How can calm be restored to Sovereign Debt Markets of E.M.U. Member States?


The rapid dismissal by the market of the ECOFIN communiqué after last Sunday’s meeting was to be expected. As discussed in my recent appraisal, it raised more questions than it provided answers, adding to uncertainty and contributing to fuel a self fulfilling negative scenario.


It is now urgent to “stop the rot” and engineer an appropriate framework to trigger a virtuous rather than vicious circle of events.


There are several questions that need to be addressed in parallel so as to provide a coherent and believable way out of the crisis and calm the nerves of the market.


The first question relates to the “credit structure” of the instrument(s) to be activated in dealing with financial assistance to EMU Members.


I have already discussed at length the shortcomings of the present EFSF arrangement which needs to be corrected in three main respects:


-          Its duration: the final mechanism should be made permanent. This is already recognised by ECOFIN but rather than postpone its implementation until 30/06/2013, it should become operational as soon as possible. It implies a comprehensive agreement covering “all” major political and technical aspects.


-          Its “credit backing”: Despite having obtained an AAA rating on the basis of its present structure, Rating Agencies can be expected to review their judgements, once a significant amount of securities are issued, unless additional enhancements are forthcoming. This is because the “several” nature of the guarantees provided by EMU Member States implies that only a portion of each issue is guaranteed by AAA rated issuers (Germany, France, Austria, The Netherlands and Finland). Ratings measure the risk of punctual full payment of principal and interest; it follows that it should never be higher than the rating of the “weakest guarantor” (currently A- by Portugal) adjusted for existing enhancements (a call on an additional amount of 20% of extant guarantees).


It is of the utmost importance that both the ESFS and the permanent mechanism that should replace it, benefit at all times from a secure and unassailable AAA rating. This implies a “joint and several” guarantee that can be provided either directly by the EMU Member States (as long as Germany agrees) or indirectly; the latter can be achieved by an explicit EU budget guarantee that benefits “by construction” of the joint and several guarantee of all EU Member States or, preferably – as already suggested – by bringing the existing EFSF under the umbrella of the EIB Group whose credit structure and market acceptance are thoroughly established.


-          Its size: Part of the current market unrest is clearly related to the fear that if the EFSF is called to assist Spain, its current size would prove likely to be insufficient, forcing the hand of Member States to come up again with a “quick fix”. If past experience is a guide this will only provoke additional testing of the ultimate political will of EMU Members by the market. Instead, Member States should make clear their unbending commitment to ensure the continued success of the Euro (it really is an outstanding success story).  It is suggested that in order to do so, an “initial” maximum size of the mechanism be set at between €1.5 and 2 trillion. Member States, having to approve each individual “stabilization” operation, will nevertheless retain full control over the amounts and the conditions under which funds are being committed and drawn. To further reassure markets, Member States could agree to review the overall size if 2/3 of the initial amount is committed.


The second question relates to the purely “financial” conditions under which funds are provided to Members in difficulty (as separate from the economic and fiscal measures that are negotiated as part of the conditionality of the loan).


There can be little doubt that the market views with great scepticism the ability of weaker MS to restore their finances if the interest burden of new debt is excessive. We are currently at the inception of a vicious circle that is gripping markets: high (re)financing costs aggravate existing deficits requiring additional austerity measures which defer improvements in the economy (particularly in employment) which in turn create social tensions reflected in widening financing spreads to the point where markets believe that the situation becomes “unsustainable”.


It is quite possible to argue that, due to the ambient uncertainty, markets have pushed spreads out to “unreasonable” levels. However, this can only be counteracted to the extent investors become convinced that borrowers will ultimately be in a position to meet their obligations. The high cost of (re)financing is a major factor in this “horse and cart” situation which induces “normal” conservative investors (Pension funds – Insurance companies – Mutual funds) to reduce their exposure to EMU sovereign debt risk, adding substantial pressure to volatility induced by “speculators”.


It should be obvious that it is in the interest of the Guarantors of the stabilisation mechanism (particularly Germany) to agree that “on lending” to the borrower should be done at a very marginal spread over the cost of funding, in order to reduce the likelihood of being called on their guarantees. This has been the time honoured practice in previous EU loans to beneficiaries of its “Balance of Payments Assistance Programs” or EURATOM loans. Such a change in the practice, that did not – unfortunately - apply to Greece and Ireland, must be a first and immediate step in order engineer a virtuous circle aiming at reducing structural government deficits. Action on this point is urgent as several borrowers are nearing the point where their refinancing costs are becoming prohibitive inducing markets to demand even greater premiums; it would also serve as a concrete demonstration (rather than words) of the solidarity between EU/EMU Members.


In the aftermath of such a measure, it is possible to hope for a progressive reversal of the trend of widening spreads which are affecting all EMU sovereigns. While it is not expected – nor appropriate – that spreads would tighten to the “absurd” low levels witnessed in the early days of EMU, one should aim at restoring a “spread curve” that would reflect appropriately the individual credit standing of each Member State, but also taking into account the existence of a credible and unassailable backstop mechanism.


The third question relates to the transparency of bank exposures to sovereign debt risk.


