What's new in fiscal policy? In an all night session, the Ecofin Council finalised the details for a much larger than- expected financial stabilisation package of up to EUR 750bn. There are three elements to the new fund: First, opening up the EU balance-of-payments facility to euro area countries and increasing its ceiling from EUR 60bn to EUR 110bn. Second, a European stabilisation fund amounting to EUR 440bn. Third, an additional IMF tranche for euro area countries of up to EUR 250bn. The latter two would make an emergency lending programme like the one implemented for Greece a much faster decision by avoiding another lengthy ratification process in national parliaments. In exchange for receiving emergency funding, recipients need to agree to a rigorous austerity plan supervised by the IMF, the EC and, we would expect, the ECB.
What’s new in monetary policy: The ECB has announced that it will intervene in public and private debt markets. The interventions will be sterilised and hence don’t constitute quantitative easing. The amount and details are still to be determined by the ECB Council. Furthermore the ECB will switch its upcoming 3M tenders back to full allotment and reinstate a 6M tender, allowing banks again access to unlimited term-funding. Finally, in conjunction with the Fed the ECB has decided to reopen the USD swap lines, which allow European banks to obtain USD funding against EUR collateral.
Our take on the measures: The stabilisation fund, which constitutes a first move towards a fiscal union, is larger than expected. If the emergency liquidity for the periphery is not complemented by aggressive austerity measures, the underlying solvency problems will continue to fester – and eventually spread to the core. The ECB’s policy actions, by contrast, probably fall somewhat short of market expectations for a big 1Y LTRO and/or big bond buying scheme. With tonight’s ECB decision to open the door to purchases of bonds, the bank is walking a fine line in terms of its perceived credibility.
Fast forward towards a fiscal union in Europe … Like the ERM crisis in the early 1990s spurred on political initiatives to bring about the long-planned monetary union in Europe, it seems that the sovereign debt crisis could be acting as a catalyst for an ever closer union of European countries. The decisions taken this weekend first by European leaders and then by finance ministers mark a big leap towards a fiscal union in the euro area, we think. Not only have countries agreed to stand in for each other in an unprecedented extent, they have also agreed to foregoing some of their fiscal sovereignty and submit to rigorous fiscal consolidation programmes should they require financial assistance. At EUR 750bn in total, the stabilisation fund amounts to a sizeable 8% of euro area GDP (equivalent to 10% of general government debt). The size of the stabilisation fund is likely to go beyond the expectation of most market participants as far as the fiscal stabilisation mechanism is concerned.
… and tighter surveillance of budget positionsThe stabilisation fund clearly represents a move towards a closer fiscal union and towards the joint issuance of government bonds via the European Community (at least for the proportion of the fund handled via the balance of payments facility). The key difference betweenthe stabilisation fund and joint bond issuance lies in the conditionality. But the surveillance mechanism will only be as good as its supervisors. Hence it was important to get both the IMF and the ECB involved too. If the experience of the Stability and Growth Pact is anything to go by there is reason for concern about the effectiveness of the peer review process within the Ecofin with the support of the European Commission. That said, the peer review process of the SGP might also be sharpened in the coming months given the recent experience and the fact that there is domestic tax payers money on the line for emergency liquidity assistance.
ECB, increasingly politicised, gives some more ground As with the decision on the collateral eligible at its refinancing operations, where the ECB already changed its rules twice, it becomes clear that the ECB’s decision have become increasingly politicised in the course of the crisis. As the delineation of responsibilities between the common monetary policy run by the ECB and national fiscal policies run by individual governments got more and more blurry, the independence of the ECB started to be compromised. Tonight the ECB decided to take one step further and – in addition to reinstating some of the measures it had already taken during the height of the financial crisis (term funding and USD swap lines) – also open the door to outright purchases of government bonds. These purchases will be sterilised and as such do not constitute quantitative easing, i.e. an expansion of the ECB’s balance sheet. So far the size of the intervention programme and the details about which debt instruments the ECB is going to buy are not known. This is a decision still to be taken by the ECB Governing Council. Apart from the sterilisation, we would guess that the covered bond buying programme of the ECB could be a blue print and would expect the ECB to reveal in due course the amount of the purchases it is targeting and the time frame over which they expect toconduct these purchases. In the highly successful covered bond programme, there were hardly any details given of which bonds they aimed to buy.
