Tag: ESM

The Grand Bargain

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.

ESM Details

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.

The Black Hole Grows

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.