The existing incestuous relationship revealed by the commitment of EU Members in the aftermath of the Lehman bankruptcy to avoid any failure of a European bank has led to an unsustainable situation in which Banks and the Governments that ‘insure” their depositors have become inextricably dependant on each other for survival, as was only too clearly demonstrated in the Irish case.


It has become urgent to resolve the unsustainable asymmetry between the commitment of National Governments to insure depositors and the total liabilities of these same banks which, in several countries, far exceed domestic GNP (Greece, Ireland, and Belgium). Rather than attempting to solve this problem by lending directly to Governments (Ireland or, if it arises, Spain, Portugal or Belgium) so they can recapitalise their banks, it might be appropriate to consider the instauration of a separate EU wide “bank stabilisation mechanism” in addition to the new permanent EMU stabilisation mechanism described here above. It would also reduce the pressure on the insurance sector to the extent that its very significant exposure to sovereign debt would benefit enormously from such a split and could minimize the effects of “pre-emptive” portfolio rebalancing on the secondary market.


For credibility reasons, such a separate mechanism must also benefit from the joint and several backing of all EU Member States. However, the mobilisation of its resources could be subject to a “restructuring” of the debt of banks being recapitalised, including- as Germans are insisting - on burden sharing by private creditors involving either/or haircuts, rescheduling and debt/equity swaps.


In this way one reduces the “pollution” of the sovereign debt segment of the market by problems affecting the banking sector. Part of this mechanism could also involve putting the interbank market on “Central Clearing Platform” as more fully described in the proposal in my paper dated Septembre 2008 « La Crise Financière : Comment structurer une solution à l’échelle de l’Union Européenne » 



At present, the ECB ensures the “transmission” mechanism by which this unstable equilibrium is being temporarily maintained. This is accomplished by a three pronged approach:


-           meeting unlimited demands for liquidity (in particular from banks excluded from the interbank market) and


-           pursuing an accommodative “collateral” policy which, against any rational “credit analysis” – but for thoroughly understandable political reasons – perpetuates the fiction that all EMU sovereign debt issues are (so far) “eligible” for securing advances to the banking sector.


-           intervening directly in the sovereign debt secondary market to alleviate market failures.


Taken as a whole, this amounts to “quantitative easing” once removed, where banks “intermediate” to obfuscate what is the equivalent, in economic terms, to direct purchases of sovereign debt from its issuers as performed in the United States quite openly by the Federal Reserve.


Let me add that in doing so the ECB has little choice if it wishes to escape the blame for creating a new systemic banking crisis. It must therefore be a priority for the ECB to put its full weight behind the “political process” that will, in the end, justify the “temporary” support it is compelled to give the system. The recent declarations of ECB President Trichet seem to support such a point of view.


An additional question concerns the European Systemic Risk Council (“ESRC”).


When it becomes operational in early in 2011, it is imperative to acknowledge that the bank holdings of EMU sovereign debt constitute a major “systemic risk”. It will be up to the ESRC to make, early on, the adequate recommendations to the EU(Council – Parliament and Commission), the Member States and the three new microeconomic regulatory/surveillance Authorities to deal with this situation. These recommendations should seriously address the points raised here above.


There can be little doubt that recognising the systemic risk associated with sovereign debt exposure of banks will have profound implications on the adequacy of their respective capital positions. It should lead to a thorough revalidation of the “stress tests” that were deemed to have been met by the great majority of banks (including the Irish) with such flying colours as recently as last July. The needs for further recapitalisations which will follow, add to the rationale behind the setting up of the EU Bank Stabilisation Mechanism. 


Finally, it is necessary to definitively cast aside the fiction that the debt of an EMU Member State should be considered on par (structurally speaking) with sovereign debt of a country that has retained full monetary sovereignty.




More and more voices are making explicit the stark choices that lie ahead:


-          Either a progressive inward looking attitude develops further, based on the exploitation of understandable social discontent and abetted by a feeling of injustice as well as populist and nationalistic slogans. This trend, if dominant, will lead to the breakup of EMU and ultimately of the EU itself.


-          Either a determined “leap forward” towards further European integration will prevail, giving the EU the necessary tools to overcome the unavoidable but nevertheless painful hardships that accompany the exit from the crisis.


Despite the disadvantages of an ageing population, the EU’s accumulated wealth, the level of education of its population, its less dire position in terms of Government debt and budgetary equilibrium compared to other main actors on the world stage, provide the Union with strong fundamentals to deal successfully with the current crisis. Therefore, there is no “structural” reason for “Euro pessimism” as long as the EU proceeds to further implement the values that presided over its very successful development since World War II i.e. “responsibility” and “solidarity”. 


I fully share President Barroso’s opinion that “there is more to fear from the pessimism of Europhiles that of the criticisms of Euro sceptics”. It should, however, not prevent those who wish to build a more secure and prosperous future for the next generations, to make concrete proposals for bold reforms that result from the current economic, financial and now also deep political crisis. My call made repeatedly for considering the rapid extension of EMU to the whole of the EU is part and parcel of such a dynamic and radical vision.


It is only by implementing thoroughly thought out reforms that confidence can be restored and that the powerful dynamics of financial markets can be put to work to underpin rather than destroy the recovery.


Brussels December 4th 2010


Paul N. Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute.






















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