Contrary to the covered buying programme the ECB might be shying away from buying bonds in the primary market. It is clear that the ECB has decided to give up some of its composure this weekend and embark on an unprecedented course of buying debt instruments in order to reduce volatility in financial markets and funding pressures in parts of the banking system.
Two tales of a sovereign debt crisis We have argued in the past that the sovereign debt crisis is likely to play out in two ways: as a credit story within the euro area because the ECB isn’t allowed to monetise government debt and as an inflation story in the UK and US where the central bank can and does monetise government debt. It now seems that the euro area could be in the worst of both worlds. Like the emergency lending facilities that Europe has activated, also government bond buying by the central bank – whether it is pure credit easing (i.e. sterilised) or outright quantitative easing (i.e. unsterilised – often casually described as printing money), involving the central bank in stabilising government bond mainly buys the governments facing financial distresssome extra time. Contrary to earlier decisions taken by other central banks, this purchase programme is not meant to up the overall amount of liquidity or lending. In other words, it is not quantitative easing. Hence, there is no additional money meant to be printed (at least not through the purchase programme). As result the potential longer-term inflationary dangers should be more contained. But it will remain to be seen whether the financial markets come to this conclusion too.
Funding pressures in the financial system The sharp sell-off in some of the peripheral bond markets in recent weeks will likely have had some repercussions on the euro area banking system. Even where euro area banks have allocated their government bond holdings to their hold-to maturity assets, they still face a daily mark-to-market for bonds that have been pledged to the ECB as collateral. Hence the sharp fall in some bond markets could have caused some stress on the funding side, rather than the asset side as such.
EU balance-of-payments facility extended to EMU states The smaller part of the stabilisation fund is based on an extension of the existing balance of payments facility to euro area member states. In addition, the facility is upped by EUR 60bn to a total of EUR 110bn. The balance of payment facility has recently provided emergency funding to Hungary, Latvia and Romania. In these cases, the European Community (EC) came to the market to raise funds by issuing EC bonds that are backed by all EU Member states and then lent the money on to the countries in question under a joint funding programme with the IMF. Typically, the lending is conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having a AAA rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, the IMF and the government concerned agree on measures designed to overcome the country’s difficulties. Based on a Commission proposal, Ecofin approved the loans to Latvia, Hungary and Romania, usually at a five-year maturity. Subsequently, a Memorandum of Understanding is signed between the EU and the member state, setting out the conditions of the loan. Following signature of the Memorandum and the Loan Agreement, the first payment tranche is released. Countries that would like to use this facility would probably be prepared to make budget cuts similar to what the CEE countries did and what Greece is doing now. Payments are usually made in instalments. Ahead of the disbursements of further tranches there is typically an assessment of the progress made with respect to the policy measures taken. So far, about EUR 15bn out of the BoP facility have been allocated to Hungary, Romania and Latvia (with around EUR 10bn having been disbursed already). Hence, there is at the moment about EUR 100bn of emergency lending available in the BoP facility.
A new SPV to stabilise euro area sovereigns The significantly larger part of the stabilisation fund though will be provided by a newly created Special Purpose Vehicle (SPV) backed by pro-rata national government guarantees of theeuro area member states. The SIV will have a maturity of three years and can have a volume of up to EUR 440bn. The IMF will provide additional funding of at least half the European contribution (hence up to EUR 220bn). The loans will be subject to strict conditionality and have similar terms and conditions as the usual IMF loans. By setting up such as SPV euro area governments want to avoid to having to go through the lengthy legislative process that we saw of the approval of the aid for Greece.
Impact on the EMU periphery The impact of the stabilisation fund will likely be felt most acutely in the EMU periphery, for two reasons. First, these were the countries that experienced some funding stress, with bond yields rising fast and furiously. Second, these are the countries that would have to agree to aggressive austerity programmes – should they have to draw on the lending facilities of the fund. In what follows we are looking at the implications for Spain and Portugal in particular, and would encourage readers to take a look at our more in-depth reports on those two countries too.
For the overall banking system this should not be a major issue given the extent of overcollateralisation and the small share of government bonds in the overall collateral pool. But for individual institutions this might not be case. To the extent that the policy initiatives announced cause bond markets to rally, they will also help to relieve the funding stress.
How much fiscal tightening for Spain and Portugal? Both countries are not facing long-term solvency concerns, i.e., their debt trajectory – especially in the short term, say over the next few years – seems sustainable. Over the long haul, when age-related public spending, i.e., pensions and healthcare, kicksin, there are some long-term sustainability issues in Spain – along with Greece, Ireland and, outside the euro area, the UK, among others.
