This is the second post for this blog on the latest Euro
area ‘deal’ struck early morning last Friday – the ‘deal’ that is thin on
details (see statement here http://trueeconomics.blogspot.ie/2012/06/2962012-deal-preliminary-reaction.html)
and even thinner on actual commitments (as in ‘new commitments’ not ‘repeated
old commitments’).
(1) The core ‘commitment’ in the deal is the possibility
that – once “effective single supervisory mechanism is established” (which may
or may not take long – depending on whether the already existent EBA structure
can be seen as ‘effective’ and whether it can be enhanced with real supervisory
powers to oversee EA17 states, who are yet to agree such enhancements and such
oversight) “the ESM could, following a regular decision, have the possibility
to recapitalize banks directly” (so on top of establishing a common supervisory
structure and endowing it with sufficient powers, the member states are yet to
endow ESM with ‘regular decision’ powers to recap banks).
Assuming that such possibility is indeed delivered upon,
this would allow banks recapitalizations via ESM instead of directly via
sovereign funds and thus will – for accounting purposes – prevent banking debt
being counted directly as Government debt. This is the positive and it is a
significant positive, for Europe.
However, it has limitations, although it also delivers some
potential positives. A mixed bag overall for Europe.
(2) Irish experience shows that – with Nama debt not
officially counted as Exchequer debt, while Promissory Notes to IBRC and
interest on them is counted as such. Both are fully backed by Government and
both have economic implications, but only one (Promo Notes) has implication for
sovereign finances. In other words, removing for accounting purposes debt off
Government balancesheet does not remove the costs and burdens of this debt off
the balancesheet of the economy as a whole. What this means is that the ‘deal’
does not share responsibility for debt across the Euro zone, as long as there
remain Government guarantees. Instead it spreads debt into the economy (as
banking system will still have to repay them), putting taxpayers into the
second line of fire.
Incidentally, Nama – that vehicle which absorbed some of the
banks bailouts – is highly unlikely to be featured in any
potential/theoretical/rumoured/alleged retroactive restructuring of the
banks-related sovereign debt.
This also means that the deal does not fully break the link
of contagion from banks bad debts to Government balancesheet, but makes this
link more opaque.
(3) There is no retrospection in the deal, although the
Irish Government claims there is. We hope there can be such retrospection, but
it is difficult to see how that can be delivered given that
a) Retrospection would open ESM to some €200 billion worth
already committed Governments’ funds from the peripheral and other states
(including Germany), effectively erasing 40% of ESM capacity before it gets to
lend to any new states (e.g. Italy and Spain).
b) Retrospection in any case would not apply to non-debt
funds committed by the Irish state (some €21 billion in NPRF cash paid in
already).
c) Retrospection could challenge some of the requirements
for conditionality (as it cannot be covered by any new conditions) and any
potential requirements for collateralization (see below).
The Irish Government is so convinced that retrospective deal
is possible, it has set the target of 17% of GDP for debt writedown (see: http://www.irishtimes.com/newspaper/breaking/2012/0702/breaking4.html)
which will require a restructuring of €34 billion and if achieved will be a
significant help to the Exchequer, although doubtful in value to the economy at
large.
(4) The deal clearly states that the banks bailouts will be
subject to the "appropriate conditionality, including compliance with
state aid rules, which should be institution-specific, sector-specific or
economy-wide and would be formalized in a Memorandum of Understanding." In
other words, the conditions will not be universal for all states, but will be
granular – specific to individual environments. Render onto… comes to mind, and
the Caesar – Italy, Spain, any other large member state, is not the same as
Ireland, Cyprus, Portugal, Greece et al.
(5) The ESM itself is, at this stage, still not set up and,
more importantly, has not raised any funds. When operational it will have
capacity to raise €500bn which is highly unlikely to be sufficient to cover
sovereigns’ own needs, let alone underwrite any significant banks bailouts. If
current EFSF participants were allowed to roll into ESM their banks’ exposures
along with Spain, the ESM will have to allocate some €200 billion or so of
funds to existent programmes, leaving €300 billion or so to fund other banks
bailouts that might arise and fund Exchequers’ needs outside banks bailouts.
