20 December 2010

December 2010 Financial Services Month in Brussels

Graham Bishop's Personal Overview

After the Summit: still waiting for the real decisions

 “The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality.” This Treaty revision was formulated as a deft constitutional measure to sidestep the need for an Inter-Governmental Conference and a referendum in Ireland. Regrettably, it was not crafted by statesmen with a clear vision of how to solve the euro’s crisis. So the Heads of Government may be forced to return to the problem early in 2011.

Their finance ministers agreed in November on the formulation of the European Stability Mechanism (ESM) – based on the European Financial stability Fund (EFSF) – to complement the enhanced economic surveillance that has been agreed in May. The ESM will take effect in 2013 and its creditor status will rank below IMF loans but ahead of the private sector. So private lenders should have no doubt about their vulnerability after 2013. Indeed, all the “problem” countries – measured by elevated credit spreads – plan to have a primary surplus by then so the financial markets will only be needed to fund interest payments due be paid back to the markets themselves. These states plan to issue nearly €350 billion of bonds in 2011, with about half that intended to refinance maturities. It is those re-financings that may force Heads of Government to meet again in agonised conclaves.

Consider the choices facing a pension fund manager whose fund receives the redemption money into a bank account at a global SIFI that is clearly too-big-to-fail. Should he leave it there with near-absolute certainty that the money will still be available for the pension payment schedule that is known with complete certainty for 10 years time?  Or should he re-invest it in the 10 year bonds of State X where there is a real question of a partial default (known as a “haircut”) at the end of the term. The fund manager will probably still be in his job at that time and be fully accountable to the pensioners. He can tell them that he had the word of a group of finance ministers in 2010 that the bonds issued in 2011 would be safe. But the impoverished pensioners might retort that such ministers had collectively signed pieces of paper for many years and made speeches about prudent fiscal policy, yet utterly failed to prevent the crisis. Moreover, probably none of them expected to be still in office at the bond’s maturity. So the governance of the process was weak.

In 2011, there will be an alternative possibility for the fund manager: invest in the bonds issued by the EFSF that would fund State X if it cannot raise funds in the market – or is unwilling to pay the price, fearing a ruinous interest burden. The EFSF bond may well be rated AAA by the rating agencies the governments dislike so much, but the fund manager will be under a duty to investigate carefully for himself the exact credit mechanics. These will be complex as each issue is backed by a set of guarantees that will vary if any of the guarantors – which include all the other “problem states” - fall into default themselves. Nonetheless, these EFSF bonds will be senior to any other bonds available and the aggregate guarantees from all the other eurozone members will make them reasonably credible. Thus risk-averse, conservative fund managers may gravitate to EFSF bonds rather than funding State X direct.

If problem states do default, Eurostat will allocate the guarantees directly to the balance sheet of the guaranteeing states, so their own indebtedness will rise – reducing the credibility of problem states even further. There is a further twist to this vicious circle. The EU seems to have forgotten the lessons learnt after the Second World War: The Treaty of Versailles in 1918 exacted such reparations from Germany that they ruined the country and led on to political instability. So a founding principle of the EU became “solidarity”. By charging say Ireland a 6% interest rate, the other eurozone members will be extracting a substantial income above the EFSF’s cost of funding. A future, populist Irish government may feel this is unfair, and lacking in solidarity. So the risk of actual default may rise – especially as there will probably be a primary surplus at the time.

Our fund manager will be contemplating all these scenarios that could play out during the life of the bonds to be offered to him in 2011, and be ever more wary of taking the risk of buying direct obligations of any but the safest governments. So the size of the EFSF will have to be raised progressively at crisis meeting after crisis meeting until it is funding many of the problem states entirely.

However, as the years roll past, the effects of the drive to enhance the eurozone members’ competitiveness will gradually come through, and public finances improve sharply - especially for those states that have taken the opportunity of reducing their debt burdens. At that stage, any remaining bonds of the problem states will seem very attractive – to those investors able to buy them. The potential wave of defaults is likely to precipitate a further round of regulatory reform to ensure that financial institutions such as banks will find it difficult to buy bonds of any but the soundest states. That will be a major constraint on finance ministers ever getting into such debts again. (But the generation of electors who voted themselves generous pensions funded by debts to be repaid by their children may regret their choice.)

© Graham Bishop