Like many commentators, I cannot but commend the achievements of last week's eurozone summit which, no doubt, constitutes an important milestone on the path to restoring financial stability. There are still many questions to be answered with regard to the implementation of the agreements and markets will soon test the resolve of the authorities to “do whatever it takes” to ensure the long term stability of the euro.
Let us be fair in underlining that the outcome is not fully under the control of the European authorities as the situation is heavily tributary to the global political, economic, financial and physical environment. Political developments such as the “Arab spring” and its consequences in Libya, Syria, Egypt or on the Israel-Palestinian conflict, the debt and fiscal problems in the US, uncertainties surrounding economic developments in China, India and other emerging economies and their impact on the global economy, as well as unforeseen “natural” disasters such as the Japanese tsunami, are all factors that can have a significant bearing on the capability of the EU to overcome its internal problems. As events unfold, markets will react in ways capable of derailing the best laid plans. Authorities should be careful not to attribute automatically to “speculation” such unforeseen developments.
This paper draws attention to a series of problems which need to be addressed and over which the EU has full control. These concern both political and technical challenges and the need for coherence between the pieces of this complex puzzle.
The first question is one of the “credibility” of the statement affirming that the Greek situation is “exceptional” and that the “restructuring” of its debt (with private sector participation), are a one off solution. Is this believable and compatible with the undertaking of doing “whatever it takes”?
While the reduction in lending rates to “programme countries” and the extension of maturities coupled with the reform of the EFSF may provide EMU with new tools that should mitigate the risk of future “restructurings”, these bold and dangerously rigid pronouncements leave little room for unexpected developments. To take but one example, a general increase of interest rates (required to fight inflationary expectations in any hoped for economic upturn) would seriously question the ability of Italy and Spain to “refinance” their maturing debt on acceptable terms and sustainable levels.
One can immediately see that the credibility of this undertaking is heavily dependent on the final arrangements that are envisaged for the EFSF/ESM, and the extent to which these will provide sufficient resources to deal with “worst case” scenarios.
It also raises the question as to whether the “mandate” of the ECB should be revisited to offer greater flexibility in terms of “inflation targeting”, as an additional tool to reduce excessive indebtedness. This would provide additional policy flexibility for managing the external value of the € and its impact on exports and economic growth.
Another fundamental departure from the present crisis management framework is to break the quasi “formal” link between EU and IMF assistance. Though these two institutions should, in no way, be prevented of collaborating closely and pooling their respective expertise in crisis prevention and management, each should retain full flexibility to act either independently or in concert. This would considerably enhance the commitment of the EU to deal appropriately with its problems and remove any possibility of third party pressure or interference that the US or emerging countries might be tempted to exert in order to defend their own perceived interests.
A third area of concern is the implications of the well advanced plans for the ESM, signed on July 11 by Eurozone Ministers, about to start its “ratification” process through the Parliaments of EMU Member States.
Right from the start of the negotiations, I challenged the idea of basing the “legal” foundation of the ESM on an “International Treaty” distinct from the EU Treaty itself. A preferable alternative would be to design the ESM as a fully-fledged EU Agency or, at a minimum, as a “Reinforced Cooperation Agreement” among participating Member States. The finalisation of the changes to the EFSF agreed last week offer the possibility to reconsider the whole matter, as ratification cannot proceed as long as the detailed amendments to the operations of the EFSF (the precursor of the ESM) have not been formalised (a more detailed discussion of the new EFSF structure is developed hereunder). Such an approach avoids future conflicts regarding the hierarchy of “norms” between the EU and ESM Treaties potentially pitching the EU 27 against the EMU 17 in the presence of a neutralised Commission, with potential disastrous consequences and raising speculation on the viability of EMU.
In addition, the European Council should be encouraged to rescind its unilateral decision to confer “privileged creditor status” on the ESM, eliminating the likely risks of future “legal” challenges. Indeed, based on the model of the IMF’s “informal” privileged status, the Council decision fails to recognise two fundamental differences: the first is that membership of the IMF is quasi “universal” and second that the IMF has no “publicly traded” securities. This means that the investors holding “sovereign debt securities” of IMF Members are not formally “subordinated” to the “inexistent” holders of IMF public debt. This would not be the case for the EFSF/ESM whose financing relies extensively on public market funding and whose holders would therefore be de facto “senior” to investors in EMU Member States sovereign debt. Subordination normally implies a “downgrade” of at least one level of ratings which would be very damaging to the cost of funding EMU Members debt.
