Monetisation of debt and Fed

In 2003, in the midst of rising fears of deflation, B. Bernanke, Federal Reserve Board member, created quite a stir with his observation in financial circles:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the United States government has a technology, called a printing press, or today, its electronic equivalent, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation...

With that statement, Bernanke said more than what the government wante people to know. The ways of Washington and the Federal Reserve could even be more profligate if need be, so, let’s not get ourselves all worried up with something as loathsome as a deflation. When Bernanke alluded to the printing press... or its electronic equivalent, he was referring to the process of monetization.

Monetization and the inner sanctum of government finance are quite often mentioned in such arcane, highly specialized language that few people – including other economists- understand what the writer is trying to convey. To simplify the terms, monetization amounts to nothing more than printing money. It works the following manner: when the federal government can’t seem to find domestic or foreign buyers for its debt issue, usually because the interest rate is not high enough to attract lenders – a particularly acute dilemma in a low-interest-rate environment, the Federal Reserve Bank buys this debt and issues a check to the government. The government spends this money and in turn debases all the currency outstanding.

This is a sophistication of a process first used by the Roman empire. They would take Roman aureus into the treasury as tax payments, shave some gold off the edges, remelt the shavings and mint them into more coins. The debased coins and the new coins would then be recirculated as equivalent in value the quantity of gold in circulation was not increased, only the number of aureii. Since an increasing supply of aureii was chasing roughly the same amount of goods, the net result was one of the first forms of currency inflation.

The modern Federal Reserve is engaged in much the same process when it monetizes debt. The most likely times for inflationary outbursts are the eighteen to twenty-four months following a presidential election. Federal Reserve chairmen, either named by Democratic or Republican administrations, have a tendency to monazite more debt previous to a presidential election in order to maintain interest rates low and the economy moving the right direction. A rising inflation rate in the ensuing years is the direct cost. The greatest inflation’s have been those following elections. The nineteen seventy-three to nineteen seventy-four outburst followed the nineteen seventy-two election year. The nineteen seventy-seven to nineteen seventy-nine outburst followed the nineteen seventy-six election. Even during the disinflationary nineteen eighties, the inflation rate jumped proportionately following the 1984 and 1988 elections.

In 1992, a record, thirty eight billion dollars was monetized by the Federal Reserve, belying claims by some political pundits that George H.W. Bush lost due to the fact that the Fed didn’t accommodate his reelection. By way of comparison. Fourteen billion dollars were monetized in nineteen ninety and twenty-four billion dollars in nineteen ninety-one. It is more than understood that in the months previous to the two thousand-four election, the Fed went the extra mile to accommodate the goal of getting George W. Bush reelected, and it remains to be seen what that accommodation could possibly produce in terms of inflation from two thousand-five onward. During the spring of two thousand-four, before the electioneering had even started, American consumers were already being subjected to record gasoline prices among other inflation manifestations.

In addition to the efforts of the fed to stimulate the economy, another additional inflationary motor is in process that, at this time, only a small amount of analysts have started to unravel. That this is the process of indirect monetization happening now in the United States through government bond purchases by exporting nation-states like China and Japan. This is an even more lethal and virulent form of inflation because the Federal Reserve has lost control of the money-printing process.

The meaning of this isthat how much inflation will be created in the United States is now strongly influenced by Japan, China, and other exporting nations, and the interest that they have in mind are their own, not the same interests as those of the United States. It is not certain how this could all possibly settle out in the economy of the United States, but let’s just put it this way: the task before fed chairman Alan Greenspan is very threatening and more different than anything faced by former fed chairmen. The United States could lose its control of its own monetary policy, and that is a scary proposition, to say the least. Commodity prices are already going up strongly – maybe an indication of what lies ahead, not only for the American economy but also for the economies around the earth.

