The (ESM) will replace the (EFSF): EU leaders to agree on permanent bailout fund, balanced budget ???
BRUSSELS | Sun Jan 29, 2012 6:40pm EST
(Reuters) – EU leaders will sign off on a permanent rescue fund for the euro zone at a summit on Monday and are expected to agree on a balanced budget rule in national legislation, with unresolved problems in Greece casting a shadow on the discussions.
The summit – the 17th in two years as the EU battles to resolve its sovereign debt problems – is supposed to focus on creating jobs and growth, with leaders looking to shift the narrative away from politically unpopular budget austerity.
The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU’s 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.
But discussions over the permanent rescue fund, a new ‘fiscal treaty’ and Greece will dominate the talks.
Negotiations between the Greek government and private bondholders over the restructuring of 200 billion euros of Greek debt made progress over the weekend, but are not expected to conclude before the summit begins at 9:00 a.m. EST.
Until there is a deal between Greece and its private bondholders, EU leaders cannot move forward with a second, 130 billion euro rescue program for Athens, which they originally agreed to at a summit last October.
Instead, they will sign a treaty creating the European Stability Mechanism (ESM), a 500-billion-euro permanent bailout fund that is due to become operational in July, a year earlier than first planned. And they are likely to agree the terms of a ‘fiscal treaty’ tightening budget rules for those that sign up.
PERMANENT RESCUE FUND
Leaders hope the ESM will boost defenses against the debt crisis, but many – including Italian premier Mario Monti, IMF chief Christine Lagarde and U.S. Treasury Secretary Timothy Geithner – say it will only do so if its resources are combined with what remains in the EFSF, creating a super-fund of 750 billion euros ($1 trillion).
The International Monetary Fund says an agreement to increase the size of the euro zone ‘firewall’ will convince others to contribute more resources to the IMF, boosting its crisis-fighting abilities and improving market sentiment.
But Germany is opposed to such a step.
Chancellor Angela Merkel has said she will not discuss the issue of the ESM/EFSF’s ceiling until leaders meet for their next summit in March. In the meantime, financial markets will continue to fret that there may not be sufficient rescue funds available to help the likes of Italy and Spain if they run into renewed debt funding problems.
“There are certainly signals that Germany is willing to consider it and it is rather geared toward March from the German side,” a senior euro zone official said.
The sticking point is German public opinion which is tired of bailing out the euro zone’s financially less prudent. Instead, Merkel wants to see the EU – except Britain, which has rejected any such move – sign up to the fiscal treaty, including a balanced budget rule written into constitutions. Once that is done, the discussion about a bigger rescue fund can take place.
After nearly three years of crisis, some economists believe the combination of tighter budget rules, a bigger bailout fund and a commitment to broader structural reforms to boost EU productivity could help the region weather the storm.
“The fiscal compact and the ESM will shape a better future,” said Carsten Brzeski, a euro zone economist at ING.
“Combined with ongoing austerity measures and structural reforms in peripheral countries, and, of course, with a lot of ECB action, the euro zone could master this stage of the crisis.”
Economists say the pivotal act in recent months was the European Central Bank‘s flooding of the banking sector with cheap three-year money, a measure it will repeat next month.
While EU leaders are managing to put together pieces of legislation and financial barriers that might help them stave off a repeat of the debt crisis, immediate concerns – especially over Greece and potentially Portugal – remain.
By far the most pressing worry is the seven-month-long negotiation over private sector involvement in the second Greek rescue package. A deal in the coming days may help restore investor confidence, although Greece will still struggle to reduce its debts to 120 percent of GDP by 2020 as planned.
“If there is a deal, the heads of state and government can endorse it, welcome it and say that now it is up to Greece to agree to and deliver on reforms to get the second financing package,” the euro zone official said.
Negotiators believe they have until mid-February to strike a deal. Failure to do so by then would likely force Greece to miss a 14.5 billion euro repayment on its debt due in mid-March.
Even if Athens can strike a deal with private bondholders to accept a 50 percent writedown on the nominal value of their bonds, it may still not be enough to close Greece’s funding gap.
The IMF has suggested it may be necessary for public sector holders of Greek bonds – including the ECB and national central banks in the euro zone – to write off some of their holdings in order to close the gap.
Such a move would not necessarily involve the ECB or national central banks incurring losses, they would just be expected to forego any profit on the bonds they have bought.
But German ECB board member Joerg Asmussen told Reuters there was no possibility of the ECB taking part in the private-sector restructuring of Greece’s debt.
