Over recent weeks, Spain has entered a “shadow” troika programme: In return for up to €100 billlion in aid to recapitalise its banks, Spain has agreed to a clear set of financial sector reforms. Less visible is Spain’s commitment, as part of the bailout, to implement the European Commission’s recommendations on fiscal and structural reform, with quarterly monitoring.
This macro-conditionality is less taxing than those demanded of Greece, Ireland and Portugal. However, the reality is that Spain has ceded fiscal sovereignty, and this is a positive step toward resolving the euro debt crisis. Ceding sovereignty results in greater eurozone fiscal coordination, a necessary prerequisite for greater financial solidarity.
Now that Spain has done its part, its eurozone partners need to agree to policies that lower Spain’s debt costs to sustainable levels. As a first step, we believe they should make good on their eurozone summit agreement to use the European Financial Stability Fund (EFSF) and European Stability Mechanism (ESM) instruments in a “flexible and efficient manner” to stabilize eurozone sovereign markets. Without this decisive policy response, Spanish voters will likely reassess the decision to cede sovereignty and the euro debt crisis is likely to continue.
Capabilities of the EFSF and ESM
The ESM is not currently operational and will remain unavailable until the German constitutional court rules on its legality on 12 September 2012. So the EFSF remains the rescue vehicle in the interim.
Assuming the ESM is not stillborn, the chief difference between the EFSF and ESM will be lending capacity: The EFSF has €248 billion in remaining funds, while the ESM will have up to €500 billion. These amounts could be increased if all eurozone governments agree but this decision will require parliamentary approval in some countries.
Other important technical differences will give the ESM more operational flexibility in a crisis. The ESM will be funded by paid-in capital, which requires prior national bond issuance, while the EFSF is backed by government guarantees. And over time, eurozone governments plan to allow the ESM to invest directly in eurozone banks.
Both the EFSF and ESM can only intervene in a sovereign’s bond market after a request from the sovereign, with a memorandum of understanding specifying the relevant policy conditionality. When it comes to near-term crisis resolution, what matters most is how the EFSF and ESM can intervene. Here the EFSF and ESM have very similar powers: They can provide loans to governments and buy bonds in the primary or secondary markets.
Lack of market capacity for EFSF issuance
The current structure of the EFSF/ESM suffers from a number of problems. The first is the market’s lack of capacity to absorb large EFSF/ESM issuance in such a short space of time. Investors typically have lower concentration limits for supranationals and agencies than government bonds.
The EFSF has dealt with this by minimizing its reliance on market issuance. Only 43% of the €97 billion in EFSF bonds outstanding were issued into the market, as shown in Figure 1. The rest were placed with institutions, such as Greek banks needing recapitalisation, which then used the bonds as collateral to obtain European Central Bank (ECB) funding. The same is likely to happen with the €100 billion Spanish bank recapitalisation.
In short, the EFSF has only managed to do its job because the ECB has channelled funding indirectly through the banking system. If the EFSF is to become more effective, the ECB will likely need to become more heavily involved in its funding.
The need for leverage
The second problem is one of size. The table in Figure 2 shows the potential lending capacity of the EFSF and ESM against potential sovereign funding needs.
The first observation is that the remaining €508 billion in combined EFSF/ESM lending capacity is inadequate. Matters will be worse if the German constitutional court does not approve the ESM in September. Increasing lending capacity is theoretically possible but politically risky as it entails another round of parliamentary approval across Europe. A more pragmatic solution would be to use leverage to give the EFSF/ESM critical mass.
The EFSF can already leverage its resources by attaching partial-risk certificates on primary issuance that reimburse investors for 20%-30% of losses in the event of default. It can also set up special purpose vehicles (SPVs) to buy sovereign bonds, funding the first-loss piece and selling the SPV’s senior notes to investors. In theory, both options would allow the EFSF to turn its €248 billion in remaining funds into a first-loss piece backing loans or bonds some three to five times greater in value. We believe these powers could also quickly be given to the ESM.
However, these leverage options currently lack credibility because they rely on funding from private investors who may be hesitant to participate because of the considerable uncertainty over sovereign debt recovery rates. Given high sovereign debt loads and complications from a potential EMU break-up, recovery rates are likely to be lower than historical case studies. In addition, the financial and economic linkages mean the default correlations among eurozone sovereigns would be high if a large sovereign, such as Spain, were to default.
Lowering EFSF/ESM funding costs to the “risk-free” rate
The third structural problem with the EFSF/ESM is pricing. The EFSF/ESM can lend money at its cost of funding plus a margin, for operational costs. But the political uncertainty over the eurozone means the market charges a premium for EFSF funding costs, currently about 1% over long-dated swaps.
Debt sustainability is a function of nominal GDP growth, the primary fiscal deficit (i.e., before interest payments) and nominal interest rates. If the cost of EFSF financial aid were lower, countries in financial distress would be more likely to achieve debt sustainability. The EFSF would be more effective in convincing the market that eurozone countries were solvent if it could coordinate with the ECB to offer long-term funding below long-term nominal GDP growth.
The “ideal” policy response: ECB and EFSF/ESM policy coordination
When deciding whether to invest in Spanish and Italian bonds, investors need to take a view on the likely policy response. The more this response directly addresses the EFSF/ESM’s structural problems, the more attractive Spanish and Italian bonds become.
The most effective policy response, in our view, would be for the ECB to buy sovereign bonds and the EFSF/ESM to use its financial resources to underwrite expected losses. In this way, the ECB could address the breakdown in the monetary policy transmission mechanism and lower the cost of credit for the Spanish economy. Any concerns about ECB political independence, driven by the increased amount of sovereign credit risk on balance sheet, would be addressed by the EFSF/ESM guarantees.
Potential ECB purchases would have to be high enough to convince investors that funding needs for all periphery sovereigns would be covered for many years. By lowering interest rates and providing ample liquidity, this policy intervention should improve debt sustainability and reduce the probability of default.
To attract private capital, we believe policymakers also need to clearly signal the policy objective in terms of financial or economic variables – the level of yields, real economic growth or long-term inflation targets – and not make their response dependent on fiscal and structural reforms. Instead, in our view, these necessary reforms should continue to be addressed by the Eurogroup of eurozone finance ministers.
Political reality: low expectations
Unfortunately, the political environment does not appear conducive to such a decisive policy response this summer. Key eurozone governments, such as Germany, want greater ceding of fiscal sovereignty first, a very difficult political task for the countries involved, and the ECB remains reluctant to provide direct funding to the EFSF/ESM.
Instead, the ECB may choose the politically less controversial path of channelling more longer-dated liquidity into national banking systems against a wide range of collateral and at very cheap rates. Some of this liquidity may be used to provide cheaper loans to the real economy in Spain, and some may be invested in EFSF senior debt or Spanish government debt directly.
The ECB may also use further cuts in interest rates to reduce the incentive for holding perceived “safe” assets, such as German bunds, and encourage investors into higher yielding EFSF and Spanish debt. This may be helpful at the margin, but the growing implicit foreign currency risk and uncertain recovery rates suggest that a rate cut is not sufficient to crowd capital back into Spain. Indeed, recent negative yields on short-dated German bunds have led to strong buying in French, Belgium and Austrian bonds but not the bonds of Spain or Italy.
A less decisive policy response will likely provide a funding back-stop to avert a default in the near term. But rather than attracting new private capital, it will instead probably finance its continued exit. In this case, the euro debt crisis will continue, with its negative implications for European growth and eurozone sovereign yields. Because we believe a less decisive policy response is the likely outcome, in our view, investors should continue to be cautious on periphery debt and look outside the eurozone for more attractive assets.