Turning to other implications of some of the proposed new arrangements, one should mention the consequences of an (even very temporary) “selective default” by Greece. As I understand the proposal, the ECB would continue to give access to its refinancing facilities to Greek banks by accepting Greek sovereign debt as collateral, to the extent that it would benefit from “enhancements” provided by EMU Member States. A rapid restoration of a “CCC rating” would thereafter ensure formal “compliance” with the ECB’s self imposed collateral eligibility rules.
Without entering into the separate debate on the rating agencies, their role, powers and governance, it remains nevertheless a question of credibility that the overall assessment of ECB collateral eligibility be both coherent and transparent. On that score, it is of great importance to eliminate the harmful fiction of the “zero” level of risk weighting associated with EMU sovereign debt securities (fiction that seriously compromised the credibility of the recent “stress tests”). A more acceptable system would be to set the level of ECB advances by reference to the published ratings limiting, for instance, advances against “unenhanced” CCC rated Greek debt to 50 per cent of the face value of the collateral; this percentage could be increased by the provision of enhancements acceptable at the discretion of the ECB. Efforts should be made to reduce where ever possible the role of ratings within all aspects of the EU regulatory framework.
One of the features of last Thursdays’ agreements, that attracted considerable praise, was the proposal to extend significantly the scope of the EFSF mandate. This was viewed as a first - if timid – step on the path towards a form of fiscal solidarity among EMU participants. Let us examine more closely the proposal which includes the recapitalisation of banks, the open market purchase of securities and the granting of credit facilities to “non programme” EMU Member States.
A preliminary clarification concerns the risks associated with the refunding of the EFSF’s outstanding indebtedness as the unilateral extension of maturities (to 30 years) and reduction in interest rates (to 3.5 per cent) create a mismatch between its existing assets and liabilities. If however, as stated, the interest rate will not be lower than the EFSF’s funding cost, does the borrower have the option of locking in today the cost of 30 year funding or does he bear the risk of the market until the future rollover of the loan? The extent of this risk will become apparent as soon as the next “draw down” of EFSF loans occur which will establish the level for EFSF 30 year bonds. Though the lengthening of maturities will provide welcome relief to the borrower, the anticipated reduction in servicing costs could turn out to be lower than expected. An important factor in this regard will be the capacity of the market to provide the necessary volume of 30 year funds required with the probable upward pressure on long term rates that it is likely to induce. Consequently, the actual reduction in debt servicing costs for Greece, Ireland and Portugal could well fall short of expectations and markets are liable to price in this risk when trading debt securities of these borrowers.
A second question concerns the compatibility of the provision by the EFSF of “capital” to banks in need with EU “State Aid” rules? Does this not interfere with a fair and level competitive playing field in the bank market? The funding of these purchases, as well as secondary market purchases of debt securities, is also a potential problem as there is no structured “back to back loan” to provide for the matched servicing of the debt incurred (other than the revenue derived directly from the portfolio). The market risk is therefore directly borne by the EFSF/EMS. The €80 billion cash contribution by Members (paid in over 5 years) could serve as a possible cushion for underwriting such market purchases. Agreements authorising the EFSF to “put” securities to the issuer “at cost” could also minimise market risk for the EFSF. The possibility of “market purchases” constitutes an additional argument for abrogating the “privileged creditor status” of the EFSF/ESM (see above) as it would be impossible to justify that sovereign debt securities purchased in the secondary market and held by the EFSF should be privileged, in the event of a restructuring of the issuer’s debt.
Another question relative to the implementation of the proposed measures is the obvious need to increase considerably the resources at the disposal of the EFSF. This should mean at a minimum “accelerating” the availability of the resources already committed to the ESM (€750 billion) well before June 30th 2013.
