08 October 2011

Hey Europe, What Is Going On? (Part 6)

A lot has happened since posting the Part 5 of this series on 10 September 2011. The troubles of Europe are no secret to anyone following the news: everyone has read or heard that a monetary union like eurozone cannot sustain without a common fiscal policy, that the eurozone banks need to be recapitalised, that enough funding has to be available so that Italy’s and Spain’s needs can be met if the markets dry up, that Greece is the same as defaulted and its case needs special handling, that the people in the troubled countries are strongly against the austerity measures, that the divergences within eurozone make reaching any reasonable agreements within Europe very challenging indeed, and that Europe is being pushed to take concrete steps by US, China and IMF because it is unable to deal with its problems alone, and because the others have too much in play. What is being done to improve the situation? Our elected leaders are not just sitting and waiting the collapse, are they?

The risk for the collapse of eurozone became an urgent issue as early as in spring 2010 when the spreads for the government bonds of some euro area countries (Greece, Portugal, Ireland, Spain, Italy) relative to German government bonds started to increase very quickly (mainly driven by the increased market concerns about the sustainability of public finances in some euro area countries, in view of rising government deficits and debt). The widening of spreads accelerated in April and early May 2010, and on 6 and 7 May they reached levels unprecedented since the start of EMU. (2010 Annual Report of ECB) This was accompanied by a wave of downgrading of European government debt. The trio of IMF, European Central Bank (ECB) and European Commission (the Troika) was mobilised to first rescue Greece and then the euro. 

The emergency measures (that’s what we have to call them as none of the measures taken has provided a solution for the eurozone, but just helped to gain some more time) implemented since then to assist the troubled governments are similar to those of handling problem credit customers if they are “too big to fail”:
a) more loans;
b) guarantees that even more loans will be available if the need should arise;
c) requiring/announcing austerity measures and cost-cutting plans (fiscal consolidation strategies, as officials call it);
d) relaxed credit conditions for the troubled customers (loan restructuring, considerably lower interest rates compared to the market prices etc.)
e) rhetoric, rhetoric and once more rhetoric (officials confirming that: “The situation is perfectly under control.”)
The difference is that there is no one single decision-maker, but (you know) in addition to the Troika there are 17 disagreeing Member States with their unhappy electorates. After the first “financial support programme” for Greece on 2 May 2010, the magic combination of letters here is EFSF combined with the EFSM and followed by the ESM.

The European Financial Stabilization Mechanism (EFSM) is an emergency funding programme reliant upon funds raised on the financial markets and guaranteed by the European Commission using the budget of the European Union as collateral. The Commission fund, backed by all 27 European Union members, has the authority to raise up to EUR 60bn. The EFSM is rated AAA by Fitch, Moody's and Standard & Poor's. (Source: Wikipedia)

The European Financial Stability Facility (the EFSF) was created by the euro area Member States following the decisions taken on 9 May 2010. In legal terms, it’s a separate company incorporated in Luxembourg under Luxembourgish law on 7 June 2010. When putting it simply, it issues bonds and other debt instruments on the market to raise the funds for:
* providing loans to the eurozone countries in financial difficulties (its primary purpose)
* finance recapitalisation of financial institutions through loans to governments, incl. in non-programme countries the governments of which have not asked for help (after the amendment of 21 July 2011)
* intervene in the primary and secondary debt markets on the basis on an ECB analysis (after the amendment of 21 July 2011)
The issued bonds are backed by the guarantees of the euro area Member States up to the agreed amount (up to EUR 440bn at first, and up to EUR 780bn after the amendments agreed in June-July 2011) on pro rata basis, in accordance with the defined contribution keys. Investors in EFSF bonds are predominantly institutional investors such as banks, pension funds, central banks, sovereign wealth funds, asset managers, insurance companies and private banks. The Facility aimed for ratings agencies to assign an AAA rating to its bonds, and has succeeded in this (thanks to the extensive credit enhancements such as over-guarantees, up-front cash reserves and loan specific cash buffers).

So far the effective lending capacity of EFSF is still EUR 440bn. The means of the EFSF are combined with loans of up to EUR 60bn coming from the EFSM (see above) and up to EUR 250bn from the IMF for a financial safety net up to EUR 750bn.

The EFSF has been created as a temporary institution. After June 2013, EFSF will not enter into any new programmes. It is planned to be replaced by the European Stability Mechanism (ESM), a permanent crisis resolution mechanism. The ESM will have a total subscribed capital of EUR 700bn (lending capacity: EUR 500bn). Of this amount, EUR 80bn will be in the form of paid-in capital provided by the euro area Member States being phased in from July 2013 in five equal instalments.

(Read more from the EFSF FAQs and from Wikipedia).

