The EU Stabilisation Plan

After the excitement of the weekend’s EU announcement, the question most people will ask is “will it work?” I think the answer to this question depends on what we mean by “work”.

There are obvious parallels here with the banking crisis. As markets began to doubt the solvency of many institutions, including the Irish banks, access to short term liquidity dried up for these institutions. Governments provided various liability guarantees to help these banks regain access to markets (ours being the most extensive) but these guarantees did not change the underlying solvency picture. Ultimately, the problem of insolvent banks had to be dealt with via costly recapitalisation measures, a process that we in Ireland have yet to complete.

The size of the funds announced in the EU deal are large enough to most likely ensure that, for a while, no EU country will fail to roll over its sovereign debt. In that sense it will most likely work. But it doesn’t change the fiscal reality.

Last week’s €110 billion Greek deal wasn’t well received by the markets because it still seemed to imply a Greek default was on the way. Last night’s announcement is being well received but then it doesn’t actually come with a concrete fiscal restructuring plan for Portugal, Spain or Ireland, so the plan can be taken good news without having to question any dubious underlying assumptions about fiscal sustainability. If the time comes when this fund is tapped but the markets don’t buy the stabilisation plan announced, the situation could unravel again.

Most of the thoughtful reaction elsewhere points to it being a long and complicated road ahead. The Baseline Scenario guys give their reaction to the plan here. Arthur Beesley also has a nice piece in the Irish times here.

European Stabilisation Mechanism Announced

The European Union has announced an agreement among heads of state to address the mounting sovereign debt crisis. Here’s Commission President Barroso’s statement. The meat of the announcement is the following:

First the Commission will present a concrete proposal for a European Stabilisation Mechanism to preserve financial stability in Europe. This proposal the Commission will make will be presented to the ECOFIN meeting next Sunday, the day after tomorrow (9 May).

Much of the speculation about the content of this proposal revolves around the ECB. Some media stories (such as this one) are discussing an extension of the ECB’s liquidity operations, which is fine but doesn’t go to the heart of the soverign debt problems.

Other stories (such as this Reuters story carried by the Irish Times) point to the ECB purchasing sovereign bonds.

“You have this ‘no monetary financing’, but you are allowed to buy in the secondary market, so what’s the difference?” an official involved in European banking supervision told Reuters. “Buying in the secondary market, you take the pressure, and so you push people in the primary market.”

Analysts have estimated the ECB might buy some €200 to €300 billion of bonds, about 20 to 30 per cent of estimated annual new issuance in the euro zone.

This point that the ECB can actually do this is correct. The wording of the no monetary financing clause (article 123 clause 1 of the current version of the consolidated Treaty on the functioning of the EU) is as follows:

Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

I suspect the direct purchase phrase was put in to make it clear that public debt instruments were fine for use in ECB repurchase agreements with banks. But the wording does not rule out secondary market purchases.

Exactly what effect this type of intervention would have would depend on how it was implemented. If it was simply a once off purchase of a load of Spanish, Portuguese or Irish debt, I can’t see how this would have much effect since the underlying stock of debt would remain the same.

If, however, the operation took the form of secondary market interventions right after primary market issues, then it would have an effect. For example, the Irish government could issue debt to some banks who could then immediately sell these bonds on to the ECB, perhaps for a small profit. the only risk for the banks being the small probability of being left with the hot potato at the moment of a default.

This would pretty much be breaking the spirit, if not the letter, of the Treaty. But, we’re in this territory already. The existing Greek bailout is being legally justified on the basis of this clause in Article 122:

Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned.

Greece, apparently, is suffering from a natural disaster or an exceptional occurence beyond its control.

Note the rumoured scale of this operation. If the rule of thumb relating to ECB capital subscription is applied again, Ireland would have to supply over €4 billion to this fund.