Two distinct but complementary issues.
The financial crisis, leading to a “Sovereign Debt” crisis affecting members of the European Monetary Union, has given birth to a plethora of proposals emanating from political, economic and financial circles. While they are all well meaning, most suffer from a lack of detail rendering their evaluation difficult, or, alternatively, demonstrate a lack of understanding of market mechanisms which make them largely inapplicable.
The purpose of the analysis hereunder is to bring some clarity to the debate. It suggests some exploratory avenues which attempt to reconcile considerations of a “political” nature which should not be overlooked with the objective constraints imposed by the workings of financial markets.
Let us analyse first the question of establishing a permanent mechanism aimed at providing assistance to EMU members facing financial difficulties.
The need for such a mechanism surfaced when it became clear, in the light of the Irish crisis, that the measures decided in the spring of 2010 – in particular the creation of the European Financial Stability Fund (“EFSF”) – were proving insufficient to alleviate the fears of investors. Followed the initiation of a vicious circle in which questions relating to the solvency of some peripheral EMU members and/or their respective banking sectors raised the spectre of the implosion of EMU which, for the first time, became a realistic concern. This development raised, in turn, the question of the survival of the single currency and implicitly that of the ultimate survival of the EU itself.
However, there can be no doubt that the economic and financial foundations of the Euro as a “currency”, as well as those concerning EMU area as a whole, are strong particularly when compared to those of the United States, the United Kingdom or Japan, three major economies which remain in full control of their “monetary” sovereignty. Even if in terms of budgetary deficits or public indebtedness the EMU “aggregates” should not worry excessively financial markets, too little attention has been given to the fact that by pooling their monetary sovereignty, EMU countries have created a situation in which the economic as well as legal position of their respective “national debt” in relation to their “national sovereignty” has been profoundly altered. Markets have been prompt to distinguish between countries who retain control over their respective monetary policies and their own national currencies and EMU members which, having abandoned their monetary sovereignty, have also lost the political and financial control over the “foreign” currency (the Euro) that they have decided to use in common.
A first question concerns the need for such a mechanism. It is clearly the fundamental role played by the local “currency” in any market economy that commands that this essential “transmission mechanism” be soundly and prudently managed in the interests of each and every of its users; as far as the Euro is concerned, it is a matter of the “pari passu” interests of the 330 million citizens of EMU’s 17 member States.
While the ECB has successfully preserved the “value” of the Euro in terms of “purchasing power” by controlling “price stability” within the Eurozone in conformity with its mandate, it is, however, totally outside of its remit and ability to influence a series of other parameters (such as levels of indebtedness, budget deficits or competitivity) whose disequilibria, either internal or cross border, can weigh heavily on the solvency individual EMU member States.
It follows that, in the absence of a credible mechanism, capable of restoring confidence in the public debt securities of EMU participants (so as to make them comparable to the trust benefitting other public issuers), financial markets will be prone to penalise the weaker issuers compromising their ability to access markets and thus their solvency.
Default by an EMU Government does not necessarily lead to the implosion of EMU and the disappearance of the Euro but such a development can only be avoided to the extent that the prevention of “contagion” remains firmly under control. However, sharing the same currency and belonging to the EU “single market” has created an extremely dense interdependent network linking EMU members to their respective banking sectors (that are closely tied through their reciprocal financing needs) as well as within the entire EMU banking sector itself, as was demonstrated in the Irish crisis. A “sovereign” default increases dramatically the “systemic” risk of contagion which should render the mere consideration of such a scenario totally unacceptable for all EMU members. Furthermore a “programmed” exit from EMU - be it by its strongest or weaker members - would create systemic risks of a similar nature which forbid its implementation.
Proof of the absolute need for setting up a permanent intervention mechanism is therefore unquestionable. Let us now turn to examine the characteristics that need to be embedded in such a system.
There are three separate aspects that must be distinguished concerning the credibility of the mechanism:
- The financial credibility of the “Borrower”, responsible for the primary funding, which ensures the interface with investors (the market). Its solvency must be beyond question which implies that it is totally independent from the final Beneficiary which – by definition – is in a precarious situation. In addition, its securities must necessarily benefit from the highest rating, so that, in the eyes of the market, the Borrower’s securities will integrate the highest standards of acceptability, benefit from a liquid secondary market and be acceptable as collateral by the ECB.
- The credibility of the structure framing the on-lending by the Borrower to the final Beneficiary. This concerns the “conditionality” appended to the loans and the accompanying surveillance mechanism as well as the specific financial conditions pertaining to each drawdown. Its main purpose is to reassure the (direct/indirect) guarantors of the loans who would be called upon in the event of default of the Beneficiary.