The “credit” structure of the EFSF (ESM) should also be subject to review. At present, EMU Members under a “programme” are excused from further “guarantee” commitments towards other Members encountering difficulties, their share of guarantees being spread over the remaining EMU participants. Would this rule apply mutatis mutandis to “non programme” Members availing themselves of an “EFSF credit line”? If so, any usage by Spain and/or Italy would considerably weaken the existing robustness of the credit structure (as implied by the remarks of Moody’s this Monday July 25th on the possible negative impact of Thursday's agreements on the ratings of the stronger EMU Members). This point clearly underscores the potential weakness of a future ESM operated completely outside of the EU Treaty as discussed here above.
The appropriate solution (already put forward on several occasions since last January) would be to restructure the EFSF/ESM as an EU Agency with the benefit of an EU budget guarantee. This would remove any doubts of investors as to the EU’s commitment to “do whatever is necessary” and ensure an uncontested AAA rating for the Agency’s securities. The issuing limits of the Agency should be set within the framework of the 2013-20 “financial perspectives” to be considered shortly within the normal budgetary procedures. To assuage non-EMU Member States and encourage them to provide their implied “joint and several guarantee”, the present commitments of EMU Members towards the EFSF/ESM would be fully maintained (or even strengthened), rendering the actual financial risk to the current 10 non-EMU Members largely cosmetic. As, according to Deputy Prime Minister Clegg, Chancellor Osborne, and other senior British politicians, the survival of a strong eurozone is vital to the interests of the UK, it is difficult to see why they would object to such a mechanism. Implementing such a structure would provide a viable framework for developing a fully competitive market for “Euro-Bonds” on a scale that could, over time, rival with the market for US Treasury securities. It would also constitute a significant step in providing a viable alternative to the USD as a world reserve currency imposing discipline both on the US and the EU in the management of their financial and economic affairs. Hesitations to engage in fundamental reform will unnecessarily forgo these additional significant benefits, accruing to the EU as a whole, as well as restoring its voice and influence in the concert of leading global powers.
A further clarification concerning the authority of the EFSF to exercise its new responsibilities pertains to its intervention in sovereign debt secondary markets. The requirement to act only on an ECB request – and subject to unanimous consent of EMU Members – weakens considerably the impact of this measure. Indeed, markets will question either the ability to secure unanimous approval or conclude that the ECB request is a clear sign of significant difficulties, fuelling uncertainty and speculative market movements. An upfront blanket authority to exercise its powers for a limited and revisable amount (similar to the debt ceiling in the US) would remove this ambiguity and provide more flexibility, confidentiality and credibility to the process.
Two additional policy areas covering regulatory and fiscal measures deserve further consideration to secure a comprehensive credible crisis management framework.
On the first, further progress must be made on integrating supervisory and regulatory matters within the eurozone. Once again, one must do away with the fiction that one can operate an EU-wide effective regulatory framework based on “intergovernmental” cooperation alongside a single monetary policy applicable only to the eurozone. Difficulties, particularly in the field of exercising responsibilities, are liable to appear only at times of crisis when it is too late to act. Considering that the EU Treaty imposes progressive convergence leading to compulsory EMU Membership on all but the two States benefiting from derogation, a more rational approach would be to confer on the three recently-established “Authorities” full regulatory and supervisory powers over all EMU Members and impose the adoption by others of this single framework during the probationary period preceding EMU accession. In the interim, the aim of harmonising rules among the 27 should be maintained while preserving a certain degree of flexibility for non-EMU Members. It is also urgent to complete the legislative process establishing the “Semester” process, the new Stability and Growth Pact including the reinforcement of the Commission’s role in monitoring and enforcing compliance. Adoption of the “reverse” qualified majority rule for voiding “sanctions” will be a very much awaited demonstration of the political will to deal comprehensively with the “economic” integration of EMU.
An additional regulatory chapter has just been opened with the publication last week of the Commission’s proposals on implementing Basel III regulations. It demonstrates the need to pay attention to the overall coherence of any new proposed measures with other decisions. The Commission proposals put the spotlight on two main questions:
First the need for sufficiently flexible rules to accommodate significantly different approaches to prudential management so as to avoid distorting competition. This is evidenced by possible contradictions between the Commission proposals and the recommendations of the British Taylor Report, in particular aiming at ring fencing ordinary banking activities from investment banking operations. Trying to accommodate all sides fully should result in an unhealthy compromise liable to be sanctioned by the market.
