How do you solve a problem like the Euro?
0It is widely reported that the Italian Prime Minister Mr Monti has proposed that the ESM and/or the EFSF should buy peripheral Euroland debt.
The irritating use of acronyms (ESM is the European Stability Mechanism and is a permanent rescue funding programme to succeed the temporary EFSF, the European Financial Stability Facility, and the EFSM, the European Financial Stabilisation Mechanism in Euroland, the 17-member single currency area) masks the reality that the ESM hasn’t even started yet and can only be launched when Member States representing 90% of the capital commitments have ratified it.
The plan has been to have the ESM in place by July 1st but it has only been passed by four countries – and some are concerned about potential obstacles that could be raised by the German constitutional court. Furthermore, it is joint but not several, so the maximum contribution of each country is capped. The EFSF is up and running, but it only has €190bn in lending capacity left, or €90bn after the Spanish banks recap. The EFSF has to raise everything it lends in the markets itself (unlike the ESM, which will have €80bn of paid-in capital) and again is not several. As a result only 27% of the ESM and 29% of EFSF is funded by Germany (they overfund by 65% so that Germany’s contribution is capped at €195bn).
Certainly it looks as if the ESM/EFSF together could fund the expected gross issuance for both Spain and Italy until early 2014, and buying in the secondary market should be expected to be more relevant than buying in the primary market as only the latter provides new cash and in a sense the market yield on existing debt is unimportant – the cash service cost is unchanged.
One challenge would be whether the link between banks and sovereigns can be broken. At present if funds are lent to the sovereign to lend to banks, there is an increase in the government debt ratio, which causes a decline in sovereign credit quality, which in turn adversely affects banks’ balance sheet quality, given their significant holdings of sovereign debt, especially after the LTROs.
The way forward realistically does require mutualisation of debt (all for one, one for all) and this is now on the public agenda, and there are helpful ideas on the promotion of growth with talk of the EIB/ project bonds. The amounts being discussed look too small to be game changing at €105bn, or 1% of Euroland GDP, and spread over several years, but at least growth is now at least as much on focus as austerity. Lead indicators (PMIs) are consistent with at least minus 1% year on year GDP growth and without growth, tax take will be inadequate and expenditure will rise, not fall. Also, growth is required to improve the palatability of structural reforms, which are essential to address imbalances and the misallocation of resources. Growth can be helped with targeted spending, and hence the helpfulness of project bonds, and currency devaluation. The role of lower bond yields would be to facilitate rather than drive growth. Lower yields would reduce the cost of capital but not directly assist demand.
An associated challenge is solvency and this challenge looks to have been put in the too difficult and too painful box. After private sector de-leveraging, it looks as if the government debt/GDP ratio is 106% in Spain, and about 140% in Ireland and Portugal. With these numbers, even if, say, the Spanish bond yield fell to 5%, fiscal tightening of 7.7% of GDP would still be needed to stabilize the government debt/GDP ratio. This degree of fiscal tightening looks close to unachievable, especially given that it would happen against the backdrop of aggressive private sector de-leveraging, bank de-leveraging and falling wages. The harsh and unpleasant reality is that there will need to be some form of hair cut, whether explicit or obscured.
This brings the banks back into focus and we do need widespread recapitalization and some form of deposit guarantee, consistent with the talk of a banking union. Meanwhile with maximum lending of €500bn, it is not clear that the ESM/ESFS are sufficiently well resourced to make a sustainable difference in lending costs for vulnerable sovereigns, given that the ECB has ‘spent’ €210bn thus far propping up sovereign bond markets without containing yields. Crisis resolution will likely require the ECB to expand its balance sheet materially, perhaps with a five year long term refinancing operation (LTRO) of around €2trn, or a funded guarantee scheme. The ECB is the only entity with access to unlimited cash and an expansion of the ECB balance sheet mutualises debt as well as driving down the euro.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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