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Tuesday, June 19, 2012

Europe's latest panacea


Press reports out of the G-20 summit in Mexico say that Italy and France have suggested that the EFSF/ESM buy the bonds of PIIGS who are engaged in fiscal consolidation, but who have been priced out of the market. This would, it is thought, allow the funds to buy these country’s bonds at subsidized interest rates, and thus reward them for their virtuous behavior. It is felt that this would allow countries such as Spain and Italy to receive assistance without having to submit to IMF/EU conditionality.

Angela Merkel, under pressure from everyone, did not dismiss the suggestion out of hand. (However, her proposal is for an EU fiscal union, which has not been embraced by Hollande.)

I must be missing something, because the treaty establishing the ESM states that: The granting of any required financial assistance under the mechanism will be made subject to strict conditionality. Everybody in the room may have agreed to ignore this provision, but the Federal Constitutional Court in Karlsruhe is a stickler on things like laws and treaties.

But let us assume that the plan can be implemented and that the ESM will be established on schedule next month. The ESM will be have EUR 80 billion in paid-in capital which can be leveraged up to EUR 500 billion using contingent guarantees (EUR 700 billion including the EFSF). The ESM is expected to be rated AAA by the three agencies, but I don’t consider that a given. The rating hangs on the AAA ratings of Germany, France and the Netherlands. France has already lost one of its AAAs, and is at risk of losing the other two.

And Germany, how sturdy are its AAAs? Clearly, the larger the ESFSF/ESM exposure to the PIIGS, the greater is Germany’s contingent indebtedness. Assuming that France ends up at AA, can the ESM really work, and will it be credible in the market? I don’t know, but the EFSF’s bond yields have been volatile, and consistently in excess of AAA benchmarks.

So I see the following challenges to the Monti/Hollande plan:
1. The treaty language about conditionality.
2. The Constitutional Court’s interpretation of the treaty.
3. The Bundestag’s willingness to consent to the plan. (The Bundestag has not yet ratified the treaty.)
4. The ESM’s rating outlook, given the iffy outlook for France.
5. The longer-term implications of the ESM for Germany’s AAA rating.

If these hurdles can be jumped, the plan will provide breathing room for Spain and Italy, and would signal Germany’s willingness to take bold steps to save the eurozone. However, the fiscal outlook for the PIIGS remains frightening, especially now that we know that their banking systems are much worse than advertised. The stress tests performed last year, we now know, were an exercise in legerdemain. The Spanish and Italian banks will require many billions to remain solvent, and the ECB won’t lend to them unless they are solvent. That too could change, but you wouldn’t know it from what Draghi and Weidmann are saying.

If Merkel signals that she is willing to pursue this plan, there will be a big relief rally. However, the best that this plan can do is to keep Spain and Italy alive for another year. It isn’t big enough to refinance all of their maturing debt. And Greece is still out there, in extremis.

2 comments:

JAMES ROSS said...

CHRIS,
IS THIS COMMENTARY YOUR SIGNAL THAT THE EURO CRISIS IS POTENTIALLY POSTPONED?

Chris Mahoney said...

James,
No, it isn't. I don't expect the Monti/Hollande plan to come to fruition. However, if it does, it would buy time for Italy and Spain. It's all up to Merkel.