Gold Mining & Gold Prospecting Investing in Gold Using Gold and Silver as Money The Effects of the Deficit on the Economy Gold and United States' Debt

Debt Monetization: the Road to Inflation The Impact of Debts on American Investors The Politics of Debt The Dollar Losing Value A Common Mistake Made when Investing How-Where to Store Gold Why You Should Add Gold to Your Portfolio Choosing a Gold Dealer Depository Storage Accounts Selecting a Gold Dealer - Broker Bullion Coins: Portable & Liquid, A Reliable Measure of Value Is Buying Gold Bullion Bars Advisable? The Pricing of Bullion Gold Investing Gold Investing Exact Gravity of Some Minerals Methods of investing in gold What is the Price of Gold Types of gold investments available: Physical Gold Paper Gold; Gold certificates; Gold accounts Gold stocks and shares Gold funds; Exchange-traded fund Gold investment strategies Modern Day Gold investors Gold Mining Companies Gold Mining Investment Gold Mining Stocks Invest in Gold Mining

Fiscal crisis, contagion, and the future of euro

Marco Pagano15 May 2010

The Eurozone has been swept up in turmoil that has ranged from stock and bond markets to exchange rates, government spending, and tax rates. Marco Pagano, Professor at the University of Naples Federico II and CEPR Research Fellow, explains events, how they hang together, and what needs to be done. This challenge facing Europe could be a historical turning point. Fiscal crisis, contagion, breakdown of the euro... Let’s try to understand what is going on. In the past few days, the scenarios discussed in the media have been changing so rapidly and dramatically that for many it may be hard to grasp the reason behind them. But in emergencies such as the one we are currently experiencing, the way to escape the worst-case scenarios and find an exit strategy is to stick to clear-headed thinking.

What happens when sovereign states accumulate large debts?
First, investors start worrying that this debt may not be sustainable: concerns rise over the ability of the state to pay back capital and interests by generating budget surpluses in the future (that is, fiscal revenues in excess of expenditures). In this case, investors require higher interest rates to subscribe new public debt as a compensation for the risk of insolvency. This in turn increases the risk of insolvency as it worsens public sector balance sheets. At some point, there may no longer be an interest rate able to compensate investors for the risk of insolvency; then they just stop subscribing the public debt. This is a situation of fiscal crisis and has only two possible (and not mutually exclusive) outcomes:

• 
  government default followed by a renegotiation of the debt (as in Argentina’s case), monetisation of the debt, which is effectively bought by the central bank. This represents an injection of money in the economy and thus generates inflation and exchange-rate depreciation.
• 
  From Greece to Italy
  Second, in the case of Greece, the second option – monetisation - was ruled out by Greece’s membership in the European monetary union: the Greek government could not force the ECB to buy its own bonds. For this reason, the only option was insolvency and enegotiation of the debt, unless other countries were willing to lend to Greece at an interest rate lower than the market rate. Why did euro-area countries choose to do so? In the past few days it has been clear that, following a substantial dose of indecision, they did it mainly for fear of “contagion”.

But what is contagion?

Here we come to the third and most interesting part of the story. As the Greek crisis unfolded, investors started to suspect that other countries with high levels of public debt, namely Portugal, Spain and Italy, would find themselves in a similar situation. But as governments of these countries rushed to point out, their fiscal position is not as dramatic as the Greek one. So why are investors so concerned? Because, as economists say, in this game between sovereign states and investors there can be “multiple equilibria”. Even if the government is not highly indebted, investors might start questioning its willingness to raise taxes above a level considered “politically sustainable”. In the future, it might seek a renegotiation of the debt, its monetisation, or both. Fear that this will happen can push interest rates to a level so high that the investors’ prophecy will eventually come true. At the prevailing interest rates a country which would have otherwise been able to service its debt ends up needing a renegotiation or a monetisation of the debt to avoid full repayment (see for example Calvo 1988).

So the outcome depends on investors’ confidence. If there is confidence, the “good equilibrium” with moderate interest rates and stable markets prevails; when confidence disappears, the economy jumps to a “bad equilibrium”, where a fiscal crisis occurs. The contagion generated by Greek crisis has been exactly of this type. It has weakened investors’ confidence in countries which would have otherwise been in a safe situation. Moreover, the burden of Greek bail-out itself is affecting negatively the fiscal position of Portugal, Spain, and Italy. This too may have contributed to weaken confidence in their ability to service the debt.