(Reporting By Jan Strupczewski, editing by Mike Peacock)
- German Chancellor Angela Merkel Deflects Pressure to Boost Eurozone Bailout Funds (ibtimes.com)
- Eurozone’s score card (bbc.co.uk)
- EU summit on debt crisis faces Brussels disruption as unions strike (guardian.co.uk)
- Germany opposes combining ESM, EFSF: reports (marketwatch.com)
- Germany, France press for rapid Greek debt deal (revolutionizingawareness.com)
- S&P downgrades euro zone bailout fund (jhaines6.wordpress.com)
- EU Leaders Are Considering Doubling The Euro Bailout Fund At The Last Minute (businessinsider.com)
- ESM’s & EFSF’s.. its just shuffling the chairs on the Titanic (seeker401.wordpress.com)
- Presenting Today’s Deux Ex Rumor (zerohedge.com)
- EC President Barroso: ‘EU should put hand in pockets AGAIN to beef up bailout fund’ (dailymail.co.uk)
- S&P Downgrades Eurozone’s Bailout Fund (ibtimes.com)
The IMF will offer a new credit line program to allow sovereigns to “break the chain of contagion.”
A new “Precautionary Credit Line” would allow governments with sound financials who have made prior agreements with the IMF to access liquidity of 1000% of a member’s quota for 1-2 years. It would also allow them to access up to 500% of their quota in liquidity on a 6-month basis.
The funds would be offered to sovereigns suffering from “exogenous shocks.”
Markets and the euro spiked immediately on the news.
There are, however, a few big problems with this new proposal.
First, it is unclear whether the IMF actually has access to the amount of funds that would be necessary to bail out a sovereign like Italy.
Italy currently has $2.2 trillion in gross external debt, far exceeding the IMF’s current available resources of about $540 billion. While that would significantly add to the resources the eurozone bailout fund—the European Financial Stability Facility—has available, this still falls short of the estimates for funding necessary to truly stem the crisis. Citi’s Willem Buiter recently suggested about €3 trillion ($4 trillion).
This suggests that the IMF might have to rapidly expand its funding resources to act as an effective bulwark against contagion. But that’s not likely to happen either.
The United States—which provides the largest percentage (17.7%) of IMF funds of any individual country—will also have to approve the plan. Previous bids to expand the IMF’s funding have hit a wall with U.S. opposition, primarily led by the GOP.
This press release from the IMF describes how the new program will work:
IMF Enhances Liquidity and Emergency Lending Windows
Press Release No. 11/424
November 22, 2011
The Executive Board of the International Monetary Fund (IMF) approved on November 21 a set of reforms designed to bolster the flexibility and scope of the Fund’s lending toolkit to provide liquidity and emergency assistance more effectively to the Fund’s global membership. These reforms, which have been under preparation for some time, will enable the Fund to respond better to the diverse liquidity needs of members with sound policies and fundamentals, including those affected during periods of heightened economic or market stress—the crisis-bystanders—and to address urgent financing needs arising in a broader range of circumstances than natural disasters and post-conflict situations previously covered.
“I commend the Executive Board for the expeditious response to support the membership in these difficult times,” said IMF Managing Director Christine Lagarde following the Executive Board meeting. “The Fund has been asked to enhance its lending toolkit to help the membership cope with crises. We have acted quickly, and the new tools will enable us to respond more rapidly and effectively for the benefit of the whole membership.
“The reform enhances the Fund’s ability to provide financing for crisis prevention and resolution. This is another step toward creating an effective global financial safety net to deal with increased global interconnectedness,” she added.
The reform replaces the Precautionary Credit Line (PCL) with the more flexible Precautionary and Liquidity Line (PLL), which can be used under broader circumstances, including as insurance against future shocks and as a short-term liquidity window to address the needs of crisis bystanders during times of heightened regional or global stress and break the chains of contagion. The Fund’s current instruments for emergency assistance (Emergency Natural Disaster Assistance and the Emergency Post-Conflict Assistance) are consolidated under the new Rapid Financing Instrument (RFI), which may be used to support a full range of urgent balance of payments needs, including those arising from exogenous shocks.
The Precautionary and Liquidity Line:
- Qualification criteria remain the same as under the PCL. A member needs to be assessed as having sound economic fundamentals and institutional policy frameworks, having a track record of implementing sound policies, and remaining committed to maintaining such policies in the future. A member can seek support when it has either a potential or actual balance of payments need at the time of approval of the arrangement (rather than only a potential need, as was required under the PCL).
- Can be used as a liquidity window allowing six-month arrangements to meet short-term balance of payments needs. Access under a six-month arrangement would not exceed 250 percent of a member’s quota, which could be augmented to a maximum of 500 percent in exceptional circumstances where the member faces a balance of payments need that is of a short-term nature and results from exogenous shocks, including from heightened regional or global economic stress conditions.
- Can also be used under a 12 to 24-month arrangement with maximum access upon approval equal to 500 percent of a member’s quota for the first year and up to 1000 percent of quota for the second year (the latter of which could also be brought forward to the first year where needed, following a Board review). As under the PCL, arrangements of these durations include Executive Board reviews every six months.
