LONDON — Europe collectively breathed a sigh of relief as the German parliament voted by a large margin for an expansion of the powers and scope of the €440 billion euro rescue fund intended to shore up the most vulnerable members of economic and monetary union (EMU). The next staging post of a roller-coaster ride of hope and fear.
But the Berlin decision does nothing more than bring the Germans up to the point everyone thought they’d already reached on July 21 when European leaders agreed to broaden the scope and powers of the European Financial Stabilization Facility. So the politicians are still about two months behind the markets.
It’s as if we have two sets of alternative cinematographic technologies competing with each other. While the politicians are still dealing in genteel, stumbling back-and-white, the financial markets are lurching onwards in glorious, gory technicolor. Unfortunately, the screens are likely to turn red — the color of blood.
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 toward 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-fueling downward spiral.
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 €440 billion that so far is the limit of its potential. 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 action over the past 16 months to purchase the bonds of weaker euro members on the secondary market, starting with Greece, Portugal and Ireland in May 2010 and extended in August 2011 to Italy and Spain.
Assuming that parliamentary ratification is completed among other EMU member states, the rescue fund will now be given new powers to extend borrowing on financial markets, buy bonds and recapitalize weak banks.
Assuming parliamentary procedures go through in the other relatively skeptical 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 has been underlined by the bond purchasing moves, totalling €157 billion 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’s size and scope come in the nick of time. The first tests of its new powers will probably come in the next few weeks. Speculation about a possible Greek debt default is intensifying, as the troika from the International Monetary Fund, the European Commission and the ECB reopen talks in Athens on Greece’s steps to accomplish budget targets for its next €8 billion portion from the country’s existing €110 billion rescue program.
If Greece defaults, euro governments know they must have the EFSF fully operational to cope with the danger of contagion. However, the EFSF headquarters in Luxembourg is still relatively under-staffed and has nothing like the full 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 €440 billion, 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 monetizing problem countries’ debts. However the ECB does stand ready to provide 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. Otherwise, they would demand punitively high interest rates for their lending to the EFSF, seriously countering the underlying logic.
In addition, action by the EFSF in buying bonds from, and otherwise 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 Germany and the Netherlands will have much greater control over its lending behavior than they currently have over the ECB, where decisions are based on the principle of majority voting rather than unanimity. So there is a long road still to travel — and plenty of opportunity for potentially disastrous alarms and setbacks.
By David Marsh, MarketWatch
David Marsh is co-chairman of think-tank OMFIF and author of The Euro – The Battle for the New Global Currency (Yale University Press).
Source: MarketWatch