Our rough-and-ready calculations suggest that debt stabilisation in Spain is unlikely to be as challenging as in Greece. For example, Exhibit 3 (the underlying model, which allows us to run different scenarios, is available on request) shows what the change in the Spanish debt-to-GDP ratio will be for different combinations of primary balance and nominal GDP growth (the cells highlighted show the outcome for themost likely combinations of nominal GDP growth and primary balance). The starting point is debt-to-GDP ratio of around 55% and average coupon on the debt of around 5%; the debt trajectory will deteriorate a lot less than in Greece (see Our First Assessment of Greece’s Loan and Austerity Package, May 3, 2010).
We highlight Spain as an example simply because of its size (12% of euro area GDP). Similar calculations for Portugal show that this country too is better placed than Greece. Right now, Spain and Portugal are under themarket spotlight, because of liquidity – not solvency – issues. In practice, these two risks are deeplyintertwined. Even a solvent country might face a restructuring or a default if it is not able to refinance its debt. In the case of a ‘confidence crisis’ any country might face refinancing risks that might morph into sustainability risks. One way to reduce these risks is to step up fiscal consolidation. How much is needed? The European Commission’s recommendations might be a useful starting point. Spain and Portugal might justcomply with these recommendations if theydeliver on their current fiscal consolidation programmes in full. But to restore confidence, the chances are that more will be needed. At this stage, both countries havehinted at more belt-tightening to come – although no details are available yet.
Impact of fiscal austerity on growth in the EMU peripheryWe will have to see what the details of any fiscal adjustment programme are. But take Spain, for example. According to press reports, the Prime Minister might present further austerity measures before the parliament onWednesday. There is virtually no indication at this stage on the nature of these measures. But the government might bring forward the Central Government Austerity plan, for example.Together with the Portuguese government it will present its additional measures before the Ecofin Council on May 18. Other measures might include restraining wageoutlays for the publicadministration, or cutting transfers and subsidies. According to newswire reports on Reuters, there were very lively discussions at the Ecofin about this issue.
Danger of a double-dip in Spain In this scenario, fiscal tightening will hit the economy harder than in our base case – in which we expect the Spanish economy to shrink by 0.7% this year and expand by 0.8% next year. Should we see much more aggressive fiscal tightening, our bear case, in which the economy continues to shrink not only this year (and at a substantial pace) but also the next, might start to look more likely. In addition to potential fiscal policy action, we are watching bank lending to the private sector and the housing market closely as potential sources of downside risks to our below-consensus base case. If these risks materialise, the Spanish economy might not only underperform the euro area in 2010-11, but it might contract outright for an unprecedented three years in a row. Our bear case forecast for GDP growth stands at -2% for 2010 and at -0.5% for 2011. Hence, even if Spanish GDP growth creeps back in positive territory in terms of sequential quarterly GDP growth rates in 1Q (as we expect), the chances are that it will double-dip further down the line.
Growth in Portugal also might be poor Similarly, the chances are that Portugal’s economic outlook might turn out to be more challenging than expected – courtesy of more fiscal retrenchment and a high exposure to Spain, which absorbs about one-quarter of Portugal’s exports. Relative to our base case GDP growth forecasts of 0.5% this year and 1% next year, Portugal might contract by as much as 1% this year and 0.5% next year – in our bear case scenario. Looking further ahead, Portugal’s potential growth rate has changed the least among the various euro area countries – even accounting for the economic fallout of the financial crisis. However, the challenge is that such growth rate was quite low – at around 1% – even before the crisis. All else being equal, this is one of the main difficulties in addressing the fiscal problems. Spain, conversely, has far outperformed the euro area average in the decade prior to the financial crisis. But with no clear substitute for the construction sector as the engine of growth, Spain’s potential growth rate too will be lower in the five years ahead.
Italy, instead, is likely to hold up ok Perhaps surprisingly to some observers, Italy looks like a quasi-core country from a fiscal standpoint (see Inching into the Core, March 15, 2010). There are many reasons for this,
but one key difference between Italy and the EMU peripherals (and also some core country, such as France), is that Italy has managed to maintain a primary budget surplus for most of the past decade. This means that Italy – unlike France – did not need to borrow in the market to cover its interest payments. Indeed, Italy’s primary budget looks in a better shape than most EMU countries. Of course, the recession triggered a shortfall in revenues and an increase in spending – courtesy of the functioning of the so-called ‘automatic stabilisers’ – in all European countries. In Italy, this resulted in a primary budget deficit last year. But this is likely to be a temporary deterioration: we expect a balanced primary budget in 2010 and a small surplus in 2011. In France, conversely, the primary balance dipped into negative territory in 2002, and has remained there ever since. The chances are that the primary deficit will stay well in the red in 2010-11, to the tune of 5.5% of GDP on average.