Stock exchanges and speculation

The fourth element that has played a role in the crisis is “roll-over risk”. Countries involved are exposed to a fiscal crisis (the “bad equilibrium”) to the extent that they are forced to rely on the market to roll-over their debt. Thus, much depends on the amount of public debt coming to maturity in the next months. This in turn depends on the maturity structure of the public debt. If public debt mainly has a long-term maturity, then the amount of debt to be rolled-over in a certain time interval is small and the burden of a high interest rate might be sustainable. In these cases, the risk of a fiscal crisis is ruled out. If instead the debt has mainly a short-term maturity so that the amount to be rolled-over is large, then a fiscal crisis can occur, as illustrated in my paper with Francesco Giavazzi (Giavazzi and Pagano 1988). The argument is similar to the one used by banks to assess companies’ solvency. There, the roll-over risk arising from short-term maturity debt is one of the main factors in determining bankruptcy risk.

Why is the euro depreciating?

Fifth, in the last few days we have witnessed the sudden depreciation of the euro. Why is the euro depreciating? A possible answer is that as the crisis spreads to other large Eurozone countries, the risk of monetisation of the public debt becomes more concrete. Even if Greece can be bailed out by other countries in the Eurozone, this would not be feasible for the much larger public debts of Italy, Spain, and Portugal. In the scenario of a widespread crisis, the possibility that the ECB will monetise the debt of weak Eurozone countries exists, and fear of the implied inflation can explain the depreciation of the euro. However, a massive monetisation is an unlikely scenario, as it would eventually undermine price stability in the Eurozone and imply a substantial transfer of resources from strong to weak Eurozone countries.

A breakdown in the euro?

An alternative explanation for the depreciation of the euro is the fear of a breakdown of the single currency itself, a scenario that was unthinkable even a few months ago. In order to avoid having to bail-out weak Eurozone countries through debt monetisation, the strong countries might push the weak ones outside the Eurozone. Obviously, this would be a dramatic scenario, as redrawing the borders of the common currency could hardly happen without generating a financial earthquake. Meanwhile, such a crisis could degenerate into the insolvency on the public debt of several Eurozone countries, with devastating effects on the global economy. Given that the public debt of these countries is massively present in the balance sheets of banks and insurance companies all over the world, and in the Eurozone in particular, instability would spread throughout the financial system. Contagion would become really global. In comparison, the sub-prime crisis would almost pale into insignificance (see a similar discussion in Eichengreen 2007).

This explains why last week stock exchanges collapsed and why governments on both sides of the Atlantic are very concerned. However, governments’ invectives against speculators and markets are childish. The word “speculator” comes from the Latin word “specula” (watchtower) and indicates someone who tries to “look far away” and thus metaphorically “look ahead”, in other words to foresee future events. Whenever a saver decides whether to subscribe public debt bonds he also tries to “look ahead” and, in this sense, we are all speculators. And we all contribute to determine market outcomes, even when we decide to abstain from participating in them. Rather than blaming them, governments have to demonstrate that speculators and markets got their forecasts and bets wrong.

Restoring market confidence

Can the markets’ confidence be restored? As the origin of the problem lies in fiscal policy, confidence needs to be re-established there: strong and coordinated signals must be sent about the ability of the weak states in the Eurozone to put their fiscal situation in order, accepting the imposition of strong monitoring and discipline on fiscal policy by the Union’s institutions. This implies a significant limitation on the fiscal sovereignty of member states, which comes on top of their delegation of monetary sovereignty to the ECB. But much more is needed than the fragile discipline imposed by the Maastricht treaty and by the stability pact, such as binding constraints on budget laws of member states and institutions able to enforce them.