- The credibility of the arrangements by which the Borrower can fund itself in the event of default of the financial Beneficiary. This entails a “political” negotiation which establishes in which form the solidarity between EMU members is organised in the event one of them defaults.
Let us outline how it is possible to conceive of a system which would articulate in a coherent manner the requirements described here above.
1. As far as the financial credibility of the Borrower is concerned, the most elegant and ideal solution is to transform the existent EFSF into a fully fledged EU debt “Agency” benefitting of its unconditional “Budgetary Guarantee”.
Such a structure would meet all the requirements outlined here above from the standpoint of market acceptability of the Borrower’s securities as it provides - “by construction” - the joint and several guarantee of all EU member States. This solution offers the advantages of simplicity and transparency and, in addition, avoids any need for a Treaty change. It implies however amending the “financial perspectives” which will have to provide for an adequate and revisable debt ceiling.
The proposal does, however, create an important “political” problem insofar as it transgresses two taboos that have been partially responsible for the unsatisfactory structures currently in place. The first of these taboos concerns the transformation of the several guarantees provided to the ESFS by EMU members into joint and several guarantees, move that has been always strongly resisted by Germany. The second would be to enlist the guarantee of all EU Members for a mechanism which, at least initially, is meant for the benefit of EMU members only and which should, on that count alone, provoke considerable opposition, in particular from the United Kingdom.
Without underestimating these difficulties, it should be possible to significantly reduce their impact through the appropriate structuring of the two complementary aspects, referred to above, which ensure the credibility of the mechanism as a whole.
2. As far as the credibility of the structure of the “on-lending” by the Borrower to the Beneficiary, the “conditionality”, based on the usual criteria imposed by both the EU and the IMF, should be complemented, on each drawdown, by the issuance by the Beneficiary for the benefit of the Borrower of “serial covered bonds” corresponding to the debt service of the loan.
The basic idea is that the additional security provided by the “covered bond” structure, derived from the pledging of specific resources of the Borrower to ensure the punctual servicing of the debt, would constitute an important assurance for the guarantors and reduce commensurately their risk of being called under the guarantee. In exchange, the financial conditions of each drawdown would be identical to those obtained in the market by the Borrower (with the possibility of adding a de minimus 0.05% servicing fee) reducing considerably the financing costs of the Beneficiary compared with the current conditions of EFSF funded loans.
3. As far as the mechanism through which the Borrower funds itself in the event of a default by the Beneficiary, it is suggested that the ECB be authorised to “purchase” at face value the covered bonds held by the Borrower on the eve of their respective maturities. This would allow the Borrower to meet, whatever the circumstances, its obligations towards its own bondholders.
Within such a mechanism, the guarantee of EMU members would be for the exclusive benefit of the ECB, separately from their implicit joint guarantee given to the EU budget. It would be perfectly possible to maintain at this level a structure of “several” guarantees limiting, for each EMU member, his commitment to his quota (without the need for a 20% enhancement) as this would in no way affect the perception by investors (or rating agencies) of the soundness of the securities issued by the Borrower.
If this structure was implemented, it could be complemented by an agreement covering the interventions of the ECB in public debt markets of its shareholders which has been recently at the centre of intense discussions: for instance, the ECB could refrain from any intervention in the market of its member’s debt securities in the event that the member had recourse to the Stabilisation mechanism. Indeed, because the ECB would be contractually committed to acquire the “covered bonds” pledged to the Borrower, it would be prudent to limit the Central Bank’s balance sheet exposure to these issuers.
A further requirement (to be compulsorily included in the loan conditionality) would be that, in exchange for the ECB’s contractual obligation to acquire the covered bonds, the National Central Bank of the Beneficiary (a member of the European System of Central Banks) would be charged with the supervision of the security attached to the issuance of the covered bonds, providing additional assurance to the ECB of the punctual servicing of the related debt.
The scheme described here above meets largely the criteria deemed necessary to ensure the long term credibility of the mechanism in the eyes of the market; it would also contribute to the creation of a more stable environment for EMU and the Euro.
Viewed in this light, it is possible to envisage broadening the scope of the mechanism in order to provide answers to two additional important objectives: the first aims at providing a suitable justification for the participation in the scheme of non EMU members; the second aims at creating a broad market for EU securities (Euro Bonds), providing all EU Members with access to a competitive financial instrument comparable to the US Treasury Securities market.