The upshot is that Italy has less work to do in terms of cutting its budget deficit than the ‘typical’ EMU country.
Indeed, bringing the deficit from around 5% of GDP this year to less than 3% in 2012 (as requested by the European Commission) implies a more limited fiscal consolidation than in the other peripherals. With a sizeable stabilisation fund in place reduced significantly.
How far does a EUR 750bn stabilisation fund go? Clearly, a EUR 750bn stabilisation fund could support peripheral bond markets for a while and provide some respite to, say, Spain, Portugal and Ireland combined, for the remainder of this year and beyond. In addition, the ECB stands as buyer of government bonds, if needed.
ECOFIN Statement
The Council adopted the following conclusions: The Council and the Member States have decided today on a comprehensive package of measures to preserve financial stability in Europe, including a European Financial Stabilisation mechanism with a total volume of up to € 500 billion.
In the wake of the crisis in Greece, the situation in financial markets is fragile and there was a risk of contagion which we needed to address. We have therefore taken the final steps of the support package for Greece, the establishment of a European stabilisation mechanism and a strong commitment to accelerated fiscal consolidation, where warranted.
First, following the successful conclusion of procedures in euro area Member States and the meeting of euro area Heads of State or Government, the way has been cleared for the implementation of the support package for Greece. The Commission has signed today, on behalf of the euro area Member States, the loan agreement with Greece and the first disbursement will proceed, as planned, before 19 May. The Council strongly supports the ambitious and realistic consolidation and reform programme of the Greek government.
Second, the Council is strongly committed to ensure fiscal sustainability and enhanced economic growth in all Member States and therefore agrees that plans for fiscal consolidation and structural reforms will be accelerated, where warranted. We therefore welcome and strongly support the commitment of Portugal and Spain to take significant additional consolidation measures in 2010 and 2011 and present them to the 18 May ECOFIN Council. The adequacy of such measures will be assessed by the Commission in June in the context of the excessive deficit procedure. The Council also welcomes the commitment to announce by the 18 May ECOFIN Council structural reform measures aimed at enhancing growth performance and thus indirectly fiscal
sustainability henceforth.
Third, we have decided to establish a European stabilisation mechanism. The mechanism is based on Art. 122.2 of the Treaty and an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. Art 122.2 of the Treaty foresees financial support for Member States in difficulties caused by exceptional circumstances beyond Member States’ control. We are facing such exceptional circumstance today and the mechanism will stay in place as long as needed to safeguard financial stability. A volume of up to € 60 billion is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. The mechanism will operate without prejudice to the existing facility providing medium term financial assistance for non euro area Member States' balance of payments.
In addition, euro area Member States stand ready to complement such resources through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating Member States in a coordinated manner and that will expire after three years, respecting their national constitutional requirements, up to a volume of € 440 billion. The IMF will participate in financing arrangements and is expected to provide at least half as much as the EU contribution through its usual facilities in line with the recent European programmes.
At the same time, the EU will urgently start working on the necessary reforms to complement the existing framework to ensure fiscal sustainability in the euro area, notably based on the Commission Communication to be adopted on 12 May 2010. We underline the importance that we attach to strengthening fiscal discipline and establishing a permanent crisis resolution framework.
We underlined the need to make rapid progress on financial market regulation and supervision, in particular with regard to derivative markets and the role of rating agencies. Furthermore, we need to continue to work on other initiatives, such as the stability fee, which aim at ensuring that the financial sector shall in future bear its share of burden in case of a crisis, also exploring the possibility of aglobal transaction tax. We also agreed to speed up work on crisis management and resolution. We also reiterate the support of the euro area Member States to the ECB in its action to ensure the stability to the euro area.
STATEMENT OF THE ECB
ECB decides on measures to address severe tensions in financial markets
The Governing Council of the European Central Bank (ECB) decided on several measures to address the severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term. The measures will not affect the stance of monetary policy.
In view of the current exceptional circumstances prevailing in the market, the Governing Council decided: To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective ofthis programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not beaffected.