Thus, ESM will be faced with a dilemma – either it acts as a somewhat credible
banks bailout fund or a somewhat credible support for Government bonds. So far,
under any of the existent proposals, it cannot do both. Were such proposals to
be put in place in the future (e.g. leveraging via ‘banking license’ etc –
explicitly excluded from the ‘deal’), the ESM will have to balloon well past €1
trillion mark.
Absent such proposals for ESM structure, the ‘deal’ says
that ESM will be allowed to directly intervene in the markets to purchase
Government debt. This is not new – in fact it was always supposed to do so.
(6) ESM structure remains unchanged under the deal, so the
fund will go to the funding markets with a backing of collective guarantees of
the member states. The internal backing of credit flows within ESM is that of
the guarantees by the borrowing states to the fund – same as in the EFSF –
except absent subordination. This can mean two things:
a) ESM will have to pay more for borrowing in the markets,
and
b) ESM might face severe difficulties, similar to those
experienced by the EFSF, in raising funds.
The things are getting so tight with the ESM (even before it
is launched) that within the ESM set-up, the combined "guarantees" by
the peripheral states borrowers from the EFSF/ESM plus Italy to ESM creditors
are proportionately in excess of the guarantee provided by Germany.
However, on the positive side here, removal of subordination
clause from ESM lending affirms to private lenders to national Governments the
equal treatment of their bonds with supra-national ESM debt. In the long run,
therefore, this should reduce risk premia for those member states still capable
of tapping the private markets for debt. Thus, making things harder for ESM
might make things easier for Germany & Co.
(7) ESM structure of guarantees is itself a troubling
scheme. When Spain receives the bailout funding, its share of ESM funding and
guarantees will be reallocated to other member states. Germany’s share will
move from 29% to 33%, Italy’s share from 19% to 22%, France’s from 22% to 25%
and so on. Two weaker Euro area states – Italy and Belgium – will become larger
guarantors of ESM. And France, which wants effectively to expand ESM and to
grow the overall euro area debt pile to finance own agenda. More fun? Unwilling
participants to the scheme – Finland, Austria, the Netherlands – all are
getting more ‘voting’ power in the ESM too. Which, of course, should make the
whole ESM proposition even more risky in the eyes of external investors.
(8) ESM structure under the ‘deal’ is reinforced by the
compulsion of the borrower state to comply with strict and specific conditions.
To maintain credibility, therefore, ESM will require these conditions to be at
least as stringent as those imposed under the EFSF (Troika) deals. The problem,
alas, is that no country, save Ireland, to-date has been able to comply with
the previous conditions and the entire mess we are in today was triggered (not
caused) by Greece and Spain refusing to comply with these conditions.
This means that either ESM will have to offer its own
funders much lesser security (higher risk of borrowers from ESM not being able
to deliver internal adjustment programmes necessary for repayment of ESM funds)
or it will have to avoid buying Spanish and Greek debts. Alternatively, the ESM
lending will have to come with even stricter conditions to compensate for the
lack of subordination, which is clearly unviable in current political
environment.
(9) To secure ESM funding, the member state applying for the
funds will be required to sign an agreed Memorandum of Understanding (as with
Troika) which then will have to be approved by other member states. In the
past, Finland, the Netherlands, Austria and Slovakia, not to mention Germany,
have opposed to some conditions that would have allowed easier access to ESM
funds. Specifically, some countries on the list have demanded use of collateral
to secure lending even with assumed (under previous ESM plans) and actual
(under EFSF) super-seniority conditions. What these and other countries might
demand from the ESM funding recipient state is, thus, completely unclear and
uncertain. The same applies to ESM lending to the banks, with an added caveat –
conditions for banks will have to be even more strict.
We are now, therefore, facing a possibility that the
collateral for loans debate can be reignited.