1. Justification for the participation of non EMU members.
In exchange for their joint budget guarantee, stemming directly from the Treaty itself, one could envisage that all EU Member States would be given access to funding of their respective national debt through the European Agency for Debt Issuance on an equal footing with EMU members. If a country availed itself of this privilege, it would assume its corresponding share of the guarantee mechanism benefitting the ECB; its National Central Bank would be responsible for the supervision of the collateral securing the “covered bonds” pledged to the Borrower within the framework of the loan conditionality.
2. Establishment of a broad market for EU public debt securities.
Several of the recent proposals addressing the question of establishing a permanent European Crisis Management Mechanism call for the simultaneous creation of a deep and liquid market for securities representative of the EU’s largely underused borrowing capacity.
These securities, referred to in general and somewhat ambiguous terms as “Euro Bonds or Eurobonds” have been the subject of various schemes, some of which went into considerable detail. However, because of extensive doubts concerning their practical feasibility, they have not been able to galvanise sufficient “political” support in order to justify a detailed preliminary assessment, a necessary precondition to implementation, as was the case with the Single Currency.
Starting from the outline described here above within the framework of assisting EMU countries facing difficulties, one could conceive of extending the mandate of the Agency (the Borrower) to allow for the funding of Member States within the “ordinary” task of managing their national public debt. While the “stabilisation” mandate of the Agency would be exercised as outlined in section B, it mandate as an “ordinary” Borrower would be subject to significantly greater flexibility as described hereunder.
Let us revisit the three aspects that ensure the credibility of the mechanism in the light of this new objective.
This is necessary in order to ensure that its securities are fungible, provide investors with adequate liquidity and benefit from the broadest market acceptance.
It could relate to a series of objective “indicators” concerning the budget deficit, the level of indebtedness, other economic imbalances (competitivity) whose appropriate articulation would provide “mechanically” an “EU Rating” graduated from 1 to 3. This rating would apply to the Beneficiary’s entire extant debt and would be updated on a regular basis, at least annually, during the European Semester exercise.
A “1” Rating would require meeting more stringent conditions than the pure and simple compliance with the SGP and would allow the Beneficiary to dispense with any specific loan conditionality. It would nevertheless be subject to the obligation of pledging debt securities whose value at maturity corresponds to its debt servicing obligations. This pledge would become subject to “enhancement” in the form of providing “cover” in case of a downgrade of the rating. In such a case, the Beneficiary would have the option to prepay his loan (subject only to a penalty covering possible reinvestment losses by the Borrower).
A “2” Rating would be assigned to a Beneficiary meeting all the conditions of the revised SGP. The only conditionality attached to the loan would be the pledge of serial covered bonds to the Borrower in order to guarantee the punctual servicing of the debt.
A “3” Rating would apply to the outstanding debt of a Beneficiary that would be the subject of recommendations, procedures or sanctions envisaged within the framework of the European Semester. The entire procedure described here above for execution of the Agency’s “stabilisation” mandate would apply, including conditionality required by the EU and IMF.
Such a Rating system, if applied objectively (the applied methodology should be made public) and without any political interference, could serve as a way to reduce significantly the market impact of rating changes by private Agencies.
Recourse to the Agency’s “ordinary” funding program by a Member State would remain purely voluntary. It should be expected that countries who retain direct access to markets at more favourable conditions would abstain, as is the case currently for Germany France and several other issuers when compared with conditions obtained by the European Financial Stabilisation Mechanism or those anticipated by the EFSF. One can however expect, with the progressive development of a deep and broad market for “Euro Bonds”, that issuing conditions obtainable through the Agency will prove advantageous for an ever growing number of Member States.
This covers in particular the “several” guarantee benefiting the ECB issued by EMU members securing the Beneficiary’s debt service obligations, which would automatically be extended to any EU Member State participating in the scheme.
If implemented, the necessary conditions leading to the creation of a deep and liquid market for EU debt securities would have been assembled, capable of mobilising, within a secure and transparent framework, the Union’s still largely underutilised borrowing capacity.
The mechanism encompasses a fair “political compromise” which should prove acceptable to all Member States. They will, indeed, both collectively and individually, benefit from the Union’s more stable financial footing. The Euro’s credibility will also be considerably enhanced by dissociating the questions relating to the solvency of individual Member States from those concerning the survival of the single currency.
It will also enhance significantly the EU’s bargaining power at international level and strengthen its independence vis à vis other major actors (China in particular) who, in the current environment, could exert undue influence if their creditor status was brought to bear to the detriment of individual Member States.
Armed with such a mechanism, the Union could also aspire to exercise greater influence within the G20 and weigh more effectively on the reform of the international monetary system and the governance of globalised financial markets.
Brussels, 7th January 2011
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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