13 May 2010

EZA 949 Report: EU Financial Stabilisation Measures

·            EU puts its broken leg in plaster but will it be given time to heal?

·            Strong demonstration of EuroZone solidarity is not a question of too little, but will it prove too late?

·            Political resolve of borrowers, and lenders, still to be fully tested.

·            ECB bond purchase programme aims at market calming, not quantitative easing.

·            ECB's other measures represent a pragmatic relaxation of its exit strategy.

1.     At an Extraordinary Meeting on Sunday, 7 May, the Economic and Financial Affairs Council of the European Union agreed an extensive package of measures intended to preserve financial stability within the EU, including a European Financial Stabilisation Mechanism which, with IMF participation, would have up to €720 bn at its disposal. The main features of the mechanism are:

·            € 60 bn to be, financed by bonds issued in the name of the European Union, for as long as is needed to safeguard financial stability, under Article 122 of the Treaty (which permits the granting of financial support where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control);

·            In addition, up to € 440 bn to be provided via a 3-year Special Purpose Vehicle, guaranteed pro rata under an intergovernmental agreement by the EuroZone Member States......

·            ........ with at least a further € 220 bn via the IMF, through its usual facilities.

Activation of the mechanism is to be subject to strong conditionality and on terms and conditions similar to those of the IMF.

2.     The Council also welcomed the commitments of the governments of Portugal and Spain to take significant additional fiscal consolidation and structural reform measures in 2010 and 2011, which will be presented to the ECOFIN Council on 18 May.

3.     Alongside the ECOFIN announcement on 7 May, the ECB Governing Council decided on the following measures, announced the following day:

·            To purchase public and private sector debt securities on the secondary markets under a Securities Markets Programme, in order to ensure depth and liquidity in dysfunctional market segments and so restore an effective monetary transmission mechanism.

·            To conduct sterilising operations to re-absorb the liquidity generated by the Securities Markets Programme, thus ensuring that the monetary policy stance would not be affected.

·            To apply a fixed-rate full-allotment procedure to the two regular 3-month longer-term refinancing operations (LTROs) scheduled for 26 May and 30 June.

·            To conduct a full-allotment 6-month LTRO on 12 May at an interest rate indexed to the average minimum bid rate of the main refinancing operations (MROs) during the six months.

·              To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the US Fed, conducting fixed-rate full-allotment repos against ECB-eligible collateral with weekly 7-day operations starting on 11 May and an 84-day operation on 18 May.

Assessment of the Financial Stabilisation Mechanism

4.     The two elements of new the European Financial Stabilisation Mechanism do not represent a totally new departure for the EU, although the scale of the overall package is certainly unprecedented. In total, including the IMF contribution, the Mechanism could provide financial support equivalent to 7.6% of EuroZone GDP. Lending funded by the issuing of bonds in the name of the EU has been carried out in the past couple of years in support of Eastern European countries, such as Hungary and Latvia, seriously affected by the financial crisis, and indeed harks back to the Medium Term Financial Support (MTFS) mechanism that underpinned the old Exchange Rate System (ERM) of the European Monetary System (EMS) and of which Treaty Article 122.2 is a vestige. That said, it represents a modest demonstration of solidarity among the 27 EU Member States in the face of threats to the solvency of individual members, to the tune of 0.5% of their aggregate GDP.

5.     The second element, the intergovernmental agreement among EuroZone Member States to provide or guarantee financial support in conjunction with the IMF, has just been tried, if not yet tested, in the case of Greece. However, this represents an even stronger demonstration of solidarity among the 16 members of the EuroZone, whose fate is bound together by the single currency and the absence of the safety valve of exchange rate realignment. The pledging of up to € 440 bn in guarantees, which are contingent liabilities on the national budgets of the participating countries, is of the order of 4.5% of their collective GDP, at a time when the aggregate general budget deficit of the Eurozone already last year had risen to 6.3% of GDP. The importance of this resolve can also be sensed by looking at the wide disparities in the fiscal behaviour of the individual members of the eurozone as illustrated in the chart below:

It is also notable that two EU Member States who are not members of the EuroZone (Poland and Sweden) and who currently enjoy very favourable fiscal positions - have agreed to participate in a mechanism designed to safeguard the single currency.

6.      Nevertheless, while the scale of this safety net might not be judged too little, its provision could still prove to be too late. There are two inter-related concerns here, both hinging on

conditionality. The first is whether the strict policy conditions that will be attached are realistic and deliverable in terms of the domestic policies of countries tapping the facility. The second is whether the fiscal and economic retrenchment entailed will so undermine GDP growth and undercut government revenues in the borrowing countries that their fiscal positions inexorably deteriorate further. Much then could hinge on whether the larger economies in the EuroZone - Germany and France in particular, but also perhaps Italy - can sustain their economic recovery on a sufficient scale that the demand generated provides an export-led stimulus to growth among the borrowers. An additional question mark hanging over the efficacy of the Financial Stabilisation Mechanism in the medium term is the extent to which countries come to accept the importance of adhering strictly to the Stability and Growth Pact, in the fat years as well as the lean, when devaluation is not an option and whether the EU, and especially the Eurogroup countries, can develop a more effective ex ante framework for economic governance.

Assessment of the ECB's special measures

7.     The EU Treaty and ECB Statute exempt the ECB from the No-Bail-Out clause that prohibits national governments and other EU institutions from purchasing the debt instruments of Member State governments, but only to the extent that purchases are on the secondary market. At the time that this provision was made, in the Maastricht Treaty, The intention was to enable the ECB to conduct outright open market operations in the pursuit of its monetary policy, and not to bail out individual governments facing financing difficulties. The ECB is careful, in announcing that it will intervene in the (secondary) markets for public and private sector bonds, to emphasise that, by ensuring depth and liquidity in those markets, the ultimate purpose is to safeguard the monetary policy transmission mechanism. In addition, it has stressed that all such purchases will be sterilised, so that there will be no net injection of liquidity. In other words, this should not be seen as quantitative easing. While such interventions in government bond markets represent a new departure for the ECB, it is conceptually not entirely new: last year it has already embarked on a €60 bn Covered Bond Purchase Programme. What remains to be seen now is the scale on which the ECB feels it can undertake such purchases given its own balance sheet constraints.

8.     The other measures announced by the ECB are essentially a partial unwinding of its phased withdrawal of the ECB's unconventional credit support instruments. It is now bringing back, at least for the next two operations, the fixed-rate full allotment procedure for its regular 3-month LTROs (which had earlier reverted to variable rate tender) and it has re-introduced an indexed full-allotment 6-month LTRO. It is also reactivating the US dollar swaps in order to conduct 7-day and 84-day repos. With these measures and the bond market interventions the ECB is demonstrating its ability to act decisively and flexibility in repose to financial market upheavals, as Trichet had foreshadowed at his press conference last week ( see EZA Report 947/10May2010). The ECB's announcement should therefore halve some calming effect on the bond and money markets, although how much it will help to assuage any lingering concerns about the efficacy of the Financial Stabilisation mechanism remains to be seen.

For further information or a direct briefing please contact:

John Arrowsmith: ECB / Regulatory

Tel: +44 7720 59 1726

john.arrowsmith@eurozoneadvisors.com

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