There is some discussion of this issue in the comments but it’s worth putting on the front page. A much-heralded part of December’s EU negotiations was the decision to change the language on Private Sector Involvement (PSI) in the ESM Treaty.
On December 9, Herman van Rumpoy said
our first approach to PSI, which had a very negative effect on debt markets is now officially over.
It was being replaced with the following
from now on we will strictly adhere to the IMF principles and practices
Sure enough, the new ESM Treaty states
In accordance with IMF practice, in exceptional cases an adequate and proportionate form of private sector involvement shall be considered in cases where stability support is provided accompanied by conditionality in the form of a macro-economic adjustment programme.
Some are arguing that this is effectively a commitment to limit PSI to Greece. I don’t see how this is a tenable assumption. As this FT Alphaville post discusses, there is no sense in which IMF procedures rule out PSI. Furthermore, bond markets are also clearly not interpreting the new ESM treaty in this fashion since Portuguese bond yields are still effectively pricing in a default.
It’s very hard to see how, if the stars end up aligning sufficiently badly for Ireland, that “an adequate and proportionate” haircut won’t get applied to private sovereign bond holders.
A newly-modified ESM Treaty has been signed. Documents are available here. One key aspect:
It is acknowledged and agreed that the granting of financial assistance in the framework of new programmes under the ESM will be conditional, as of 1 March 2013, on the ratification of the TSCG by the ESM Member concerned.
Viewers of the Vincent Browne show take heed!
Much of the pessimism about Ireland’s predicament has centred on the challenge of stabilising the debt to income ratio. Undoubtedly this will be challenging, with good outcomes on nominal GDP growth and fiscal adjustment capacity required. Of course, it has been made much more difficult by the massive bank losses the State has had to absorb. But I think a focus on the stabilisation challenge misses a critical issue, which is regaining market access at a high if stable debt to GDP ratio (probably somewhere in the region of 120 percent of GDP).
Martin Wolf’s column from last week provides a useful starting point for a diagnosis of the problem – an article that garnered all of one comment on the blog (from DOCM). It draws on Paul de Grauwe’s insightful work on the susceptibility of countries in a monetary union to a debt crisis (see here), where a country without its own currency and central bank to act as lender of last resort is vulnerable to self fulfilling expectations that it will not be able to roll over its debts. The EFSF/ESFM/ESM were put in place to help fill this LOLR gap, but have so far proven to be a poor substitute. It is understandable that Germany and other likely net funders want to eventually reinstate market discipline, and so demand losses are borne by private creditors as part of any new bailout. It is also understandable that they want to protect themselves from losses under the permanent bailout mechanism (the ESM) by demanding preferred creditor status. But it is becoming increasingly evident that crisis-hit countries will find it extremely hard to regain market access with a half-hearted LOLR facility in place given any doubts that they will not be able to pass a debt sustainability test under the ESM.
The official funders have to be willing to take on some additional risk if a mutually damaging combination of default and ongoing dependency is to be avoided. One element is to clarify the way the debt sustainability test will be applied. A current problem is that austerity measures weaken growth, thus making it harder to pass the test. A useful amendment would be to assess growth in the debt sustainability calculation assuming a neutral fiscal stance. Another useful amendment would be to set a ceiling on the size of any haircut, thereby limiting the uncertainty faced by potential new investors.
As a quid pro quo for these amendments the government could offer to speed up the fiscal adjustment (along the lines recommended by the ESRI in its Spring QEC). Of course, more fiscal adjustment is the last thing the economy needs as it struggles to pull out of recession. Yet a quasi-permanent loss of creditworthiness and dependency on unreliable official support looks to be the bigger threat, as it saps confidence and undermines the perception of the economy’s stability. Those resisting fiscal discipline must realise that the situation changed profoundly when Ireland’s creditworthiness disappeared in the second half of last year. Some observers are putting forward the same fiscal policy prescriptions as they did when bond yields were around 5 percent. They must see that the ground has fundamentally shifted.
It is hard to see how further public sector pay cuts could not be part of any balanced additional adjustment. A credible new regime for long-run fiscal discipline is also essential.
The government should take the offensive in pointing out the incoherence of the current international support approach, while avoiding playing a self-defeating grievance card. What is needed is a hard-headed look for a mutually advantageous set of policies that allow Ireland to shed its dependency. The first step is a proper diagnosis of creditworthiness challenge.
The Sunday Business Post carries an interesting opinion piece by Paul De Grauwe in today’s paper. Although articles are not available on the paper’s website until the Monday after publication, Cliff Taylor has kindly given us early access to article.
The European Stability Mechanism will not not lead to more stability
After much hesitation and a lot of pressure exerted by financial markets, European leaders finally decided at the end of March to set up a permanent financial support mechanism which was given the name of European Stability Mechanism (ESM). From 2013 on, Eurozone countries will pool financial resources to be disbursed to member-countries in times of crisis. This historic decision illustrates the painful and slow way the Eurozone moves in the direction of more political integration in Europe.