It is not an easy task. Such a monitoring and enforcement system is difficult to put in place and politically painful to accept, as the riots and deaths in Athens demonstrate. Will governments and national parliaments be willing to do it? If the answer is “yes”, then Europe will re-emerge stronger from this crisis and will move toward completing its supranational structure with the gradual introduction of fiscal federal institutions, the natural counterpart of the ECB. This may also offer the opportunity to finally fill the “democratic deficit” of the EU, since it is natural that binding fiscal decisions be taken by representative political bodies. In this way, the necessary limits to national fiscal sovereignty would not be seen as coming from the diktat of some technical and bureaucratic organism or ministers’ committee, as they have a supranational democratic legitimacy. If Eurozone countries have the courage to embrace this great challenge, not only will confidence be restored on security markets, but this crisis will become the occasion for a historical turning point in the development of Europe as political entity.

References
Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review, September.Eichengreen, Barry (2007), “The euro: love it or leave it?”, VoxEU.org, 17 November.Francesco Giavazzi and Marco Pagano (1988), “The Management of Public Debt and Financial Markets,” in L Spaventa and F Giavazzi (eds.), High Public Debt: the Italian Experience, Cambridge University Press.
This article may be reproduced with appropriate attribution. See Copyright (below).
Topics: Europe's nations and regions
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euro
Eurozone crisis
Fiscal crisis
Greece

Marco PaganoProfessor of Economics, University of Naples Federico II and CEPR Research Fellow
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What does this mean for other countries?

What does this mean for other countries?

As well as Greece, banks and credit rating agencies are going through their books looking for other bad risks. That means countries that have a big budget deficit, compared with how much money their economy generates. The crisis in Greece is being felt in financial markets around the world. Portugal and Spain are reckoned to be two that could face problems next. The EU hopes that its bailout will reassure the money markets that their cash is safe. However, that depends on Greece getting control of the situation and proving it can make the cuts needed. The UK does not use the Euro currency, but could still be affected. Its budget deficit is also large, and we could start to appear unattractive to lenders.

UK banks also hold some of the debt of countries such as Greece, Spain, and Portugal. If they were to go bankrupt, it would mean more problems for Britain's banks. In the mean-time, there is some good news for holidaymakers. A fall in the value of the Euro means the pound currently goes a bit further at the bureau de change.

Greece's debt crisis pushes down mortgage rates here

Blame Greece's debt crisis for contributing to the recent drop in your stock portfolio, but give it credit for something that could benefit consumers: lower mortgage rates.Last week, rates on fixed-rate mortgages fell to their lowest level this year, while rates on adjustable-rate loans dipped to a point not seen for years, according to a weekly survey by mortgage giant Freddie Mac.

The average 30-year fixed-rate mortgage slipped to 4.93 percent last week, down from 5 percent the week before and down to the lowest level since early December."Rates are certainly very low. It's a really great time now to shop for a mortgage for a home purchase or to refinance," says Frank Nothaft, Freddie Mac's chief economist.Early this year, rates weren't expected to be headed lower. Then came the financial crisis in Greece. Worries that this Greek tragedy could spread across Europe prompted investors to flee to U.S. Treasuries for safety, and the demand pushed down long-term interest rates that influence the 30-year fixed rate mortgage,

Nothaft says. Inflation, too, is in check, so the Federal Reserve is unlikely to boost short-term rates that affect adjustable rate mortgages anytime soon, he says.As of last week, the 15-year fixed-rate mortgage fell slightly to 4.3 percent, its lowest level since in more than six months, Freddie Mac reports.The one-year adjustable-rate mortgage dipped to an average of 4.02 percent. Not since November 2004 has the rate been lower. And the five-year adjustable-rate mortgage, where rates are fixed for five years and then adjusted annually, averaged 3.95 percent, the lowest since Freddie Mac started tracking the loan in 2005.

"These very low levels may prove to be fleeting. As soon as the nervousness subsides, we could see rates move up a little bit," says Greg McBride, senior financial analyst with Bankrate.com.But McBride doesn't expect that to happen for a while."These global uncertainties will keep the Federal Reserve on the sidelines even longer so mortgage rates are going to stay lower longer than we had been expecting just a couple of weeks ago," he says.He predicts the popular 30-year fixed-rate mortgage will hover around 5 percent through mid-summer. If the economy continues toward recovery, the rate could run 5.5 percent to 6 percent by year-end, he says.Those in line to benefit are the home buyers who rushed to get a house under contract last month so they could claim the federal homebuyer credit and now have until the end of next month to close the deal, McBride says.