Second, the stark contrast between the derisory shortfalls of regulatory capital for the 91 banks subject to the recent stress tests estimated at €2.5 billion (to be secured by next April) and the recapitalisation of the EU banking sector as a whole estimated at some €470 billion (required by 2019). It is clear that markets will dismiss any relevance of the former figure and focus eagerly on the latter, voiding in the process much of the value of the much-vaunted stress test exercise. Meeting the challenge of Basel III can be reached by three avenues: raising additional capital (diluting the present shareholders and assuming new investors are willing), retaining earnings (requiring a sufficient level of profitability under a very uncertain economic outlook) or reducing the size of credit exposures (this implies an incapacity of financing adequately an economic recovery which is the key to exiting from the crisis). Neither of these options appears particularly conducive to underpinning a healthy recovery of the banking sector; this can be readily observed in the poor performance of banking shares and the extreme volatility to which they are being subjected.
On the regulatory front, the ESRC mandate and structure needs also to be revisited. It is quite apparent that since its creation in early 2011, it has been unable to meet the expectations of its conceivers as evidenced by its total silence throughout the developing sovereign risk crisis. This must be attributed in part to the makeup of its Board, composed overwhelmingly of Central Bankers (with an inbuilt majority of eurozone participants). Under these circumstances, it is difficult to imagine the ESRC delivering unbiased recommendations that were not fully aligned on the views of the ECB, itself a major protagonist in the negotiations. A first step in restructuring this body might be to reduce representation of EMU Members from currently 20 out of 33 voting members to say 5, and replace the 15 others by representatives of a broader section of economic, social and private sectors (on the model of the Group of Thirty). To add to the perception of greater “independence” of the ESRC, Mr Trichet could be asked to continue to assume its presidency upon his retirement end of October. The views of an unbiased ESRC would be particular useful and welcome in advising authorities on ways to deal with the relationship of sovereigns with their respective domestic banking sectors, proposals of a better governance applied to credit ratings to avoid the realisation of unwelcome self-fulfilling expectations, advice to the EBA on the credibility of stress test scenarios, etc.
On the fiscal front, the recent discussions over the option of imposing a “bank tax” as part of dealing with the Greek crisis underscores the sensitivity of such measures. Under the circumstances it was probably very wise to shelve the French proposal as there was an obvious contradiction between the requirement of the banking sector to reinforce its tier I capital resources and the imposition of a flat tax on bank assets, however minimal. This should not, however, deter deciders from devising fiscal measures that enhance the twin political objectives of ensuring that the banking sector assumes its full share of responsibilities for the harm its excessive greed and wanton behaviour wrought on the world economy, while simultaneously encouraging the reinforcement of the banks' “own funds” to ensure that the taxpayer will not be called upon to rescue failing institutions. This could be achieved by adopting – at EU level – uniform accounting and tax rules such as a limitation of the deductibility of sums paid out as compensation: for instance, total variable compensation (bonuses, benefits etc) should be limited to 50 per cent of an employee's fixed salary with an overall cap at say €600.000. Sums in excess of these amounts could be freely paid out of after tax profits. Such ex gratia payments as well as dividend payouts would be limited to sums that did not put compliance with the maintenance of regulatory capital in jeopardy.
At such time when budgetary rigour is imposing severe sacrifices on the most vulnerable social classes, it is of particular importance that efforts are spread equitably among all segments of society and that the better off participate fully in the efforts required. This sharing of the pain must happen both at national level (all Greeks must be made to pay their taxes) and at EU/EMU level (there is growing recognition that implementing progressively a fiscal transfer capability is a precondition for ensuring the survival of EMU and ultimately of the EU itself).
In conclusion, this is undoubtedly a time when strong political leadership is required, if one wishes to resolve the immense complexities and challenges posed by the financial crisis. Politicians must, for once, put aside their own (and their parties’) ambitions for the greater good and the survival of our values which have created such unprecedented prosperity as well as hardship. Failure will mark the unavoidable and definitive decline of our living standards and of Europe as a world power. It is up to our political elites (that we elect) to see that the outcome does not end in a “financial Munich” when unwarranted hopes of “peace in our time” ended in utter disaster.
Les Crosets, Switzerland, July 25th 2011
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute
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© Paul Goldschmidt