The Rapid Financing Instrument:
- The RFI broadens coverage of urgent balance of payments needs beyond those arising from natural disasters and post-conflict situations, and can also provide a framework for policy support and technical assistance.
- Funds are available immediately to the member in need upon approval with access limited to 50 percent of the member’s quota annually, and to 100 percent on a cumulative basis.
- The member needs to outline its policy plans to address its balance of payments difficulties, and the IMF must assess that the member will cooperate in finding solutions for these difficulties.
Review of Flexible Credit Line and PCL:
The Executive Board also reviewed the FCL and PCL and found that that these instruments have bolstered confidence and moderated balance of payments pressures during a period of heightened risk. The rigorous qualification framework has worked well and access decisions have reflected the evolution of risks facing users of these instruments. The review calls for focusing qualification discussions more on qualitative and forward-looking aspects of policies and policy frameworks, and enhancing the transparency of access decisions.
- IMF to rescue eurozone from debt crisis? (cbsnews.com)
- G20 asks IMF for solutions to eurozone crisis (thestar.com)
- Steen’s Chronicle: Wrestling with a lack of liquidity (tradingfloor.com)
- IMF Playing Larger Role In Addressing Europe Debt Crisis (huffingtonpost.com)
- ECB in talks to lend to IMF Quantitative Easing by the back door to save the Euro (politics.ie)
- IMF’s Largarde: IMF to Propose New Crisis Management Tools (forexlive.com)
- What lies beneath the IMF’s (liquid) blanket (ftalphaville.ft.com)
For the majority of a nerve-wracking summit that dragged on more than 10 hours, from 6 PM CET Wednesday to 4 AM CET Thursday morning, all attempts at progress to stem the crisis appeared to hit a wall.
But EU leaders finally made a breakthrough.
At 3:30 AM CET, we heard that they were closing talks with bank representatives on “voluntary” 50% haircuts on holdings of Greek bonds. Then we started hearing about leverage, and suddenly — at 4 AM CET (10 PM EST) — we finally got word of some agreement.
So here’s the rundown of what leaders decided (EU leaders were still pretty vague about all the numbers, however, citing estimates for most things):
- 50% haircuts on private holdings of Greek bonds through 2020. Evidently this will still be voluntary. It would cut Greece’s debt by €100 billion ($139 billion). German Chancellor Angela Merkel said EU leaders aim to see the credit swap take place in January.
- Leverage will increase the firepower of the European Financial Stability Facility by 4-5 times, to somewhere in the range of €1 trillion ($1.4 trillion).
- China and the IMF could play a huge role in the bailout. Not only has the IMF expressed interest in playing a role, French President Nicolas Sarkozy told reporters that he will call Chinese Premier Hu Jintao around midday tomorrow, presumably to discuss this.
- Greece will receive €130 billion ($180 billion) in fresh aid. We’re thinking this includes the nearly €110 billion ($150 billion) it was promised back in July.
- EU leaders believe Italy’s commitment to debt sustainability and encouraging growth, even though Italian PM Silvio Berlusconi didn’t propose any new measures to accomplish these goals in a letter he wrote to some members of the summit today.
- The European Banking Authority estimates that only €106 billion ($147 billion) in funding will be needed to recapitalize European banks and help them meet capital requirements of 9%. Turns out it didn’t actually conduct new stress tests accounting for adverse scenarios this time around. European Council President Herman van Rompuy told reporters that banks must reach this 9% ratio with only the “highest quality capital.” We’re hoping he means Tier 1 capital and will not allow banks to use riskier convertible bonds to meet this number.
- We aren’t likely to see a final roadmap on EU treaty changes until March 2012.
- A statement from the summit can be found here.
Clearly there’s still a lot more progress to be made towards truly solving the crisis. None of these steps alone — or even altogether — will do that, not to mention that the numbers we’re seeing here have not all been written in stone. Indeed, until we see EU authorities start to execute some of these proposals, it will be difficult to bank on their success.
That said, the fact that EU leaders actually made (at least preliminarily) plans on a lot of the issues they said they would — particularly after all the negative news today and earlier this week — will reassure markets that these leaders are indeed capable of accomplishing something when pressed.
Looking forward, we will be looking to see EU leaders make good on these proposals, without diluting them to ineffectiveness. In particular, treaty changes — probably the most controversial of any measures we’ve heard discussed thus far — will be key to actually mending the broken bones of the euro area.
