The European Union's Path Forward in 2011
As usual, the European Union Council meeting on December 16 and 17 was accompanied by demands for "bold solutions" and paradigm shifts in the form of fiscal union and eurobonds. And as usual, their conclusions were disappointing. Largely at Germany's behest, EU leaders instead merely agreed to do what they had said they would in October. They plan to revise the EU Treaty marginally to set up a permanent European Stability Mechanism (ESM) to replace the temporary arrangements of last May, in the manner settled by their finance ministers in November. Concluding a year of short-term crisis solutions, most of EU leaders' time focused on the long term. Whether this will be sufficient to enable particularly Portugal to return to the financial markets in January 2011 at anything other than punishing interest rates remains doubtful.
On the other hand, there is more clarity about where the European Union and the eurozone are headed next year.
New Eurozone Bank Stress Tests
Eurozone leaders confirmed that their banks will face new stress tests in early 2011, implicitly acknowledging that the stress tests published in July failed to restore confidence in the zone's banking system or anticipate the implosion of the Irish financial system. Some skepticism should greet this announcement, though the new tests may be more robust than the last. They will be conducted, for example, under the new European Banking Authority (EBA) and the new EU supervisory system taking effect January 1, both of which will be under pressure to strengthen their credibility and avoid "process capture" by the various national (champion) banks and their regulators, as occurred in the first set of stress tests.1
Second, the new Basel III rules will play a larger role in the design of the stress test scenarios. The regulators will be hard pressed to be less lenient on banks in general than the IMF, European Central Bank (ECB), and European Commission staff are expected to be on the Irish banking system in early 2011.
Irish banks will be subject to several capital requirements, for example. The Irish central bank will enforce recapitalization of viable banks to achieve a capital ratio of 12 percent Core Tier 1 by the end of February and employ adverse scenarios affecting current asset valuations over a horizon of three years. Most important, all key details of these new stress tests will be made public.2
In addition, Irish banks will have to meet a minimum Core Tier 1 ratio of 10.5 percent under the baseline scenario and a minimum Core Tier 1 ratio of 6 percent under the stress scenario running from 2011–13. This time, the stress tests will also include a "liquidity assessment" and an analysis of the impact of higher funding costs from credit rating downgrades. Following the stress tests, a capital ratio of 10.5 percent Core Tier 1 will become the new regulatory minimum for Irish banks.
If the Europe-wide tests follow these procedures, the eurozone banking system will likely require substantial new capital, probably with the help of governments. Given the high reliance of many eurozone banks on ECB liquidity, an inclusion of a meaningful "liquidity assessment" on a pan-European level could provide supervisory authorities with a forceful tool to "impose recapitalization" upon reluctant bank boards and shareholders.
As always with regard to these stress tests, Germany looms as a problem. The Bundesbank and its cohorts in the Landesbanken must not be allowed to dictate the "lowest common stress test denominator," as they have in the past. Hopefully Spain, which implemented the most far-reaching transparency exercise in the last stress tests, can move the process forward by unilaterally revealing the true state of its regional and savings banks (the cajas).3
The ECB Capital Increase
The eurozone leaders have a €5 billion increase in subscribed capital to €10.76 billion for the ECB. The bank said this was "deemed appropriate in view of increased volatility in foreign exchange rates, interest rates, and gold prices as well as credit risk." This move could be interpreted as designed to reassure those concerned about potential losses arising from the bank's purchases of €71.8 billion in peripheral eurozone bonds through its Securities Markets Program, or SMP, as of December 10 2010.
In reality, however, the ECB capital increase and its timing are a political statement that has nothing to do with capital adequacy. What matters is not the level of paid-up ECB capital, but the consolidated balance sheet of the entire eurosystem, i.e., the ECB and the 16 national central banks of the euro area. The current capital and reserves of that system are €78.2 billion. Even if the €5 billion is new capital, it would amount to a mere 6.4 percent increase in the capital reserves of the eurosystem, a token amount.
Keep in mind, too, that the ECB has considerable "income" from seigniorage, derived from the income accrued by printing new money to grow the current circulation of euro coins. With €840 billion in circulation (roughly 9 percent of eurozone GDP in 2010), and an assumed nominal rate of GDP growth of 3.5 percent, ECB annual (narrowly defined) seigniorage income alone runs into the tens of billions of euros per year, many times the amount of the new capital increase.4
In the final analysis, the ECB capital increase was intended as a signal to EU leaders not to expect the bank to bail them out, but rather to take the necessary initiatives to restore fiscal solvency. One can also hope that it will nudge eurozone banks to shore up their capital base ahead of new stress tests and the Basel III implementation process.