In addition, the ECB and the Eurosystem introduced a series measures aimed at reducing volatility in the financial markets and at improving liquidity:
* On 3 May 2010, the ECB suspended its minimum threshold for Greek debt "until further notice", meaning the bonds will remain eligible as collateral even with junk status
* Reintroduction of some non-standard monetary policy measures in May 2010 (3-month and 6-month full allotments of Long Term Refinancing Operations (LTRO's); the temporary liquidity swap lines with the Federal Reserve System)
* Launch of the Securities Market Programme (SMP) on 10 May 2010 / beginning of open market operations (i.e. buying government and private debt securities)

A few days ago, the IMF’s Borges said that the IMF could use its own resources to restore confidence in the debt markets of Italy and Spain. He said that the IMF could be “helpful” to the debt markets of the two countries by providing “precautionary lending” or “special purpose facilities. (Bloomberg, 5 October 2011)

Now the focus clearly is on recapitalising the European banking sector as declarative general (implied) guarantees do not help any more, and as we showed in Part 3 of this series, several weakly capitalised banks are larger than the economies of their home countries. Assisting banks has led to the large government deficits; now the sovereign debt crisis in the “peripheral” Europe is leading to the banking sector troubles in the “core” of the eurozone which in turn may easily mean a large minus for France, for Germany etc. With Dexia going broke (Why the EU bank stress test 2011 failed again?), the unravelling of the European banking system may just have began... It’s obvious that the sovereign debt crisis and problems in banking sector feed into each other, and one cannot be solved without dealing with the other.

Buying time is of course one thing, and a pretty expensive one. Consider the following numbers.

Official bailouts of eurozone governments:
* The first Greek Loan Facility (2 May 2010): EUR 110bn (before the EFSF), incl. EUR 80bn from the euro area Member States and EUR 30bn from IMF;
* The lending programme for Ireland (28 November 2010): EUR 85bn, incl. EUR 17.5bn contribution from Ireland (from the Treasury and the National Pension Fund Reserve), EUR 22.5bn from EFSM, EUR 17.7bn from EFSF + bilateral loans from the UK (EUR 3.8bn), Denmark (EUR 0.4bn) and Sweden (EUR 0.6bn);
* The programme for Portugal (17 May 2011): EUR 78bn, incl. EUR 26bn from each, the EFSM, the EFSF and the IMF;
* The second programme for Greece (21 July 2011): EUR 109bn, the details of the package are still to be finalised.
Of course, bailout funds from the Member States, EFSF, EFSM and IMF are told to be just loans, but they are loans that can possibly be repaid from the proceeds of the new loans...

Cost of the Securities Market Programme (SMP):
* As of 30 September 2011, the outstanding amount of the programme was EUR 160.3bn (source: ECB)
No one knows how much of this will come back, but more importantly, what will be the value of money at the time when ECB manages to get rid of the purchased securities...

According to the IMF’s European head, Antonio Borges, European banks need up to EUR 200bn.

Very roughly, when we just sum up the above numbers, we get that approximately EUR 750bn is the same as “invested” into the euro rescue operation already (or actually more, because non-standard monetary policy measures taken by ECB are not free either).

But that’s just the tip of the iceberg, the numbers that have been admitted by the officials. As you know, only 1/7 to 1/8 of an iceberg can be seen above water; the rest is hidden below the surface. If that’s also true in the European sovereign debt crisis, the total funds needed for rescuing euro might be between five and six trillion euros... Ok, this number is pure speculation but given the pyramid structure of our monetary system, it’s probably not less precise than the result of any finer calculation.

Iceberg or not, but:
* The total financing need of eurozone governments over the years 2012-2013 is approximately three trillions of euros, incl. more than one trillion for Italy + Spain (data source: IMF’s Global Financial Stability Report, September 2011).
* For the past three months, European banks have been largely unable to sell debt at affordable prices to investors. The analysts estimate that the banks face a mountain of debt, totalling nearly EUR 800bn, that comes due in 2012 (Source: WSJ, 27 September 2011). Whoever these analysts are, I think that they are optimists: my own approximate estimate is that the debt rollover requirement of the euro area financial institutions in 2012 may amount to 1.5-2.0 trillions of euros. (According to the data from IMF’s Global Financial Stability Report, September 2011, the financial institutions’ gross debt is 143% of the forecasted GDP for 2011, thus approximately 13.5 trillions of euros. Based on the data from IMF’s Global Financial Stability Report, April 2011, we can assume that the rollover need in 2012 amounts to at least 10%, but more realistically up to 15% of this debt.)
Thus, if financial markets should freeze (which may easily happen because there have been too many empty promises), the total amount of five to six trillion euros seems even too realistic... And it’s still only about buying time for two more years or so.

At this point remember Part 5, where we showed that the eurozone as a whole does not actually look that bad (although the situation is getting worse because of the difficulties in reaching political consensus). Thus, even more important than the above described emergency measures and speculations about the total cost of rescuing euro, is the question: how / for what the time bought is being used? That’s the topic for the next part of this series.


It’s not difficult to show the absurdity of the situation, and construct scenarios that would lead to the collapse and disorder. It’s much more difficult to convince people that everything is under control (simply because it’s not true). Finding an acceptable way out is even more challenging.

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