Like many derivatives products dreamed up by Wall Street’s financial innovators, the Developed Market (DM) Sovereign Credit Default Swap (CDS) market was borne out of the desire to transfer risk off the books of banks to investors suited to managing those risks. Following the successful establishment and effectiveness of risk transfer in the corporate CDS market, the onset of the Asian Financial Crisis spurred growth in trading in Credit Default Swaps on Emerging Market countries’ debt. However, legal documentation issues relating to the 1998 Russian bond default hinted at the structural problems embedded in the contracts, subsequently confirmed when the economically coercive 2001 Argentinean so-called “Mega-Swap” did not trigger CDS. Indeed, even though Argentina eventually repudiated its debt unilaterally, many protection buyers’ swaps had already expired by then, and trading volumes in EM CDS fell substantially, only really recovering post the 2003 overhaul of ISDA’s rulebook.
It is then, perhaps, surprising that despite proven complications related to the terms under which EM Sovereign CDS would pay out that market participants extended the concept to cover Developed Market Sovereigns in 2006. Arguably, along with its siblings ABS CDS, made famous by Hedge Fund manager John Paulson’s multi-billion dollar bet against the US Subprime market, trading in DM CDS took off as a way to hedge the risk of countries who had been forced to assume the liabilities of their banking systems coming under pressure themselves. But as with earlier EM-specific non-triggers, the Icelandic government’s decision to put its banks into administration in November 2008 rather than default on its own debt, resulted in its CDS falling from as wide as 1400bps to current levels closer to 320bps. The LSE’s Professor Willem Buiter, a former Bank of England MPC member, in early-2009 asked the question “Is the London Reykjavik on Thames?”, leading to CDS on the UK to spike to as high as 166bps, but this sparked many to point out that the UK’s debt was denominated in Sterling, which the Bank of England could print an unlimited amount of. A month later, in March 2009 the Bank of England’s decision to purchase £75bn in its Asset Purchase Programme seemed to support this view, despite a second widening of UK CDS in the run up to the 2010 General Election as investors worried about the UK government’s commitment to its medium term solvency.
Nevertheless, the incoming PASOK-led Greek government revealed in November 2009 that the country had under-reported its deficits, triggering the onset of the Eurozone crisis, and Greek CDS began to widen, culminating in the April 2010 EU/IMF bailout of Greece, and a month later, in the face of contagion to other European government bond markets, the establishment of the European Financial Stability Facility (EFSF). An explosion in trading of DM CDS on Eurozone peripheral countries’ debt ensued as hedge funds sought to speculate upon the likelihood of an eventual Greek default and banks sought to hedge their exposures to those countries built up over the preceding decade.
Inevitably, faced with the political cost of bailing out foreign countries, European politicians lashed out at the CDS market, blaming it for breeding panic and allowing speculators to “bet” against bond markets and the Euro. As seen in the 2008 Global Financial Crisis, banks under pressure, along with politicians, blamed short sellers and speculators for spreading rumours and exacerbating the situation, while speculators argued that the market was merely “the messenger”, pointing to fundamental problems with balance sheets. As financial market pressures became ever more severe, European policymakers resorted to short selling bans and attempted to implement a ban on CDS trading. The debate continues to rage over whether the CDS market caused or exacerbated the Eurozone crisis, or whether the crisis was inevitable.
But what eventually killed the Developed Market Credit Default Swap market in the end, was the agreement with the Institute of International Finance (IIF), representing banks owning Greek bonds, to accept a 50% haircut on their holdings. The possibility that despite such a large haircut on Greece’s debt, that CDS contracts would not trigger, led many investors and bank hedging desks to question the value of their CDS contracts. The repercussions soon spread, as those institutions that believed they had hedged their bond holdings, or bet upon a Greek default, rushed to sell their contracts before the price collapsed. Volumes soon collapsed as it became evident that developed market governments had the ability to force their banks into taking haircuts without rewarding what they view as speculators.
Developed Market CDS soon faded into history alongside Perpetual Floating Rate Notes, Libor-cubed Notes, Asset Backed Collateralised Debt Obligations, War Loans, Endowment Mortgages and other financial products that were found wanting.
Following last night’s big meeting — which is being greeted with a strong rally — here’s what to watch next:
We would expect the next 24 hours to be driven by how the Sarkozy call to China President Hu Jintao goes, how investors analyze the sustainability of Greek debt under this program, and the reception that the EFSF proposal will get. We are a bit surprised by the enthusiasm given the lack of detail and lack of surprise. We are also wondering how seriously investors will take the EFSF guarantees (which only apply in the event of a default), given that the banks were strongly encouraged to declare the current restructuring voluntary. Investors may fear that the EFSF – guaranteeing – governments will similarly contrive to avoid paying out on their first-loss guarantees.
- Europe’s new debt crisis agreement: the good, the bad, the ugly (curiouscapitalist.blogs.time.com)
- EU to leverage EFSF to 1 trillion euros: report (marketwatch.com)
- Watch for Sarkozy-Hu Jintao headlines (forexlive.com)
- Europe crafts debt deal that pleases markets (seattlepi.com)