Homeowners with adjustable-rate mortgages that will reset in two or three years should consider refinancing now, McBride says."There is no better time than now to trade away the uncertainty of what might happen in exchange for the predictability of these fixed rates that are still near record lows," he says.But many consumers may not be able to take advantage of these rates as lending standards have tightened, making it difficult to qualify.The rules have changed since the subprime mortgage fiasco, during which homebuyers didn't even have to verify income to get a loan. Underwriting standards today are stricter, and lenders require far more documentation.Exacerbating the problem: A lack of house sales in certain neighborhoods can make it difficult to get an accurate appraisal or one that meets the borrower's higher expectations, says Neil Sweren, vice president of Southern Trust Mortgage in Owings Mills.

Sweren says he gets lots of queries about mortgages and refinancing from consumers. About half can't be helped because they can't verify they have enough income — a frequent problem for the self-employed — or they aren't able to get the loan amount they need largely because their house is worth a lot less than they owe on their mortgage, he says.There are loan programs for those with credit scores starting at 620 — the low side of a FICO score, Sweren says. But consumers should be prepared to document all their income and assets, Sweren says.

國行升息帶動 銀行股料受追捧

（吉隆坡16日訊）美股上週五挫跌，馬股市料再受到拖累；國家銀行再升息，銀行股將成為本週市場焦點。

美國零售數據不佳，美股節節敗退，週五道瓊斯指數下挫162.79點或1.51%，報1萬620.16點。標普500指數下跌1.88%至1135.68點，Nasdaq綜合指數跌1.98%達2346.85點。

歐美股市不斷傳出“壞消息”，導致區域股市的投資情緒日益減弱，包括馬股市在內。過去一週，富馬隆綜指走勢尚穩定，僅在週五報跌，全週累積小升6.41點，最后報價1339.30點。
分析員說，若指數無法衝破1347點至1350點，升勢將會受限。

本週焦點多，除了升息振興銀行股外，本週股項看點包括，聯昌集團（CIMB，1023，主要板金融）、星獅控股（F&N，3689，主板消費股）及太平金溢（PACMAS，4782，主要板金融）。
聯昌集團週五晚上宣佈，以17億令吉向國庫控股（Khazanah）收購印尼聯昌商銀（PTBank CIMB-Niaga）17.10%股權，持股權增加至78.26%。

隨著隔夜官方利率（OPR）再次調高后，銀行相繼上調利率，使市場焦點都落在銀行股項上。

星獅控股以7億1100萬令吉脫售玻璃生產業務，料進袋3億2470萬令吉或每股91仙。

太平金溢獲國行批准，與外資夥伴Fairfax Asia接洽脫售保險業務。

MASTERSKILL教育機構籌資約7億1800萬令吉，是今年以來規模最大首發股，也是本月第二隻新股。

國家統計局將在19日（週三）公佈4月份的消費價格指數（CPI）。

首季无新资金流入 跌金融海啸以来低位

2010/05/16 6:06:19 PM ●南洋商报
（香港16日讯）香港金融管理局在向立法会提供的报告中指出，去年全年约6000亿港元资金流入香港，不过，2010年第一季度情况突变，不再有新资金流入。业界认为国际流入资金暂未有外流趋势，内地货币政策收紧将令来港热钱减少。据悉，金管局提交的文件指出，从2008年四季度到2009年四季度，共有6400亿港元资金流入香港，但情况在今年初发生改变。今年第一季没有新资金流入，香港银行的总结余连同未偿还外汇基金票据及债券总额，维持在8000亿港元，与去年第四季度一样。金管局认为，今年第一季度投资环境发生改变，美国经济的复苏比其它主要先进国家快，加上受希腊的债务危机影响，全球转流入美元，美元兑主要货币汇率上升。同时，由于希腊的债务危机及各国央行最终退市措施不明朗，投资者在年初态度趋于审慎，全球主要股市都在1月下跌。其后因联储局表明维持宽松货币政策，投资者才稍微变得积极，2月股市也开始反弹。金管局言论引起外界高度关注，投资者担心资金有流出风险，不过业界和分析人士大都认为，暂时没有流出的风险。另一方面，英国贸赤增幅高于预期，加上内地房产税启动在即，市场避险情绪升温，港元汇价再度受压，跌至金融海啸以来低位。金管局报告指，今年首季没有新资金流入港元。银行界人士指出，亚洲经济势头良好，不担心资金大举流走。

