Clear answers are absolutely needed to - at least - the following problems:
1. Recognizing that dealing with financial assistance and, in particular, sovereign debt resolution, are fundamentally different for countries that retain “full” monetary sovereignty and those who do not (EMU Members).
This poses a difficult “political” problem for the IMF as it is supposed to treat its Members “equally”. That is why, in a recent paper, I suggested the “pooling” of EMU members IMF quotas/votes and having a single Board representation, similar to the USA.
2. Addressing squarely the question of creating a true level playing field in the FX markets by restoring EMU’s capability to defend its interests on an equal footing with others major participants rather than allowing the level of the Euro to be tributary to decisions made, inter alia, by the USA, China, Japan, the UK etc., and remaining the “adjustment variable” of the system.
3. Recognizing the increasing dangerous and incestuous relationship between the Sovereign Debt problem and banking sector solvency (as clearly demonstrated in the Irish case), in which Central Banks play a central role in the transmission mechanisms, not only of liquidity, but also of risks that are not being adequately recognized. Here again politics play a major part in perpetuating, against any rational argument, that the Sovereign Debt securities of all EMU Members are equally eligible as collateral for ECB advances. It is evident that such a stance is not tenable, in particular if, as Ms Merkel insists, a permanent Sovereign Debt resolution mechanism must include haircuts on privately held sovereign debt securities. So, the more progress made in devising a “credible resolution mechanism”, the more the current ECB collateral policy will need to be amended. Avoiding a new banking crisis within such a context is an incredibly difficult challenge because the weaker EMU Members rely on their banks to buy their securities while, in case of a crisis, these same banks must be bailed out by the same governments (Ireland).
4. Recognizing that the current “unlimited” liquidity provision by the ECB at 1% is providing banks with “so far riskless arbitrage opportunities”, encouraging them to take on more “sovereign risk” rather than lending to the “real” economy. (The EMU/IMF Greek Facility allows banks to buy short term Government securities with the full assurance that funds are available at maturity – the same will apply to Irish debt or that of other recipients of EFSF/IMF support). The moral hazard aspect is here very significant.
5. Recognizing that the current EFSF credit structure is flawed: How can its securities command an AAA rating when the commitment of AAA several guarantors (even enhanced to 120% of their commitments) only cover approximately 65% of each of the Facility’s operations. When established, it was expected that the € 440billion amount – deemed sufficient to reassure markets - would not need to be drawn. Now that the Irish loan is being put in place, the market will scrutinize carefully the modalities with potential disastrous consequences: the possible downgrade of the rating. In the event,a new solution will need to be put in place long before June 30th 2013 when the Facility was due to expire.
6. Recognition that the “stress tests” carried out last summer in Europe are no longer credible if appropriate reserves need to be made against sovereign debt bank assets. This means banks will either have to reduce their holdings (depriving their governments of desperately needed funding) or significantly increase their capital base (Basel III). The consequences on the sector’s lending capacity as well as the cost of lending will necessarily impinge negatively on economic growth prospects.
Markets will continue, if not intensify, their probing of the will and ultimately capacity of the EU to defend EMU. As President Van Rompuy said: a disintegration of EMU would lead to the end of the EU itself. Such an outcome, up until recently unthinkable, will get more and more traction until the situation becomes irreversible unless drastic credible measures are put in place. That is also the basis of my recommendation of extending – as foreseen in the EU Treaty – EMU to all EU countries so as to restore monetary sovereignty to the Euro area. This is, I believe, the single most important decision to be taken – together with the implementation of deeper economic coordination – in order to reduce the risk of implosion of the EU.
Brussels, 24th Novembre 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259
© Paul Goldschmidt
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