To adopt a fixed-rate tender procedure with full allotment in the regular 3-month longer-term refinancing operations (LTROs) to be allotted on 26 May and on 30 June 2010. To conduct a 6-month LTRO with full allotment on 12 May 2010, at a rate which will be fixed at the average minimum bid rate of the main refinancing operations (MROs) over the life of this operation.
To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on 11 May 2010.
Source : Morgan Stanley Research Report 10 May 2010
What’s new in monetary policy: The ECB has announced that it will intervene in public and private debt markets. The interventions will be sterilised and hence don’t constitute quantitative easing. The amount and details are still to be determined by the ECB Council. Furthermore the ECB will switch its upcoming 3M tenders back to full allotment and reinstate a 6M tender, allowing banks again access to unlimited term-funding. Finally, in conjunction with the Fed the ECB has decided to reopen the USD swap lines, which allow European banks to obtain USD funding against EUR collateral.
Our take on the measures: The stabilisation fund, which constitutes a first move towards a fiscal union, is larger than expected. If the emergency liquidity for the periphery is not complemented by aggressive austerity measures, the underlying solvency problems will continue to fester – and eventually spread to the core. The ECB’s policy actions, by contrast, probably fall somewhat short of market expectations for a big 1Y LTRO and/or big bond buying scheme. With tonight’s ECB decision to open the door to purchases of bonds, the bank is walking a fine line in terms of its perceived credibility.
Fast forward towards a fiscal union in Europe … Like the ERM crisis in the early 1990s spurred on political initiatives to bring about the long-planned monetary union in Europe, it seems that the sovereign debt crisis could be acting as a catalyst for an ever closer union of European countries. The decisions taken this weekend first by European leaders and then by finance ministers mark a big leap towards a fiscal union in the euro area, we think. Not only have countries agreed to stand in for each other in an unprecedented extent, they have also agreed to foregoing some of their fiscal sovereignty and submit to rigorous fiscal consolidation programmes should they require financial assistance. At EUR 750bn in total, the stabilisation fund amounts to a sizeable 8% of euro area GDP (equivalent to 10% of general government debt). The size of the stabilisation fund is likely to go beyond the expectation of most market participants as far as the fiscal stabilisation mechanism is concerned.
… and tighter surveillance of budget positionsThe stabilisation fund clearly represents a move towards a closer fiscal union and towards the joint issuance of government bonds via the European Community (at least for the proportion of the fund handled via the balance of payments facility). The key difference betweenthe stabilisation fund and joint bond issuance lies in the conditionality. But the surveillance mechanism will only be as good as its supervisors. Hence it was important to get both the IMF and the ECB involved too. If the experience of the Stability and Growth Pact is anything to go by there is reason for concern about the effectiveness of the peer review process within the Ecofin with the support of the European Commission. That said, the peer review process of the SGP might also be sharpened in the coming months given the recent experience and the fact that there is domestic tax payers money on the line for emergency liquidity assistance.
ECB, increasingly politicised, gives some more ground As with the decision on the collateral eligible at its refinancing operations, where the ECB already changed its rules twice, it becomes clear that the ECB’s decision have become increasingly politicised in the course of the crisis. As the delineation of responsibilities between the common monetary policy run by the ECB and national fiscal policies run by individual governments got more and more blurry, the independence of the ECB started to be compromised. Tonight the ECB decided to take one step further and – in addition to reinstating some of the measures it had already taken during the height of the financial crisis (term funding and USD swap lines) – also open the door to outright purchases of government bonds. These purchases will be sterilised and as such do not constitute quantitative easing, i.e. an expansion of the ECB’s balance sheet. So far the size of the intervention programme and the details about which debt instruments the ECB is going to buy are not known. This is a decision still to be taken by the ECB Governing Council. Apart from the sterilisation, we would guess that the covered bond buying programme of the ECB could be a blue print and would expect the ECB to reveal in due course the amount of the purchases it is targeting and the time frame over which they expect toconduct these purchases. In the highly successful covered bond programme, there were hardly any details given of which bonds they aimed to buy.
Contrary to the covered buying programme the ECB might be shying away from buying bonds in the primary market. It is clear that the ECB has decided to give up some of its composure this weekend and embark on an unprecedented course of buying debt instruments in order to reduce volatility in financial markets and funding pressures in parts of the banking system.