罗森柏格：投资人宜尽早出场 熊市将卷土重来

2010/05/16 6:06:19 PM ●南洋商报
“下牌桌的时候到了。”投资机构 Gluskin Sheff & Associates xiaomi malaysia 经济学家罗森柏格 （David Rosenberg）周四在一份对客户的短笺中如此表示。他认为股市自去年来涨幅已高、波动幅度大，而目前的经济情况也无法带动市场继续上攻。这并非罗森柏格第一次提出警告，过去一年来这位美林前首席经济学家不断强调，美股股价过高，以本益比来看高估的幅度甚至可达35%。

这回，罗森柏格更严正指出，熊市很快就会卷土重来。虽然过去一年，股市并未如他预期般大幅滑落，但可别忘了罗森柏格曾在 2007 年金融海啸爆发前，就成功预言股市将出现崩盘。

罗森柏格说，本月6日道琼工业指数暴跌后随即反弹400多点等剧烈波动现象，更是明显的警讯，暗示投资人该及时出场，因为崩盘在即。他强调，道琼单日暴涨逾400点的现象几乎都发生在股市长线陡降的走势中。历史经验显示，在过去至少16次的这类状况里，12次发生在资产泡沫危机发生之时，另外4次则在10年前网路泡沫化时出现。

Malaysia's EON Capital shares up on reported Primus Pacific buy; MGO unlikely

13.07.2007 04:52
Malaysia's EON Capital shares up on reported Primus Pacific buy; MGO unlikely

KUALA LUMPUR (Thomson Financial) - Shares of Malaysian banking group EON Capital Bhd were higher in midmorning trade after Hong Kong-based fund Primus Pacific Partners was reportedly given approval to start negotiations for the acquisition of a stake in EON Capital from its shareholders.

At 10.20 am, EON Capital was up 10 sen or 1.3 percent at 8.05 ringgit. Citing unidentified sources, the Star newspaper reported Thursday Primus Pacific Partners has outbid Newbridge Capital Bhd and Temasek-controlled Malaysian Plantations Bhd for the 51 percent block put up for sale by DRB-Hicom, Rin Kei Mei and other shareholders.

The Primus Pacific Partners offer is believed to be between 9.25-9.50 ringgit per share, the Star report said.

ABN Amro has been appointed to place out the block and facilitate the sale of EON Capital shares, it said.

DRB-Hicom, which controls 20.2 percent of EON Capital, earlier said trading in its shares has been suspended pending the announcement on a major corporate exercise involving the proposed acquisition of a substantial asset.

OSK Investment Bank research analyst Chan Ken Yew said given that Malaysian law does not allow an institutional investor to hold more than 20 percent in a bank, the reported Primus Pacific Partners offer, if materialises, is unlikely to trigger a mandatory general offer (MGO) for EON Capital.

Based on historical trend, EON Capital's share price is likely to trade at a discount of about 10 percent to the offer price, until the offer becomes unconditional, said Chan. Chan is keeping his 'trading buy' call on EON Capital although the current share price has surpassed his target price of 7.50-7.70 ringgit.

'We maintain our trading buy call until we get a clearer picture on the identity of the potential acquirer, hence the probability of launching a MGO,' he said. The rating may be downgraded in the absence of a MGO, he said.

(1 US dollar = 3.44 ringgit)

Source : AFX News.