The Scale of the EFSF/ESM
EU leaders pledged to "ensure the availability of adequate financial support" through the European Financial Stability Facility (EFSF) and its successor, the new European Stability Mechanism (ESM) but did not raise their scale above the previously announced level of €440 billion for the EFSF. Standing pat on the level will disappoint many, but it will not be binding in the future.5
Once the ESM replaces the EFSF and the €60 billion European Financial Stability Mechanism (EFSM), the new sum would have to be at least €500 billion. Moreover, a fixed maximum makes no sense when EU leaders state that they "stand ready to do whatever is required to ensure the stability of the euro area as a whole."
Ultimately, given the essentially limitless European political commitment to shore up the euro, the real constraint on the scale of the EFSF/ESM would logically be the ability of the EFSF to issue new bonds at short notice in excess of the €440 billion threshold. Since the willingness of France and Germany to ultimately shoulder the largest burden from a future debt issuance is ultimately a political decision, the real issue is whether such new debt would be issued at rates below those available to the intended recipient country. Given the AAA rating of Germany and some other countries, the EFSF/ESM would certainly be able to do so while retaining its AAA rating.
On the whole, it is better for European leaders to maintain a "constructive ambiguity" on the size of their rescue mechanism, since any announcement of a specific larger number might be taken as a sign of official concerns about the economic weakness in Spain or Italy.
Would a large EFSF-bond issue attract new purchasers or merely lure those already in the market for national eurozone governments' bonds? Here one can speculate that political considerations may play a role. Trading partners dependent on the euro maintaining its value in currency markets could easily be imagined as potential EFSF bond purchasers, for example. China, which eagerly purchases US securities to maintain a competitive renminbi peg to the dollar, would likely be similarly concerned about a loss of exports to the eurozone and/or European Union and step in if necessary.
Europe would not be expected to raise the same "national security concerns" about Chinese-owned debt that one hears in the United States. Greece, after all, sold its sovereign debt to foreigners with barely a peep of protest. Indeed Chinese commitments to purchase EFSF/ESM bonds would no doubt earn it considerable political praise among EU leaders.
Lastly, as a likely long-term "political creditor," it would probably make most sense for China to purchase the conditional EFSF/ESM bonds, rather than simply the bonds of peripheral countries directly, so as to see peripheral countries' ultimate creditworthiness (and with that the creditworthiness of the European Union as a whole) benefit from the conditionality attached to EFSF/ESM assistance.
The Future Functioning of the ESM
In endorsing the eurozone announcement of November 28 that future liquidity assistance will be accompanied by "strict conditionality," EU leaders further stated that the ESM "will be activated by mutual agreement of the euro area [member states] in case of risk to the stability of the euro area as a whole." They also tasked the eurozone finance ministers and the European Commission to complete the establishment of the ESM by March 2011. Non-eurozone members may participate in its operations voluntarily.
In the first quarter of 2011 we should consequently expect details about how the old and new mechanisms will operate after 2013. Given concerns discussed earlier on RealTime about the new eurozone Collective Action Clauses as they relate to the flow of new debt and the existing debt stock in several peripheral eurozone members, the question of how the ESM will operate is crucial to the stability of eurozone sovereign bond markets.
Recipient countries can expect to have to adhere to a standard IMF program of conditionality, for example. For long-term proponents (like this author) of accelerated structural reforms throughout the European Union, this is unambiguously good news. The structural reforms listed in the second IMF review of the Greek Stand-By Arrangement6 are refreshing to read. They ensure that ESM recipients will both improve economic performance and debt capacity (implicitly addressing some solvency concerns), as well as make it clear to taxpayers in eurozone creditor nations that recipients "work for their money."
Far less clear are the conditions under which the ESM will lend money in the future, however. What will be the ESM triggers for action, and at what rate will the ESM lend?
First, ESM triggers: Since the precise definition of the "a threat to the stability of the eurozone" is a matter for political leaders, the current limited wording on ESM operations cannot yet rule out a scenario where ESM loans could be used in a more preemptive manner without "the trigger of acute financial market pressure." It may well be deemed in their interest, too, for leaders of creditor nations in the eurozone to accept use of the ESM to promote their own political goals in other member states.
Future eurozone governments unable, for instance, to overcome entrenched domestic opposition to required structural reforms of pension, healthcare, or labor market systems may decide that in "the interest of future generations" they must tie the hands of recipient government leaders applying for help. Could they do so by imposing conditions that would extend well into the future? Such a course of action would mirror past EU directives aimed at overcoming domestic opposition in errant countries. One could even envision that the eurozone might try to suppress regional separatist movements in affected countries by imposing rules against their breakup as a condition for help.