Two tales of a sovereign debt crisis We have argued in the past that the sovereign debt crisis is likely to play out in two ways: as a credit story within the euro area because the ECB isn’t allowed to monetise government debt and as an inflation story in the UK and US where the central bank can and does monetise government debt. It now seems that the euro area could be in the worst of both worlds. Like the emergency lending facilities that Europe has activated, also government bond buying by the central bank – whether it is pure credit easing (i.e. sterilised) or outright quantitative easing (i.e. unsterilised – often casually described as printing money), involving the central bank in stabilising government bond mainly buys the governments facing financial distresssome extra time. Contrary to earlier decisions taken by other central banks, this purchase programme is not meant to up the overall amount of liquidity or lending. In other words, it is not quantitative easing. Hence, there is no additional money meant to be printed (at least not through the purchase programme). As result the potential longer-term inflationary dangers should be more contained. But it will remain to be seen whether the financial markets come to this conclusion too.
Funding pressures in the financial system The sharp sell-off in some of the peripheral bond markets in recent weeks will likely have had some repercussions on the euro area banking system. Even where euro area banks have allocated their government bond holdings to their hold-to maturity assets, they still face a daily mark-to-market for bonds that have been pledged to the ECB as collateral. Hence the sharp fall in some bond markets could have caused some stress on the funding side, rather than the asset side as such.
EU balance-of-payments facility extended to EMU states The smaller part of the stabilisation fund is based on an extension of the existing balance of payments facility to euro area member states. In addition, the facility is upped by EUR 60bn to a total of EUR 110bn. The balance of payment facility has recently provided emergency funding to Hungary, Latvia and Romania. In these cases, the European Community (EC) came to the market to raise funds by issuing EC bonds that are backed by all EU Member states and then lent the money on to the countries in question under a joint funding programme with the IMF. Typically, the lending is conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having a AAA rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, the IMF and the government concerned agree on measures designed to overcome the country’s difficulties. Based on a Commission proposal, Ecofin approved the loans to Latvia, Hungary and Romania, usually at a five-year maturity. Subsequently, a Memorandum of Understanding is signed between the EU and the member state, setting out the conditions of the loan. Following signature of the Memorandum and the Loan Agreement, the first payment tranche is released. Countries that would like to use this facility would probably be prepared to make budget cuts similar to what the CEE countries did and what Greece is doing now. Payments are usually made in instalments. Ahead of the disbursements of further tranches there is typically an assessment of the progress made with respect to the policy measures taken. So far, about EUR 15bn out of the BoP facility have been allocated to Hungary, Romania and Latvia (with around EUR 10bn having been disbursed already). Hence, there is at the moment about EUR 100bn of emergency lending available in the BoP facility.
A new SPV to stabilise euro area sovereigns The significantly larger part of the stabilisation fund though will be provided by a newly created Special Purpose Vehicle (SPV) backed by pro-rata national government guarantees of theeuro area member states. The SIV will have a maturity of three years and can have a volume of up to EUR 440bn. The IMF will provide additional funding of at least half the European contribution (hence up to EUR 220bn). The loans will be subject to strict conditionality and have similar terms and conditions as the usual IMF loans. By setting up such as SPV euro area governments want to avoid to having to go through the lengthy legislative process that we saw of the approval of the aid for Greece.
Impact on the EMU periphery The impact of the stabilisation fund will likely be felt most acutely in the EMU periphery, for two reasons. First, these were the countries that experienced some funding stress, with bond yields rising fast and furiously. Second, these are the countries that would have to agree to aggressive austerity programmes – should they have to draw on the lending facilities of the fund. In what follows we are looking at the implications for Spain and Portugal in particular, and would encourage readers to take a look at our more in-depth reports on those two countries too.
For the overall banking system this should not be a major issue given the extent of overcollateralisation and the small share of government bonds in the overall collateral pool. But for individual institutions this might not be case. To the extent that the policy initiatives announced cause bond markets to rally, they will also help to relieve the funding stress.
How much fiscal tightening for Spain and Portugal? Both countries are not facing long-term solvency concerns, i.e., their debt trajectory – especially in the short term, say over the next few years – seems sustainable. Over the long haul, when age-related public spending, i.e., pensions and healthcare, kicksin, there are some long-term sustainability issues in Spain – along with Greece, Ireland and, outside the euro area, the UK, among others.
Our rough-and-ready calculations suggest that debt stabilisation in Spain is unlikely to be as challenging as in Greece. For example, Exhibit 3 (the underlying model, which allows us to run different scenarios, is available on request) shows what the change in the Spanish debt-to-GDP ratio will be for different combinations of primary balance and nominal GDP growth (the cells highlighted show the outcome for themost likely combinations of nominal GDP growth and primary balance). The starting point is debt-to-GDP ratio of around 55% and average coupon on the debt of around 5%; the debt trajectory will deteriorate a lot less than in Greece (see Our First Assessment of Greece’s Loan and Austerity Package, May 3, 2010).
