Drawing a line under the European sovereign debt crisis

What’s at stake

The European Crisis has taken another turn lately with a growing realisation of the inadequacy of the current support mechanism and the need to reform it. The eurogroup meeting on Monday has taken stock but decided nothing publicly and much remains to be done as opinions seem to diverge greatly. Yet there is some degree of consensus on the idea that something needs to be changed which probably will not happen before the European Council on February 4th at best.

The third way: bonds buyback

Eurointelligence reports that European governments are considering ways to reduce the debt burdens of struggling euro-zone countries through bond buybacks, as part of broader measures aimed at ending the crisis of confidence in Europe's common currency. The buyback ideas being discussed would allow Greece or other indebted countries to borrow money from Europe's bailout fund, and use it to buy up their own bonds at depressed prices from investors. The financial key aspect of this structure is the gap in the interest rates through which the EFSF can raise funds, due to its AAA rating, and the Greek sovereign yields, which are currently over 10%. Officials denied the story but Kurt Lauk, president of Merkel’s CDU Economic Council, said that European leaders should drop their “taboo’ against debt restructuring.
John McHale writes in the Irish Economy blog that a buyback provides an interesting “third way” between the problematic bail-out strategy (new lending in the hope that some combination of growth/limited bank losses/primary budget surpluses will restore solvency) and the problematic bail-in strategy (restoring solvency through default). For illustration, a buyback of debt equal to 30 percent of GDP at a one-third discount would reduce the net debt to GDP ratio by 10 percentage points, possibly enough to restore enough fiscal space to ease creditworthiness fears. There are of course potential legal issues to the extent bonds have covenants against such buybacks. But where buybacks are seen to benefit all parties, these restrictions do not appear to have been deal stoppers in the past.
Harvinder Sian argues that it will help at the margins but is not enough to bring back confidence in Greek debt sustainability. From 2012 onwards the outstanding debt in Greek government bonds is a notional EUR 234 bn. The average weighted price of this debt is currently at 71.1 cents. Not all of this debt can be bought back voluntarily as a large chunk is held by banks in held-to-maturity books at par, in addition to perhaps EUR 35-40 bn in ECB purchases. Suppose that the free float that may be purchased amounts to some EUR 50 bn. In that case, buying the debt back at an average of say 75% of face value amounts to a debt cost saving of EUR 12.5 bn. Greek debt peaks in 2013 at 158% of GDP and a saving of this amount will bring the peak down to 153%.
Alphaville notes that restructuring buybacks are common enough in Latin American and African states — and this old paper from the Inter-American Development Bank makes a point of interest to EFSF-watchers that you need to convince the market that you’ll be less able to pay off debt in the future, so holders may as well sell now. Giving the EFSF preferred creditor status would do the trick.

Fixing the EFSF: increase its size

 
Because defaults continue to be the most unattractive thought to European policymakers, the idea of a reformed EFSF seems to be making progress. Olli Rehn in an FT Op-Ed followed by Barroso’s remarks contributed to build expectations of substantial changes to the EFSF, what Jean Claude Trichet described as “qualitative and quantitative improvements” to the EFSF. These changes can essentially me summarised by (i) an increase in the size, (ii) a lowering of the cost for borrowers at the EFSF and (iii) a change of its modus operandi such that it could buy bonds in the second market which is something Minister Lagarde seems to regard as a good idea.
Alphaville argues that the European Financial Stability Facility largely resembles a giant CDO. It’s overcollateralised by 20 per cent to achieve a triple-A rating, which means the funds it’s actually able to lend out are much reduced. Indeed the €440bn headline figure disguises actual possible lending of just €250bn.
Willem Buiter argues – in what has become an authoritative report on the European crisis – that the liquidity facilities will have to be increased greatly in size from their current level of barely over €700bn of loanable funds to at least €2 trillion. At least half of this should be pre-funded to be available at the speed of crises. To prevent the liquidity facilities from becoming transfer or subsidy facilities, their enhancement would have to be accompanied by the restructuring of unsecured bank debt (subordinate and senior) of insolvent banks and of the sovereign debt of those sovereigns for whom default makes more sense than fiscal pain and continued debt and crisis overhang.