(10) Pretty much everyone agrees that the only lasting
resolution to the crisis will have to arrive via ECB. Yet, to-date, ECB has
been reluctant to engage even with the crisis spinning out of control. If the
latest agreement de facto injects more funds in support of the banking and
sovereign balancesheets, the current deal can actually result in even lower
willingness of ECB to engage. In other words, the ECB might play a wait-and-see
game, allowing the ESM to become fully engaged and only thereafter, assuming
the crisis remains acute, stepping in. In other words, instead of deploying
monetary policy upfront, we might see Euro area first increase its overall
level of indebtedness via ESM and only after that move for the aggressive deployment
of the monetary policy. As we know, this has happened in Japan and it has shown
the weakness of the monetary policy at the time of elevated debt crisis.
(11) On a positive side, we must recognize that the deal
explicitly recognized two things:
a) Germany no longer holds total power over the Euro area
decisions,
b) A Euro area state should not be forced to accept
bankruptcy level debts in order to underwrite banking system solvency (although
there is yet to be a realisation on the side of same happening to the economy)
(12) Also on a positive side, it appears that likely outcome
of common supervision regime will include deposits guarantee and banks
insolvency resolution regime. Both are net positives and both are consistent
with my long-held views on what should be done to repair Euro area banking
system. Alas, the resolution regime will have to come ex post already adopted
measures, so it is unlikely to make material difference to the banking system
we currently have.
(13) A unified banking supervision itself might be a tight
spot. Suppose it is set up. And suppose it is functional. In this case, any
Euro area banking regulator will be faced with a problem – banks under his/her
supervision holding massive and increasing exposures to the sovereign debt of
their own governments, some of which are in ESM. There is a clear-cut case here
to be made that this situation cannot be sustained. However, should the Euro
area regulator move to curtail, say Italian or Spanish banks buying more of
their Governments debts, there will be effectively an end to these countries
participation in the funding markets and a larger call on ESM. Alternatively,
should the regulator ignore the problem of accumulating risks, the regulatory
system itself can be undermined.
(14) The deal – and especially the path that it took to
arrive at – is the example of European policy brinkmanship, not cooperation.
All accounts show that the meeting was broken by Mario Monti with support of
Rajoy and that Hollande provided back up. There is absolutely no argument to
make that any other member state was explicitly on their side, although most
likely Ireland and Portugal were only happy to ride on the coattails of the
opposition. Either way, the whole process of deriving the deal was not a cooperative
solution, but a stand-off. This is not a break from the established pattern of
past summits. But equally ominously, the latest success of brinkmanship is
underpinned not by the change in the Euro area leaders’ positions, but by
changes in the electoral landscape in Europe, with opposition to the status quo
growing on the side of the ‘rebels’ in Greece (Syriza), Italy (Five Star),
France (recent lections shift toward more extreme parties support), Finland
(the True Finns), Germany and so on.
(15) In the end, ESM will not resolve the problem of too
much debt accumulated on the shoulders of European sovereigns and dysfunctional
banking system. The economies involved – Spain, Ireland, Greece, Portugal,
Cyprus, and potentially Italy – are simply incapable of repaying these debts
(please, do consider that even under the rosy Irish Government scenarios – the
best performer in the group – Government debt reductions envisioned post 2014
are minor and mostly driven by economic growth, not repayment of actual debts).
With this, the ESM can become a perpetual lender, with the requirement to
continue raising funds well past the envisioned 10-15 years period. Any
cyclical recession before then or after will derail repayments and the ESM debt
will have to simply rise, risking a debt spiral that we are experiencing today
replaying at some point in the future. Not a pretty thought and certainly a
risk that the ‘game changer’ of the ‘deal’ might end up being the ‘end-game’
losing move.
(16) The deal does provide some room for ECB to claim that now there is a realistic progression toward more centralized oversight over banking sector and thus it can engage more actively in monetary easing. The signal to watch for is the ECB 1% repo rate, which can be lowered, implicitly signalling ECB willingness to long-term tolerate inflation over 2%. Thereafter, 4% inflation becomes feasible and ECB can start priming the pump. In turn, devaluation of the euro will compensate German economy by boosting exports and will put even more pressure on internal devaluations in peripheral states (imports costs up, exports largely non-existent to benefit from cheaper euro, etc).
Today’s PMI figures showing broad euro zone-wide and sharp
contraction in activity in June should make the ECB move this Thursday a ‘no-brainer’.