We highlight Spain as an example simply because of its size (12% of euro area GDP). Similar calculations for Portugal show that this country too is better placed than Greece. Right now, Spain and Portugal are under themarket spotlight, because of liquidity – not solvency – issues. In practice, these two risks are deeplyintertwined. Even a solvent country might face a restructuring or a default if it is not able to refinance its debt. In the case of a ‘confidence crisis’ any country might face refinancing risks that might morph into sustainability risks. One way to reduce these risks is to step up fiscal consolidation. How much is needed? The European Commission’s recommendations might be a useful starting point. Spain and Portugal might justcomply with these recommendations if theydeliver on their current fiscal consolidation programmes in full. But to restore confidence, the chances are that more will be needed. At this stage, both countries havehinted at more belt-tightening to come – although no details are available yet.
Impact of fiscal austerity on growth in the EMU peripheryWe will have to see what the details of any fiscal adjustment programme are. But take Spain, for example. According to press reports, the Prime Minister might present further austerity measures before the parliament onWednesday. There is virtually no indication at this stage on the nature of these measures. But the government might bring forward the Central Government Austerity plan, for example.Together with the Portuguese government it will present its additional measures before the Ecofin Council on May 18. Other measures might include restraining wageoutlays for the publicadministration, or cutting transfers and subsidies. According to newswire reports on Reuters, there were very lively discussions at the Ecofin about this issue.
Danger of a double-dip in Spain In this scenario, fiscal tightening will hit the economy harder than in our base case – in which we expect the Spanish economy to shrink by 0.7% this year and expand by 0.8% next year. Should we see much more aggressive fiscal tightening, our bear case, in which the economy continues to shrink not only this year (and at a substantial pace) but also the next, might start to look more likely. In addition to potential fiscal policy action, we are watching bank lending to the private sector and the housing market closely as potential sources of downside risks to our below-consensus base case. If these risks materialise, the Spanish economy might not only underperform the euro area in 2010-11, but it might contract outright for an unprecedented three years in a row. Our bear case forecast for GDP growth stands at -2% for 2010 and at -0.5% for 2011. Hence, even if Spanish GDP growth creeps back in positive territory in terms of sequential quarterly GDP growth rates in 1Q (as we expect), the chances are that it will double-dip further down the line.
Growth in Portugal also might be poor Similarly, the chances are that Portugal’s economic outlook might turn out to be more challenging than expected – courtesy of more fiscal retrenchment and a high exposure to Spain, which absorbs about one-quarter of Portugal’s exports. Relative to our base case GDP growth forecasts of 0.5% this year and 1% next year, Portugal might contract by as much as 1% this year and 0.5% next year – in our bear case scenario. Looking further ahead, Portugal’s potential growth rate has changed the least among the various euro area countries – even accounting for the economic fallout of the financial crisis. However, the challenge is that such growth rate was quite low – at around 1% – even before the crisis. All else being equal, this is one of the main difficulties in addressing the fiscal problems. Spain, conversely, has far outperformed the euro area average in the decade prior to the financial crisis. But with no clear substitute for the construction sector as the engine of growth, Spain’s potential growth rate too will be lower in the five years ahead.
Italy, instead, is likely to hold up ok Perhaps surprisingly to some observers, Italy looks like a quasi-core country from a fiscal standpoint (see Inching into the Core, March 15, 2010). There are many reasons for this,
but one key difference between Italy and the EMU peripherals (and also some core country, such as France), is that Italy has managed to maintain a primary budget surplus for most of the past decade. This means that Italy – unlike France – did not need to borrow in the market to cover its interest payments. Indeed, Italy’s primary budget looks in a better shape than most EMU countries. Of course, the recession triggered a shortfall in revenues and an increase in spending – courtesy of the functioning of the so-called ‘automatic stabilisers’ – in all European countries. In Italy, this resulted in a primary budget deficit last year. But this is likely to be a temporary deterioration: we expect a balanced primary budget in 2010 and a small surplus in 2011. In France, conversely, the primary balance dipped into negative territory in 2002, and has remained there ever since. The chances are that the primary deficit will stay well in the red in 2010-11, to the tune of 5.5% of GDP on average.
