28 November 2014

President Junker’s Plan: A “European Fund for Strategic Investments” (EFSI)

A multi billion plan for stimulating the EU’s economy: who can question the need to foster growth, fight unemployment, restore confidence…, and is there any better alternative than stimulating investment to achieve such goals?

Whether it concerns the €315 billion plan announced by the Commission, the €400 billion suggested by the Social Democrats in the European Parliament or the €700 billion thrown in by Guy Verhofstadt in the name of the ALDE, each of these proposals must answer a series of precise questions to avoid remaining purely rhetorical. Let us endeavour to bring some coherent responses:

The first question concerns theavailability of the required resources. At present the existence of abundant financial resources is evident: rarely have the monetary policies of Member State’s Central Banks – in particular the ECB and the BoE - been so accommodative. Even if the new prudential regulatory framework has led the banking sector to reduce its credit exposures (deleveraging), the consequences have been largely offset by the spectacular development of non bank financing as well as by the contraction of the demand reflecting the sluggish economic environment. These developments are nevertheless welcome because they spread risk more broadly among lenders and increase the security of bank depositors.

Furthermore, the amount of funds required by the EFSI represents only a modest fraction of those needed to (re)finance sovereign indebtedness. However, the low rates at which the best issuers are able to borrow, often referred to completely out of context, are not necessarily an expression of investor confidence: rather they reflect the simultaneous existence of abundant liquidity together with a severe contraction of available alternative quality investments, phenomena that feed the vicious circle of the threat of deflation and economic stagnation. The issuance of securities representing a credible investment alternative providing both risk diversification and a suitable return should be welcomed by the market.

If the availability of capital seeking productive deployment is beyond any doubt, does, for that matter, the plan outlined by President Junker meet market expectations?

The Commission is confronted with several contradictions:

In the first place, it feels bound to limit recourse to “public” financing while, at the same time the wish list of projects dreamed by the President (Schools in Thessaloniki, hospitals in Florence, investments in transport infrastructures, investments in education and innovation) can only be financed by public funds (or by borrowing from the private market with a public guarantee).

Furthermore, the proposed innovative management approach aims at integrating professionalism (i.e. exempt of political interference) while imposing, in addition to purely “economic and financial” considerations, that appropriate weight be given to the “societal value” of projects, an eminently “political” criteria! It is clearly the responsibility of thePublic purse to assume the servicing of the “societal” elements of a project that would not be covered by the purely economic and financial criteria.

An analysis of the proposed structure of the EFSI demonstrates that it meets the requirement of limiting the recourse to budgetary funding. The leverage factor aiming to provide at EIB/EIF level € 63 billion (21 x 3) can be deemed realistic. On the other hand the leverage factor (63 x 5) concerning the contribution of the private sector appears far more questionable. Let us examine more closely the interventions by the EIB and EIF based on the funds provided by the EFSI.

The EIB will be charged with directing the investments in infrastructure and other projects with a high societal value. In theory these projects should be financed (x5) by long term loans. Raising the funds should cause no difficulty (see above) to the extent that the credit risk is limited, that means that the servicing of the loan is considered secure (quality of the borrower and/or of guarantees provided). Will the “cushion” meant to absorb potential “first losses” be limited to the € 16 billion provided by the EU budget guarantee or will it be extended to encompass the funds invested by the EIB (48 billion)? In other words, will the EIB “subordinate” its claims to those of its co-financiers from the private sector? Does the security offered to lenders not have to include the guarantee of the Member State benefitting from the project, i.e. conforming to the pattern of EIB standard loans?

Should a borrower/guarantor default on its obligations to the EIB, even if the latter’s claims were “subordinated”, significant legal consequences would follow: it would, for instance, trigger the “acceleration” of all EIB loans outstanding owed/guaranteed by the defaulting party leading, by contagion, to the default of the country in question. Any attempt to isolate contractually the risks associated with loans in which the EFSI brings directly or indirectly its support would curtail significantly the availability of private co-investment funds; it follows that the cost of financing would increase and the financial returns expected from the project diminish.

The question of potential conflicts of interest should also be raised. If there is no doubt concerning the competence of the EIBand the clear benefits deriving from accessing its expertise, how will one ensure the complete insulation of the EFSI from the management of EIB’s daily business? Will there not be a natural tendency to direct more risky loans to entities depending from the Fund? If this is the objective and is fully assumed, as can be implied from the President’s speech, then, is it not reasonable to reward co-investors for the increased riskiness or instead, to recalculate downwards the leverage factor that can be anticipated from the total amount of public funds committed?

