Luis Rodríguez Zapatero, Spain’s prime minister, recently declared the European sovereign debt crisis was over. He told the WSJ, "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed." But Zapatero may be being hopelessly optimistic.
A common fear is that the vehicle created by the EU to draw a line under the so-called 'PIIGS' sovereign debt crisis and provide a “backstop” to EU members facing fiscal difficulties – the €440m European Financial Stability Facility – is fundamentally flawed.
The EFSF is essentially a giant collateralized debt obligation (CDO), and is based in a tax haven – exactly the sort of structure that was to blame for the global financial crisis. Predictably enough, the facility was given a triple-A rating by all three ratings agencies on September 20.
However, at best, the EFSF is unlikely to be able to do "what it says on the tin" and at worst, it is fundamentally flawed. In particular, commentators question its opacity, why it is structured as CDO (FT Alphaville argues this will mean it has to overcollateralize in order to sustain its triple-A rating) and why its corporate governance is so feeble. The Economist wrote:
"For such a large fund using public money, there remains a remarkable lack of transparency about how it plans to go about its business. Economists are still unsure whether it will be used to lend directly to struggling governments, buy their bonds, set up a European “bad bank” to take over bad loans or even to invest directly in banks that fall short of capital."
The Financial Times commentator Wolfgang Munchau warned the EFSF is far weaker and less attractive to troubled countries than its proponents claim. In a well-argued piece, Munchau said the facility will “need government guarantees of €1.2bn for each €1bn in bonds it wants to issue.” Should the EFSF raise €1bn of bonds, it will only be able to lend on €700m, wrote Munchau, equivalent to "the portion backed by the collateral of those countries that themselves have a triple-A rating."
Given its arcane fund-raising methodology, the facility can be expected to lend at interest rates of 7.5%-8%, said Munchau. “No matter how you twist this, it is hard to construct a cheap loan out of this.”
The economist Robert McDowell said that fiscally-challenged countries would be loath to approach the new facility, partly for fear of being stigmatized and having their credit ratings further slashed, and partly because of the strings attached. Writing on Asymptotix, McDowell said:
“Governments can borrow if they agree to adopt reform programs designed by the IMF, European Commission and ECB. This extends the role of both the commission and ECB in ways that I expect borrowers would fiercely wish to resist, hence any borrowing will be a clear signal of desperation..."
Even before Ireland's fiscal crisis worsened this week, there was widespread speculation that Ireland's austerity programme isn't doing enough to reassure the global financial markets, and that it would have to go cap in hand to the EFSF (and IMF) for emergency funding.
Official sources including Ireland's finance minister Brian Lenihan and Luxembourg prime minister Jean-Claude Juncker have downplayed such talk.
But economists including Goldman Sachs’s Eric Nielsen believe there is a measurable risk that Ireland (and Portugal) will need to access the EFSF and the IMF "but probably only early next year. They are still well funded for some months". He said it was less likely that Spain would have to approach the EFSF.
The econoblogger Edward Hugh questions the whole premise of the EFSF, given that allowing over-indebted nations to borrow even more may not be the best solution to their problems.
"What the countries involved all need is more exports and larger industrial sectors... Simply running a double digit deficit to generate less than 1% (in the best of cases) GDP growth is not exactly a "wise" use of resources."
Overall Hugh said Zapatero is wrong, and that the European debt crisis is far from over. “For heaven's sake, the only thing we don’t need to be told at this point is that the danger has already past, even as we slide, inch by inch, onwards and downwards.” Hugh said the most popular current analogy for Europe’s fiscal plight comes from the world of mountaineering:
“Euro area countries could be likened to a group of 16 Alpine climbers ... who find themselves tightly roped together in appalling weather conditions. One of the climbers – Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding the Greeks dangling … even if they cannot quite manage to pull their colleague back up again. But as the day advances others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge ... But just behind comes Portugal, while further back lies Spain … But if all three finally go over, dragged down by the weight of those who precede them, then this will leave 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario."
In such a desperate scenario Hugh said the EFSF chief executive Klaus Regling and whoever succeeds Jean Claude Trichet at the ECB are going to have their work cut out.
Further reading on European debt and the sovereign debt crisis:
- Greek bailout rewrites rulebook for EU sovereign debt by Ian Fraser [blog]
- Sovereign debt: Anxiety levels on the rise by Anthony Harrington [blog]
- Measuring Country Risk by Aswath Damodaran
Tags: central banks , EFSF , EU , European Central Bank , Greece , PIIGS , sovereign debt