIN communiqué.
If, on the other hand, the intention is merely to introduce after 2013 “standard” CAC clauses, then their real effect will only kick in once nearly all the outstanding debt, not covered by CACs, is retired. It is clear that this option will do very little to reassure “private” investors with regard to the problems of the current financial/debt crisis and the capacity of EU Member States to deal with it.
In addition to the previous considerations, the very sketchy and ambiguous proposals do not address the fundamental problem of dealing with the current incestuous and vicious circle created by the systemic interdependence of government debt issuance and solidity of the banking sector which, as the Irish case has clearly demonstrated, need each other to survive.
If one considers that banks will be called upon to “share” in the pain of sovereign debt restructurings, it follows that their appetite for holding such paper will be severely curtailed. Where will the States find investors under these circumstances and at what “inflated” price, especially for weaker issuers? Will Governments in “healthy” countries be forced to bail out their banks if they have large exposures to foreign sovereigns? If there is the slightest doubt on this question, the (re)financing opportunities for weaker credits will be reduced and their cost increased considerably.
What will be the credibility of the Government “Deposit Guarantee Schemes” if banks don’t even trust the Governments that are insuring their depositors? If this question ever arises, the ground will be laid for “bank runs” as depositors withdraw their assets from any institution which is excessively exposed to a sovereign debt risk.
A fully mutualised European Union Guarantee Scheme could contribute to alleviate this problem. However, can one expect Germany to accept such a show of solidarity when it has insisted and obtained the “several” nature of the EFSF guarantee mechanism?
As I finish my remarks, markets are already reversing their initial positive appraisal of this weekend’s announcements corroborating, even faster than I expected, the predictions made here above.
With the acuteness of the Irish problem dealt with, authorities should impose a period of embargo on their - too often - contradictory declarations until such time (hopefully very rapidly) as a comprehensive and coherent agreement has been reached. The insistence by officials, in some relatively stronger EMU countries, that they are not concerned by the current turmoil (France, and Belgium in particular) lacks credibility because such declarations are in overt contradiction with the simultaneously proclaimed necessity to adopt stringent restrictive budgetary policies. Furthermore, it should be abundantly clear to all that should the survival of EMU ever be put into question, there would be no winners; only greater or lesser losers including mighty Germany!
Brussels, 29th November 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259