A similar reasoning can be applied to the € 15 billion that the EFSI expects to dedicate to the support of the EIF (on the board of which I served in 2001-2). A first question concerns the source of the EIF funding: does it represent the € 5 billion invested by the EIB in the Fund to which an additional € 10 billion of private investments is added? Are these private funds “borrowed” by the EFSI who then on- lends them to the EIF or are they co-invested (with or without the subordination of EFSI claims)? The feasibility of the operation is largely dependent on the answers to these questions. With regard to the second stage (leverage factor x 5), it is difficult to see why the additional € 15 billion of investment capacity of the EIF would trigger additional interest from private investors. If one is relying primarily on the “subordination” of the EIF’s claims, there is a serious risk of encouraging a simple transfer of private investment funds from existing instruments to the new and less risky ones being offered. Under such conditions the objective of a leverage factor of 5/1 seems highly dubious.

Those readers who have had the patience to follow my questioning concerning the realism of the plan as presented to the European Parliament are also entitled to demand alternative constructive proposals since there is complete agreement on the diagnosis requiring a bold investment program as an essential ingredient of any initiative to stimulate growth within the European economy. I will attempt to bring hereinafter some brief answers to these questions.

Without challenging the need for a Strategic Investment Fund, the wisdom of relying on the accumulated experience of the EIB/EIF nor modifying the economic and societal objectives proposed by President Junker (I am leaving 75% of the plan untouched), I will focus on describing a simplified financing structure which avoids any additional burden of national budgets and which relies on a transparent mechanism, easily understood by investors, citizens and taxpayers.

The problem to solve is maintaining an appropriate balance between the availability of existing sources of funding and the legitimate investor demands for an equitable remuneration of the amount of risk underwritten. The current financial environment is particularly conducive to finding a point of equilibrium that allows a very low funding cost, provided that efforts concentrate on reducing credit risk; this reflects the fact that the appetite for risk is proportionate to the outlook for growth and its cost, inversely proportionate.

To achieve such an objective, the source of the funds dedicated to servicing the indebtedness incurred must be clearly identified, an aspect which has been totally overlooked in the presentation of the plan. These resources must be easily identifiable, recurrent and easily collectable.

I suggest instituting a limited annual levy on a series of goods and services the consumption/usage of which are broadly spread throughout the entire population.

It might include a European road tax (collected by insurers) a small levy on telephone bills (collected by operators), a minimal charge on electricity usage (collected by distributors), etc.  The proceeds would be considered as EU budget “own resources” dedicated to guaranteeing the EFSI indebtedness. Any surplus would be used to reduce the budgetary contributions of Member States. Such a system, the practical implementation modalities of which deserve closer scrutiny, boils down to guaranteeing the securities issued by the Fund by the EU budget and constitutes an innovative approach to foster solidarity, not only among Member States but far more importantly between all European citizens. Such a scheme would enhance the perception of the positive contribution that the EU brings to their lives.

Later on, if the system was successful, it could be extended to cover the entire EU budget. It could also underpin the servicing of an autonomous “Community” debt (Eurobonds). A further non negligible advantage would be the creation of a financial instrument allowing the ECB – in the footsteps of the FED and the BoE – to strengthen its “tool box” for ensuring the transmission of its monetary policy while avoiding the trap of “moral hazard” associated with the purchase of sovereign debt instruments issued by Member States. By substituting “community levies” to direct national budgetary contributions, Member States would retain their total freedom in deciding how far they would share their savings with their taxpayers; there would be no new transfer of sovereignty.

This proposal would, in its final development, constitute an enormous step forward towards European integration, providing a far more autonomous (federal)basis for its funding and would, at first glance, not imply fundamental changes to the Treaty.

In conclusion, the Junker plan, as outlined, risks facing serious implementation difficulties and disappoint its many ardent supporters. If it were to fail, it would be a catastrophic defeat for the Union capable of validating the labelling of “the Commission of the last chance” by the President himself! 

Paul N. Goldschmidt, Director, European Commission (ret.); Member of the Steering Committee of the Thomas More Institute.

© Paul Goldschmidt