The euro area debt crisis has reached the acute stage: The contagion from Greece has begun to infect the markets for the sovereign debt of the large countries in the zone, Spain and Italy. Euro group finance ministers are considering a range of old and new options, including a previously rejected but worthy proposal to have the European Financial Stability Facility (EFSF) purchase government bonds at a discount on the secondary market. Euro area leaders are planning to meet over the next several days. But they are once again behind the curve and the path to agreement and implementation is uncertain, while bold action is needed now.
A mechanism known as "precautionary financing" is designed for contingencies in which country policies are fundamentally sound but the country is vulnerable to a seizing up of financial markets. The International Monetary Fund (IMF) has designed and successfully deployed two relatively new precautionary facilities—the Flexible Credit Line (FCL) and Precautionary Credit Line (PCL)—and made its plain vanilla Standby Arrangements (SBA) available on a precautionary basis. (Proposals for a more sweeping Global Stability Mechanism (GSM) have not been adopted.) These commit the IMF, after an inspection of a country’s policies, to lend large amounts with no (in the case of the FCL) or relatively few (in the case of the PCL) additional policy conditions.
The euro area authorities, on the other hand, are relatively constrained in the amount of precautionary financing that they can offer. The EFSF is not available on this basis, which limits precautionary capacity to the relatively small medium-term financial assistance facility.
The governments of Spain and Italy have sought to differentiate their situations from those of Greece, Ireland and Portugal and have done so in part by eschewing any suggestion that they would consider official financing. But, with recent contagion, that strategy has now reached the end of its useful life. These governments should now apply to the IMF for precautionary financing.
Neither country would qualify without promising to follow through on existing policy reforms and committing to some new ones, however. These have recently been identified in these countries’ Article IV consultations at the Fund. (See http://www.imf.org/external/np/ms/2011/062111.htm; http://www.imf.org/external/np/ms/2011/051111.htm) Spain is running a fiscal deficit of about 6 percent but will probably need additional austerity measures of about two percent of GDP to reach the path objective through 2014. Its government debt, about 64 percent of GDP, is less problematic. Perhaps more important, Spain would have to commit to further recapitalization and consolidation of its banking sector—important information about which will be published very soon with the much-anticipated stress tests.
Italy, by contrast, runs a primary fiscal surplus and is within reach of a roughly balanced budget by 2014. Noting that surplus, the IMF’s new Managing Director, Christine Lagarde, said a few days ago that Italy’s crisis was "essentially market driven." Depending on the results of the stress tests, moreover, its banking sector is in relatively good shape. Italy’s greater dangers are two. The first is the outstanding debt, which is 120 percent of GDP; this gross number is relevant as this debt needs to be rolled over. The second is political, as Prime Minister Silvio Berlusconi’s coalition is fragile and the position of his finance minister tenuous; the credibility of the new fiscal consolidation package could well suffer as speculation about an early election increases. A precautionary agreement with the IMF and the euro area partners could lend some confidence to markets that the package will be effectively implemented.
If persuaded to approach the IMF, both countries would prefer the FCL, which was granted to Poland and could be larger than a PCL. Given the stakes involved and the need for additional policy measures to reach fiscal and financial restructuring goals, though, neither would qualify for precautionary financing without making further commitments. If the Executive Board of the Fund cannot see its way clear to granting FCLs for this reason, the PCL should be considered. The IMF states: "Countries suffering any of the following problems at approval cannot access the PCL: (i) sustained inability to access international capital markets; (ii) the need to undertake large macroeconomic or structural policy adjustment; (iii) a public debt position that is not sustainable in the medium term with a high probability; or (iv) widespread bank insolvencies." Spain’s banking sector and Spain and Italy’s long-term structural problems would undoubtedly be scrutinized by the Executive Directors under this scenario.
Make no mistake, such programs would be very large—five to ten times quota in the case of the PCL and larger in the case of an FCL. Spain’s quota is about Special Drawing Rights (SDR) 4 billion; Italy’s is SDR 7.9 billion. (Roughly $6.5 billion and $12.7 billion respectively.) The combined commitment of the Fund could thus be more than $200 billion, or even much larger depending on the facilities activated. To maximize the impact, the two arrangements would ideally be announced together.
Programs of this magnitude would essentially "bet the bank" on the satisfactory resolution of the debt crisis in the euro area. But the rest of the world has a strong interest in preventing contagion to the large euro area countries, and the uncertainty over U.S. fiscal policy makes this an especially vulnerable moment for the global financial system. What is the purpose of having a large Fund if we don’t actually deploy it in such an emergency?
The European authorities might fear being sidelined on the specification of policy adjustments if these countries agreed with the IMF on a precautionary arrangement. But it does not appear that the measures likely to be required by the IMF would conflict in substantial ways with the preference of European authorities. The European member states would have to be thoroughly consulted on any such arrangements, in any case, and could weigh in on conditionality through their Executive Directors. The insistence by some of them, notably Germany, on private sector involvement for Greece raises questions in the market about how far that approach will be taken, giving rise to the need for precautionary financing for Spain and Italy. These precautionary arrangements would thus complement their solution for Greece and their efforts to reconfigure the financial architecture of the euro area.
The Asian governments and emerging and developing countries more broadly might object to what they might perceive as preferential treatment for Europe at their expense. But such precautionary financing would be conceding the correctness of the arguments that several Asian governments have been strenuously making since the 1997-98 crisis and set precedents for requests that they might well make of the Fund when their turn (eventually) comes again.
The greater resistance however is likely to come from the governments of Spain and Italy. Neither will relish acknowledging the need for precautionary financial help or negotiating with the Fund. But they should also be attracted by the possibility of reducing the risk premiums on their bonds. More fundamentally, even successful euro group negotiations over the instruments for final resolution of the crisis are likely to be contentious and subject to risks. Precautionary financing would bridge this period of uncertainty to implementation of institutional reforms and introduction of the European Stability Mechanism (ESM). Facing elections sooner rather than later, both governments could benefit from external endorsement of fiscal and banking measures that they are going to have to introduce anyway. Better to bite this (manageable) bullet in advance than to fight an election and full-blown financial crisis simultaneously.