Thursday, June 24, 2010

Sometimes my predictions are proven correct

Avid readers may recall that in early February, I said how I thought a bailout of the PIGS should work:

The EU (not the eurozone) establishes an entity called something like the Federal Solidarity Fund. The FSF would be capitalized by the member states with government bonds and callable capital using a formula based on GDP (like other international financial institutions). 

The capitalization would be sufficient to get the FSF a bond rating of AAA from the three agencies, which have established standards for rating such institutions.

The FSF would then issue debt to fund its loan book. Such bonds would be eligible for purchase or rediscount at the ECB. Borrowers would have to submit to IMF-style conditionality, including an amortization schedule. Conditionality should be sufficiently onerous that accessing such funding would be a last resort. 

There is no reason why the ECB should not be a big purchaser of  FSF bonds. The ECB has an EUR1.7 trillion balance sheet, with plenty of marketable assets that could be sold to offset FSF funding. 

The critical constraint is sufficient capital to maintain the AAA rating while having sufficient funding to meet the needs of needy states. 

Well, that's just about what was announced by the European Commission on May 9th:

We have decided to establish a European stabilization mechanism. The mechanism is based on Article 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.

Article 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 euro 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 euros. 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 programs.

Unfortunately, the the fund has not been set up yet, Greek bond yields are rising again, and the markets are not calmed. It is hard to be optimistic.

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