The upshot is that Italy has less work to do in terms of cutting its budget deficit than the ‘typical’ EMU country.
Indeed, bringing the deficit from around 5% of GDP this year to less than 3% in 2012 (as requested by the European Commission) implies a more limited fiscal consolidation than in the other peripherals. With a sizeable stabilisation fund in place reduced significantly.
How far does a EUR 750bn stabilisation fund go? Clearly, a EUR 750bn stabilisation fund could support peripheral bond markets for a while and provide some respite to, say, Spain, Portugal and Ireland combined, for the remainder of this year and beyond. In addition, the ECB stands as buyer of government bonds, if needed.
ECOFIN Statement
The Council adopted the following conclusions: The Council and the Member States have decided today on a comprehensive package of measures to preserve financial stability in Europe, including a European Financial Stabilisation mechanism with a total volume of up to € 500 billion.
In the wake of the crisis in Greece, the situation in financial markets is fragile and there was a risk of contagion which we needed to address. We have therefore taken the final steps of the support package for Greece, the establishment of a European stabilisation mechanism and a strong commitment to accelerated fiscal consolidation, where warranted.
First, following the successful conclusion of procedures in euro area Member States and the meeting of euro area Heads of State or Government, the way has been cleared for the implementation of the support package for Greece. The Commission has signed today, on behalf of the euro area Member States, the loan agreement with Greece and the first disbursement will proceed, as planned, before 19 May. The Council strongly supports the ambitious and realistic consolidation and reform programme of the Greek government.
Second, the Council is strongly committed to ensure fiscal sustainability and enhanced economic growth in all Member States and therefore agrees that plans for fiscal consolidation and structural reforms will be accelerated, where warranted. We therefore welcome and strongly support the commitment of Portugal and Spain to take significant additional consolidation measures in 2010 and 2011 and present them to the 18 May ECOFIN Council. The adequacy of such measures will be assessed by the Commission in June in the context of the excessive deficit procedure. The Council also welcomes the commitment to announce by the 18 May ECOFIN Council structural reform measures aimed at enhancing growth performance and thus indirectly fiscal
sustainability henceforth.
Third, we have decided to establish a European stabilisation mechanism. The mechanism is based on Art. 122.2 of the Treaty and an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. Art 122.2 of the Treaty foresees financial support for Member States in difficulties caused by exceptional circumstances beyond Member States’ control. We are facing such exceptional circumstance today and the mechanism will stay in place as long as needed to safeguard financial stability. A volume of up to € 60 billion is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. The mechanism will operate without prejudice to the existing facility providing medium term financial assistance for non euro area Member States' balance of payments.
In addition, euro area Member States stand ready to complement such resources through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating Member States in a coordinated manner and that will expire after three years, respecting their national constitutional requirements, up to a volume of € 440 billion. The IMF will participate in financing arrangements and is expected to provide at least half as much as the EU contribution through its usual facilities in line with the recent European programmes.
At the same time, the EU will urgently start working on the necessary reforms to complement the existing framework to ensure fiscal sustainability in the euro area, notably based on the Commission Communication to be adopted on 12 May 2010. We underline the importance that we attach to strengthening fiscal discipline and establishing a permanent crisis resolution framework.
We underlined the need to make rapid progress on financial market regulation and supervision, in particular with regard to derivative markets and the role of rating agencies. Furthermore, we need to continue to work on other initiatives, such as the stability fee, which aim at ensuring that the financial sector shall in future bear its share of burden in case of a crisis, also exploring the possibility of aglobal transaction tax. We also agreed to speed up work on crisis management and resolution. We also reiterate the support of the euro area Member States to the ECB in its action to ensure the stability to the euro area.
STATEMENT OF THE ECB
ECB decides on measures to address severe tensions in financial markets
The Governing Council of the European Central Bank (ECB) decided on several measures to address the severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term. The measures will not affect the stance of monetary policy.
In view of the current exceptional circumstances prevailing in the market, the Governing Council decided: To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective ofthis programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not beaffected.
To adopt a fixed-rate tender procedure with full allotment in the regular 3-month longer-term refinancing operations (LTROs) to be allotted on 26 May and on 30 June 2010. To conduct a 6-month LTRO with full allotment on 12 May 2010, at a rate which will be fixed at the average minimum bid rate of the main refinancing operations (MROs) over the life of this operation.
To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on 11 May 2010.
Source : Morgan Stanley Research Report 10 May 2010
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