13 April 2018

VoxEU: EMU: Liquidity of solvent member states more important than fiscal stabilisation

This column, which joins VoxEU's Euro Area Reform debate, argues that the EMU's best use is not in the support of fiscal expansion in recession countries, but in ensuring the liquidity of solvent sovereigns under market pressure.

Market discipline needed but hard to establish

The impotence of the fiscal rules necessitates strengthening market discipline on sovereigns as a complement. This again requires a credible mechanism for the debt restructuring of insolvent member states. Simultaneously, debt restructuring would reduce the need for fiscal consolidation in the affected country. The proposal by Bénassy-Quéré  et al. is well-founded.

However, mandating the ESM/EMF to implement debt restructuring is, by itself, unlikely to sufficiently increase the credibility of restructuring and thus market discipline. A key challenge remains: the potential for panic reactions. To avoid such reactions, decision makers are under strong pressure to resort to a bailout even when debt sustainability is clearly questionable.

To alleviate this risk, the decision-making process should be predictable and rapid. Eliminating the unanimity rule of the ESM decisions would help, as would more comprehensive (one-limb) common action clauses in the debt contracts. At least as important is limiting banks’ exposure to sovereign debt, as proposed in the Franco-German paper.

Liquidity support for solvent member states inadequate

Even with these elements in place, one cannot exclude significant contagion effects on other sovereigns. To prevent this, the restructuring decision would have to be accompanied by extensive liquidity support to solvent member states.

Currently, only the ECB has the resources to provide sufficient liquidity to other countries under pressure. The ESM can in principle provide such support in the form of precautionary financial assistance. However, its resources could quickly be exhausted, particularly if a significant part of the €500 billion capacity is tied to supporting the state which is subject to debt restructuring.

This situation is problematic. First, any decision by the ECB, including in particular the OMT asset purchases, is at the discretion of the ECB Governing Council. While the collaboration between the ESM and the ECB could function smoothly, no mechanisms are in place to ensure it is so.

Second, the role of the ECB as a lender of last resort directly to the member states gives it substantial power over sovereigns. This is difficult to reconcile with the independence of the central bank.

Third, a precondition of the activation of the current OMT promise is that the member state applies for ESM assistance and agrees on an adjustment programme. The last requirement may delay the activation of any assistance, thereby allowing market conditions to deteriorate unnecessarily.

ESM/EMF access to ECB funding should be explored as a solution

One should be able provide effective liquidity support to solvent member states while limiting the problematic role of the ECB. This could potentially be achieved by giving the ESM/EMF access to central bank liquidity to finance precautionary financial assistance.

If one wants to avoid expansion of the overall ESM capital commitment by the member states, ECB lending to the ESM could utilise the debt instruments of borrowing states as a form of collateral and be without recourse. This arrangement would not leave the ECB worse off in regard to credit risk when compared to the current OMT, which involves direct purchases of such debt instruments.  

To further limit the risk to the ECB, the ex-ante conditionality of the current precautionary assistance could be sharpened. In particular, there should be a strict upper limit for the ratio of government debt to GDP for any country willing to make use of the facility. Given that there is no such constraint in the OMT, this would reduce ECB’s credit risk relative to the current situation. One might also use the member state’s share in the future seigniorage income as collateral for the precautionary assistance. In addition, a fraction of the €700 billion capital commitment could be allocated to credit enhancement on a first-loss basis. 

The new arrangement would make a clear distinction between normal financial assistance, conditional on an adjustment programme (and the associated strict monitoring), and precautionary lending subject to ex-ante conditionality. The former would have a definite aggregate upper limit and be financed by the member states. The low-risk precautionary lending facility would be financed by the ECB alone and would be more flexible with regard to the aggregate size. The member states which would not fulfil the ex-ante criteria but remained under market pressure, would be required to resort to ordinary ESM assistance. [...]

Fiscal stabilisation function not very useful

Risk sharing in the form of a fiscal stability mechanism would naturally help badly affected member states to bolster aggregate demand. Nevertheless, to be effective, the size of the mechanism would have to be large when compared to the current EU budget of 1% of GDP. In the proposal by Benassy-Gueré et al. the support remains clearly insignificant. With the given parameters, the support would have been on average about 1/10 of the actual deficits of the worst hit countries in 2009 to 2013 (Vihriälä 2018).

On the other hand, there is a risk that the unconditional support from a fiscal stabilisation mechanism could result in unintended transfers, with the associated political consequences. These factors speak against relying on a fiscal stabilisation mechanism as a major help in financial crises, especially when taken together with the observation that fiscal smoothing has played only a minor role in stabilising asymmetric shocks across the US states in comparison to the stabilisation through the capital and credit markets (Alcidi et al. 2017). [...]

Full article on VoxEU

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