As for future ESM lending rules, EU leaders have repeatedly emphasized how the Collective Action Clauses could entail private sector haircuts in compliance with the standard IMF doctrine.7 The question becomes whether ESM lending rates will also be given according to IMF standards, or whether they will be considerably higher. Will the ESM lend at rates similar to an IMF-Stand-By Agreement (SBA) provided to Greece or an IMF Extended Funds Facility (EFF) provided to Ireland? Both types of IMF facilities lend to countries at rates below those at which eurozone money has been made available to Greece and Ireland.
The rate at which official sector financial support is available to recipient countries (i.e., the scale of the implicit subsidy) obviously affects their solvency. If the interest rate is too high, it cuts into the value of the assistance. Many in Europe already criticize the eurozone bailouts as too costly for recipient countries.
Implicitly, the criticism has been acknowledged by the eurozone and the European Commission. Both are now preparing to align "the [SBA] maturities of the financing for Greece to that of Ireland [EFF]." Such a step would likely amount to a Greek debt "restructuring of the official sector Greek debt"8 and thus an implicit fiscal transfer. The extent to which this process of "debt relief by another name" can be repeated in the ESM offers an opportunity to ease the debt burdens for Greece and Ireland.
Leniency on interest rates and maturities by the ESM could help ensure the recipient country's debt sustainability and thus a way out of the peripheral debt stock crisis. A lenient ESM would retain its conditionality and limited use only to governments willing to suffer the associated loss of sovereignty. Help would not come in the form of a standard eurobond—a good thing for the eurozone, where eurobonds are still seen as lacking political legitimacy by the overwhelming majority of citizens who identify more with their nations than with Europe itself. European leaders would do well to resist the implication that eurobonds represent a kind of open-ended "taxation without representation," unless of course they want to spawn a lot of European tea party equivalents.9
Even private creditors of existing debt would benefit from a lenient ESM, because it would lift the onus of "voluntary debt forgiveness" and guarantee their payment in full as private debt gets replaced by subsidized ESM loans. Also likely to benefit are eurozone creditor country banks with shaky levels of capital, including Germany's Landesbanken, which are dominated by regional governments.10 A lenient ESM would consequently be considerably easier on existing creditor banks than the "Brady Bonds" issued by Latin American countries in the 1980s. Those bonds required negotiated debt relief to be granted by creditor banks before they could swap loans to collateralized longer maturity Brady Bonds.
Other components of the European Union's goal of a sustainable fiscal regime for the eurozone include increased surveillance, fiscal data validity, Collective Action Clauses on all sovereign debt after 2013 and thereby implicit cementing of interest rate differentials inside the eurozone. The latter will also be of particular interest to creditor nations (again especially Germany), as persistent sovereign debt differentials will translate into lasting advantages in the cost of capital for private German borrowers, as their eurozone corporate competitors pay the same risk premium as their sovereign.11
The new regime is certainly better for Europe than the Stability and Growth Pact (SGP). Sovereign bond differentials that affect a peripheral country's private sector creditors are a much better insurance against reckless private lending behavior than automatic fines for fiscally sinful governments under the SGP.
A final important question to address is whether the new arrangements underway in Europe will eventually offer a credible alternative to an outright European Fiscal Union, similar to the United States. Could Europe be heading, intentionally or not, to a union where large transfers are possible among various groups? This major issue will be explored here on RealTime in a future posting in early 2011.
1. Hopefully a new set of "EBA eyes" will be used in the same way as the new Irish stress tests' diagnostic studies, which must not be conducted by an audit or consultancy firm that has provided such services to the bank in the last three years.
4. As Willem Buiter has pointed out repeatedly, what really matters is the present discounted value of the ECB's monopoly on creating new money also in the future. This value is easily in the trillions of euros. See Buiter (2010) for an in-depth analysis.
5. Note that the required AAA rating for the EFSF makes its actual disbursement capacity significantly lower at around €250 billion.
8. Restructuring would imply reduction of the net present value (NPV) of Greek debt, while a rescheduling would extend maturities without reducing the NPV.
9. Note that unless full conversion of the existing national debt stock into eurobonds were possible, partial conversion would leave remaining holders of national peripheral debt worse off and in possession of de facto subordinate debt and for instance Greece would not be in a position to issue additional national debt. As such, partial eurobond conversion without extremely large haircuts accepted by private creditors in return for eurobonds has the same stock-flow problem as does CACs for countries with already unsustainable debt levels.
10. For conspiracy theorists, this provides Angela Merkel's coalition with a way to "buy support" in the Bundesrat where it has just lost its majority.
11. It seems likely that instances of corporations with lower cost of capital than the sovereign in whose territory they reside will rise inside a eurozone with sovereign default risk priced into differential sovereign bond yields.