Fast-track to Fiscal Union?

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

Basel II Accord To Guard Against Financial Shocks

Basel Accords Determine Bank Equity Capital
The Basel Accords determine how much equity capital - known as regulatory capital - a bank must hold to buffer unexpected losses. Equity is assets minus liabilities. For a traditional bank, assets are loans and liabilities are customer deposits. But even a traditional bank is highly leveraged (i.e., the debt-to-equity or debt-to-capital ratio is much higher than for a corporation). If the assets decline in value, the equity can quickly evaporate. So, in simple terms, the Basel Accord requires banks to have an equity cushion in the event that assets decline, providing depositors with protection. The regulatory justification for this is about the system: If big banks fail, it spells systematic trouble. If not for this, we would let banks set their own levels of equity -known as economic capital - and let the market do the disciplining. So, Basel attempts to protect the system in much the same way that the Federal Deposit Insurance Corporation (FDIC) protects individual investors. (For more insight, read Are Your Bank Deposits Insured?)

Bank Loans - Then and NowThe traditional "loan and hold" bank may now only exist in a museum. Modern banks "originate and distribute" and they have astonishingly complex balance sheets. For example, many banks have been tilting away from long-term illiquid assets and toward tradable assets. In addition, many banks routinely securitize. That is, they sell loan assets off of their balance sheets, or achieve a similar risk transfer by purchasing credit protection from a third party, often a hedge fund indirectly. This is a called a synthetic securitization. (To learn more, read Behind The Scenes Of Your Mortgage and What is securitization?)

The Original Accord Is Broken
The Basel I Accord, issued in 1988, has succeeded in raising the total level of equity capital in the system. Like many regulations, it also pushed unintended consequences; because it does not differentiate risks very well, it perversely encouraged risk seeking. It also promoted the loan securitization that led to the unwinding in the subprime market. (For more on the subprime crisis, check out our Subprime Mortgage Feature page.)In short, Basel I has several shortcomings. And, although some people are mistakenly implicating all of Basel in some of the problems it has created, it is too early to tell whether Basel II will fail in regard to credit derivatives and securitizations. Basel II does try to address new innovations in risk but the cost is complexity.

Basel II Is Complicated
The new accord is called Basel II. Its goal is to better align the required regulatory capital with actual bank risk. This makes it vastly more complex than the original accord. Basel II has multiple approaches for different types of risk. It has multiple approaches for securitization and for credit risk mitigants (such as collateral). It also contains formulas that require a financial engineer.

Some countries have implemented basic versions of the new accord, but in the United States, Basel II is seeing a painful, controversial and prolonged deployment (even as large banks have been working for years to meet its terms). Many of the problems are inevitable: The agreement tries to coordinate bank capital requirements across countries and across bank sizes. International coherence is hard enough, but so is scaling the requirements - in other words, it is very hard to design a plan that does not give advantage to a banking giant over a smaller regional bank.

Basel II has three pillars: minimum capital, supervisor review and market discipline.



Minimum capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk.

Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system.

Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency.

Basel II Charges for Three Risks
The accord recognizes three big risk buckets: credit risk, market risk and operational risk. In other words, a bank must hold capital against all three types of risks. A charge for market risk was introduced in 1998. The charge for operational risk is new and controversial because it is hard to define, not to mention quantify, operational risk (The basic approach uses a bank's gross income as a proxy for operational risk. It is not hard to challenge this idea.)

The Basel II Transition
Not only is the implementation staggered globally, but the accord itself contains tiered approaches. For example, credit risk has three approaches: standardized, foundation internal ratings-based (IRB), and advanced IRB. Roughly, a more advanced approach relies more on a bank's internal assumptions. A more advanced approach will also generally require less capital, but most banks will need to transition to more advanced approaches over time.

Summary
The Basel II Accord attempts to fix the glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity. The technical rules will be importantly supported by supervisor review (Pillar 2) and market discipline (Pillar 3). The goal remains: Maintain enough capital in the banking system to guard against the damage of financial shocks.