Will the establishment of the ESM shield the Eurozone from future crises? My answer is unambiguous. It will not. In fact it is worse than that. Some of the features that have been introduced in the functioning of the ESM will make it more difficult for a number of countries, in particular Ireland, to attract funds in private markets. These features will have the effect of increasing rather than reducing volatility in the financial markets. Continue reading “Paul De Grauwe on austerity and implications of the ESM”
Wolfgang Münchau has an interesting take on the bailout/default debate that is relevant to recent posts (see here).
Having been a bit tough on the FT yesterday morning, I would like to echo commenter DOMC in drawing attention to a very good article by David Oakley (see here; related piece here). While our attention has naturally been on the Ireland-specific aspects of negotiations over the crisis-resolution mechanisms, the Grand Bargain on the ESM is probably far more significant for our creditworthiness.
David Oakley notes that market conditions are improving for Italy and Spain. This is consistent with the idea of a self-fulfilling equilibrium: if you look like your will need a bailout no one wants to lend to you (and get caught up in a later “bail-in”), and so you end up losing market access and forced into a bailout. This is what seems to be happening to Portugal at the moment; Italy and Spain have been able to stay out of the critical region — at least for now. A problem for Ireland is that improving your fundamentals looks less effective once already in the bailout mechanisms. Can it make sense to have this “black hole” (potentially) spreading from the periphery? Hardly a Grand Bargain.
Details of the proposed structure of the new European Stabilisation Mechanism can be found in various parts of the World Wide Web thingy, e.g. here and here.
Two things jump out to me. First, the agreed margin on a 7.5 year fixed rate loan from the EFM would be 260 basis points, about 60 points lower than the current rates on offer from the EFSF. Perhaps someone will insert a clause making the margin dependent on a country’s corporate tax rate but somehow I doubt it.
Second, despite a lot of previous focus on the idea that only bonds issued after 2013 would be eligible for restructuring, the proposal does not contain such a commitment. As expected, there is a commitment that government bonds with a maturity greater than one year issued after the introduction of the ESM will have to have collective action clauses facilitating restructuring. But rather than adopt a position that existing bonds cannot be haircut, the proposal seems to essentially take the opposite strategy. A country that fails a “sustainability analysis”
will be required to to engage in active negotiations in good faith with its creditors to secure their direct involvement in restoring debt sustainability. The granting of the financial assistance will be contingent on the Member State having a credible plan and demonstrating sufficient commitment to ensure adequate and proportionate private sector involvement.
I’m all in favour of this, having argued at various times (e.g. here and here) that a proposal to only haircut bonds issued after the introduction of ESM was unworkable. However, this does help to explain the market jitters of the past few days. The Irish two-year bond yield was up another 40 points or so today and stands at 10.25% as I write, having reached as high as 10.7% earlier today.
It has been apparent for some time that proposed design of the post-2013 ESM — notably preferred official creditor status and arrangements for creditor bail-ins — is undermining peripheral country creditworthiness. The so-called bailout mechanisms have the rather grotesque feature that they can suck a country in once it begins to show enough vulnerability.
At the moment, markets do not want to lend to Portugal in large part because markets expect Portugal will enter the bailout mechanisms, increasing the risk they will be caught up as junior creditors in later accelerated bail-ins. This could end up happening well before 2013; hence the surge in our 2-year yields. These fears are likely to be self-fulfilling, despite the resistance of the Portuguese government (no doubt informed by watching what happened to Ireland). As we are learning more by the day, once in, it is damn hard to get out. Peripheral yields have shot up every time the ESM became that bit more certain (latest news on the agreement here). With the evidence so clear, it is hard to understand how European leaders persist with a solution that could end up destroying the Eurozone. The interest rate issue appears a sideshow by comparison.
The FT has a couple of good articles that nicely capture that damage being done to our and others’ creditworthiness (see here and here). A flavour:
Investors warned they could boycott peripheral eurozone bond markets as reform of the region’s bail-out fund sparked fears of a sovereign default in Europe.
Irish three-year bond yields leapt close to a full percentage point at one point on Tuesday, while the cost of borrowing for Portugal and Greece also shot up on worries that one of these countries would have to restructure their bonds.
European finance ministers finally drew up plans to make investors share the burden of potential sovereign defaults beyond the summer of 2013 in a deal hammered out on Monday night. Concerns centre on the preferred creditor status given to European Stability Mechanism, the permanent eurozone rescue fund, which takes up the reins from the temporary fund, in the middle of 2013.
Investors warn that this will mean they will be the last in the queue for the recovery of money in the event of a default. One fund manager said: “We will definitely not buy peripheral bonds now, not with the uncertainty this has created.”
Tamara Burnell, head of sovereign and financials analysis, M&G Investments, said: “This agreement will not do anything further to encourage investors to buy peripheral bonds.