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Analysis
Hurdles lie ahead on EFSF leveraging

Hurdles lie ahead on EFSF leveraging

by David Marsh

Mon 3 Oct 2011

Last week’s German parliament vote on expanding the powers and scope of the €440bn euro rescue fund does little more than bring the Germans up to the point many thought they’d already reached on 21 July when European leaders agreed to broaden the EFSF.

While politicians in the last two months have indulged in that essential and immortal characteristic of Europe – long holidays – the markets have moved dramatically further towards pricing in a Greek default. And, predictably, Greece has shunted several steps backwards. Deficit targets are ever less likely to be achieved - the result of a self-fuelling downward spiral in the Greek economy.

Many contentious issues regarding the euro rescue mechanism have not yet been resolved. One of the most difficult is ‘leveraging’ the EFSF to increase many times over the €440bn that's the limit of its potential so far. Such a scheme is controversial – especially in Germany – but is probably inevitable, given the spreading of the euro malaise to Italy and Spain.

Overshadowing everything is Germany’s opposition to European Central Bank (ECB) secondary market purchases over the past 16 months of the bonds of weaker euro members, starting with Greece, Portugal and Ireland in May 2010 and extended in August 2011 to Italy and Spain.

Assuming parliamentary procedures go through in the other relatively sceptical countries that have still to vote, the Netherlands and Slovakia, ECB bond purchases should end at the latest in mid-October as the onus for action on fiscal support is transferred to the EFSF.

A growing body of opinion on the ECB’s 23-member decision-making governing council has been arguing that the central bank’s stature is being undermined by the bond purchasing moves, totalling €157bn since May 2010. Opposition has been led by German representatives on the council, along with more nuanced resistance from the Dutch and the Luxembourgers – all countries with large creditor positions.

The moves to broaden the EFSF come in the nick of time. The first tests of its new powers are looming. Speculation about a possible Greek debt default is intensifying, as the troika from the International Monetary Fund, the European Commission and the ECB reaffirm they are still not satisfied with Greece’s steps to accomplish budget targets for its next €8bn portion from the country’s existing €110bn rescue programme.

If Greece defaults, euro governments know they must have the EFSF fully operational to cope with the danger of contagion. However, the relatively under-staffed EFSF headquarters in Luxembourg has nothing like the technical capacity to carry out the additional onerous duties that are being suddenly thrust upon it. There is awareness, too, that, even with a borrowing capacity up to the full €440bn, the EFSF will be neither large nor flexible enough to counter a new bout of market speculation that could hit Italy or Spain. This is why, in addition to intervening in the secondary markets to buy the bonds of hard-hit countries, the EFSF is expected to borrow from financial markets (against the collateral of the euro members’ bonds in its portfolio) to increase further its ammunition.

The ECB will not lend directly to the EFSF, as some analysts have suggested, because this would fall foul of German objections about monetising problem countries’ debts. However the ECB does stand ready to provide plentiful liquidity to banks that lend to the EFSF – an indirect form of support.

Such ‘leveraging’ will be subject to clear market discipline. Sovereign funds and other pools of capital in Asia – which have made clear their appetite for EFSF bonds in recent months – will only put up more money if they are convinced that the EFSF’s actions in supporting euro members in difficulties are economically sustainable. Action by the EFSF in supporting trouble-torn euro member states will have to be decided on the basis of unanimity by EMU states – meaning that hard-line creditor countries such as German and the Netherlands will have much greater control over its lending than they currently have over the ECB, where decisions are based on majority voting. So there is still plenty of opportunity for potentially disastrous alarms and setbacks.

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