Fixing the EFSF: move from AAA to AA rating

Re-Define argues that the discussion on expanding the size of the EFSF should focus not on increasing MS commitments which is politically poisonous in Germany but on moving from a AAA to AA rating or providing bond guarantees instead of giving loans. Taken together they can treble the effective size of the EFSF from Euro 250 billion to Euro 750 billion instantly. A shift from making loans to providing (partial) guarantees can instantly double the size of the EFSF to Euro 500 billion without any additional commitment from Member States. A decision to drop the obsession with an AAA rating and settle for AA will increase the effective size of the EFSF from Euro 250 billion to Euro 400 billion.
Alphaville notes that although Europe might not be comfortable with a less-than-triple-A-rated EFSF bond, the bonds are already classified as Category II, rather than Category I, in the European Central Bank’s collateral framework. Which means they’re looked at more like supranational debt than central government debt, and get a higher haircut when used at the ECB’s refinancing operations.

Fixing the EFSF: reduce the interest rate being charged

Barry Eichengreen argues that the EU can re-think the terms of its rescue packages.  To give Greece and Ireland fighting chance, it can reduce the 6 per cent interest rate they are being charged on their IMF-EU loans.
Alphaville notes that the EU lends balance of payments assistance loans to Latvia and Romania at much lower rates (3.2 per cent, for Latvia); The EFSF’s own average cost of funding is much lower than the 5.8% it charges Ireland (Citigroup’s Peter Groves reckons the first EFSF bond issue will yield around 3 per cent, based on EFSM issuance;); Lower rates wouldn’t (in theory) violate national laws directing sovereign guarantee commitments to the EFSF.

Fixing the EFSF: turn it into a European debt agency

Wolfgang Münchau argues that a way to construct the EFSF so that it could be part of a genuine solution to the crisis would be to turn it and its successor into the kernel of a European debt agency, and turn the bonds it issues into eurozone sovereign bonds. As a first step there would need to be a much higher lending ceiling – not €750bn, nominal or real, but more like €2,000bn since market purchases by the EFSF are unlikely to be much more effective than that of the ECB unless operated at a very different scale. Second, as Mr Buiter points out, the guarantees would have to be “joint and several” – in other words a joint liability of all eurozone states – as opposed to a collection of guarantees by national governments. Pooling the bond issues of the European periphery, and allowing the EFSF to guarantee them, would be a big leap indeed. One could go further and endow the EFSF with the ability and funds to recapitalise the financial sector. A few hard-to-understand technical changes and voilà: we have in fact created a European bond and a fiscal union via the backdoor.
John McHale argues that the existence of such an official buyer of last resort should give market investors reasonable confidence that governments would be able to roll over their borrowing as bonds mature over a significant time period. The proposal has the potential to provide support to a country facing difficult market conditions without crowding out longer-term private investors from the market.
Perry Mehrling from the Institute for New Economic Thinking has a blog post about why an enhanced EFSF could take away the burden of stabilising financial markets and quasi fiscal action from the ECB. He concludes that any such enhancement of the EFSF would be a clear step towards a European Treasury. Emma Saunders writes that the ECB would welcome a change to the EFSF mandate, which would allow the central bank to focus once again on inflation.

Fixing the EFSF: allow the funds to take equity stakes in systemically important European banks

Michael Noonan proposes a bank resolution framework that would (i) have the EFSF put capital directly into systemically important European banks; (ii) have the EU provide insurance against bank losses beyond some specified level (an idea already suggested by Patrick Honohan); (iii) the fast-tracking of an EU-wide of a bank resolution regime (that presumably would not be limited to future bank creditors); and (iv) an ECB-funded special purpose vehicle for bank assets to avoid the alternative of firesales with losses rebounding on the State.

Fixing the EFSF: the strings attached

Real Time Brussels points that if European leaders are going to agree to reinforce the euro zone’s rescue fund, its paymasters seem determined to exact a price. Germany, the Netherlands and Finland want deeper structural economic reforms across the euro area if they are to finance a larger European Financial Stability Facility.

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