European bailout fund remains unfunded
Raising emergency money could cause instability
by David Marsh
Mon 27 Sep 2010
Europe breathed a deep sigh of relief when, at a moment of deep crisis in May, finance ministers conjured up a new structure to resolve the imbroglio in economic and monetary union, or EMU.
The new monetary kid on the block was given the unwieldy name of the European Financial Stability Facility (EFSF), designed as a “get out of jail free” card for peripheral euro members hit by massive selling of their government bonds and fears of EMU break-up.
The ministers put together the colossal sum of €440bn, backed by state guarantees, designed to be raised through combined European bond issues with the proceeds flowing to euro states in difficulty. Together with an existing €60bn European fund and €250bn from the International Monetary Fund, they brought to the table the mighty tally of €750bn. Surely sufficient to halt the bond sales, quell the speculators and rescue the toppling edifice of the single currency?
You might think so. But you would need to think again. Four and a half months after its inception, the EFSF balance sheet is by no means wholly positive. The special facility has been established in Luxembourg under the leadership of seasoned German financial technocrat Klaus Regling. The 16 members of monetary union have completed legal preparations for the EFSF’s entry into force – with the exception of Slovakia, which decided to opt out, and Greece, which is being propped up by a separate €110bn IMF facility and can hardly afford to bail out anyone else.
The announcement effect, however, has been pretty muted. Portugal and Ireland – the two countries that, together with Greece, have really got their backs to the wall – are still in deep trouble on the capital markets. Interest rates on their new borrowings, in both longer- and shorter-dated bonds, are now well above the crisis levels of the springtime, and spreads compared with prime-rated German bonds have shot up to well above 4 percentage points. Not just for Greece, but also for Portugal and Ireland, bond prices are now signalling that investors expect debt restructuring in the next year or so.
Neither these countries’ governments nor the European Commission nor the European Central bank wishes such an outcome. They fear it would lead to an ever-deepening spiral that could end in EMU’s breakdown.
Since interest rates on the problem countries’ borrowing have now comprehensively breached the 5% level that was supposed to trigger EFSF deployment, all indications would seem to point to the Luxembourg facility now being used. But the special fund is staying firmly stuck in its box. Regling has told potential lenders that the new borrowing vehicle will go to the capital markets to raise funds only of one of the problem debtors makes a formal application for money.
The EFSF is trapped in a crux of Catch-22 dimensions. Unless it raises ammunition in pre-emptive financing, the capital markets will doubt whether it has the wherewithal to support errant EMU members. On the other hand, if the fund does start to do the logical thing and issue bonds, the Germans in particular feel that this could cannibalize other European states’ issues and could also weaken the facility’s claim on a continued Triple A rating.
The reasons for the dilemma lie in the complex political and economic circumstances of the EFSF’s birth. As the most important guarantor of the funding vehicle, and also the European state that is most firmly in favour of financial stability and against moral hazard, Germany approved the EFSF set-up only with great and highly evident hesitation. Berlin wants to make the fund’s deployment subject to extremely restrictive rules to maintain a disciplinary effect with as much force as possible.
The problem is that European self-abstinence could propel EMU into a new phase of instability. One significant straw in the wind: the Asian creditor states have made enormous investments in the euro area and will have a key influence on its further development. Based on recent indications, they already seem to have come to the conclusion that the EFSF is at best an awkward experiment with an uncertain outcome.
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