Monday, November 21, 2011

Eurozone’s Self-Inflicted Killer?

Bethany McLean, contributing editor at Vanity Fair, wrote an op-ed comment in Reuters, The euro zone’s self-inflicted killer:
There were a lot of things that were supposed to save Europe from potential financial Armageddon. Chief among them is the EFSF, or European Financial Stability Facility.

In the spring of 2010, European finance ministers announced the facility’s formation with great fanfare. In its inaugural report, Standard & Poor’s described the EFSF as the “cornerstone of the EU’s strategy to restore financial stability to the euro zone sovereign debt market.” The facility itself said in an October 2011 date presentation that its mission is to “safeguard financial stability in Europe.”

That of course hasn’t happened. And the evidence suggests that the EFSF may have only exacerbated the problems.

In theory, the facility is supposed to provide a way for a country that the market perceives as weak to still borrow money on good terms. The initial idea was that instead of the financially troubled country itself trying to sell its debt to live another day, the EFSF would be the one to raise the money and lend it to the country in question. The logic was simple: country X might be shaky, but the EFSF deserved a triple-A rating.

For all of its would-be financial firepower, the EFSF isn’t much to see—it’s just an office in Luxembourg with a German-born economist CEO named Klaus Regling, who oversees a staff of about 20. Its power—and that rating—is derived from the assumption that any debt it issues is guaranteed by the members of the euro zone. Initially, each member pledged unconditionally to repay up to 120% of its share of any debt the EFSF issued. (A country’s share is determined by the amount of capital it has in the European Central Bank.)

On paper, it all sounded great. The reality is that the EFSF wasn’t meant to be an active institution; it was supposed to be a fire extinguisher behind glass: never to be used. “The EFSF has been designed to bolster investor confidence and thus contain financing costs for euro zone member states,” wrote Standard & Poors in its initial report granting the triple A rating. “ If its establishment achieves this aim, we would not expect EFSF to issue a bond itself.” Moody’s, for its part, wrote that the EFSF “reflects the political commitment of the euro zone member states to the preservation of the euro and the European Monetary Union.” That show of commitment alone was supposed to be enough to reassure the market.

In granting the EFSF the all-important triple-A rating, the rating agencies were somewhat cautious. They weren’t willing to assume, as they did with subprime mortgages, that any subset of debt guarantees—no matter how small—made by countries that weren’t themselves triple-A rated would be worthy of the gold-plated standard. Instead, they insisted that the EFSF’s loans had to be covered by guarantees from triple-A rated countries and cash reserves that the EFSF would deduct from any money it raised before it passed those proceeds on to the borrowing country. Based on that, euro zone members initially pledged a total of 440 billion euros ($650 billion) in guarantees. However, S&P said in its initial report that the EFSF would be able to raise less than $350 billion of triple-A rated proceeds.

Of course the euro zone did break the glass: the fire extinguisher was used, first in support of Ireland, and then Portugal, and then Greece. This summer, the European Powers That Be agreed to bolster the EFSF’s lending capacity by increasing the maximum guarantee commitments of the member states to 165%, instead of 120%. That was supposed to enable the EFSF to borrow up to 452 billion euros “without putting downward pressure on its ratings,” according to S&P.

As we now know, that’s not nearly enough money to end the crisis, especially given that the EFSF’s commitments to Ireland, Greece and Portugal leave the facility with a lending capacity of just 266 billion euros, according to a recent report from Moody’s. (I found it difficult to add up where the money went.)

Hence the politicians’ latest idea: leverage the EFSF’s remaining ability to borrow. Either have the EFSF offer first-loss insurance when a country issues debt, or turn its remaining capacity into the first-loss tranche of a collateralized debt obligation, which would raise money by selling bonds to other countries like China.

Besides being undersized for the job, there’s a core structural problem with the EFSF: It is only as strong as its triple-A members—not just Germany, which according to that October 2011 EFSF presentation contributes 29% of the total value of the EFSF’s guarantees, but also France, which contributes 22%, and the Netherlands, which contributes 6%.

Some financial analysts have questioned why any European country deserves a triple-A rating, seeing as EU members can’t print their own currency to pay off their debts. As the financial turmoil has unfolded, it’s become clear that the only EU country the market views as a bona-fide triple-A is Germany. So as much of Europe crumbles, the EFSF’s triple-A, in the eyes of the market, is supported by a lone country. As one bond market participant says, “Eventually, only the German guarantee will matter, and it isn’t big enough to cover this.”

Indeed, Germany represents less than a quarter of the EU’s GDP, and obviously the nation’s economic health is to no small degree dependent on other members of the EU buying German goods. (Such interconnectedness was the whole point of the European Union—and that helps explain why the cost to insure against a German default has more than doubled since the summer, to $93,655 a year to insure $10 million of 5-year German debt.)

Not surprisingly, the EFSF’s last 3 billion euro bond sale, on Monday, November 7, met with what Moody’s called “significantly less demand” than a similar issue last spring. The issue was originally supposed to be 5 billion euros, and the spread, relative to German debt, that was required to lure investors was over three times the spread that was needed last spring. As Moody’s wrote in its report, “the demand for the EFSF bond issuance was dampened by a lack of confidence over the credit resilience of its guarantors.” Another way to think about this is that since the strength of the EFSF is dependent on the strength of its parts, the more individual countries have to pay to raise money, the more the EFSF itself has to pay.

In fact, it’s the definition of a vicious cycle. The EFSF’s funding costs rise along with those of its guarantors, and perversely, bond market participants say that the very existence of the facility also causes its guarantors’ cost to rise. That’s because there aren’t many investors who are interested in buying European sovereign debt these days. Those who are demand a very high premium if they’re going to buy, say, Italian debt instead of EFSF debt. This is why the EFSF was going to be hurtful, rather than helpful, if it had to be used: it competes with its very creators for investment, driving spreads higher and higher. One hedge fund manager calls the EFSF a “self-inflicted killer” of Europe’s bond markets.”

The EFSF is due to expire, and is supposed to be replaced by the European Stability Mechanism, or ESM, in mid-2013. But the ESM looks like it’s going to have same problem the EFSF does: Its finances depend on the very same countries that it is supposed to bail out. In other parts of the world, this isn’t called stability; this is called a Ponzi scheme.

The EFSF is clearly not the long-term solution to European debt woes. Only meaningful structural reforms that include growth, not just austerity, will get Europe back on track. And it's high time Ms. Merkel reconsider the idea of a real Eurobond market.

On this last point, Andreas Koutras sent me his latest, Eurobonds. Democratic Deficit:

The idea of the Eurobond as a Deus ex Machine saviour of Europe is not new. Various European leaders in distress like Mr Papandreou and others coined the idea of a single Eurobond that is going to solve all present and future problems. The problem is that everyone has a different idea of what a Eurobond is and how it would achieve saving Europe.

So let me describe what a bond is in my simple mind. It is a senior unsecured (most often) obligation (legal contract) of a legal entity that has the financial means to service the interest rate payment and repay the principle according to the schedule and covenants of the bond. Furthermore, the prospectus of the bond describes the way this legal entity is going to generate the cash that is going to repay interest plus principle.

Sometimes, this description is very vague but nevertheless it should be there, otherwise how a prospective buyer would gauge the risk and assess the ability of the entity to repay him. In addition, as Bonds or debt is senior to the equity owners of the entity, the stockholders, have to vote or (democratically) approve the taking on of debt.

In the case of an independent sovereign like most European countries would like to think of themselves this means:
1. Legal entity is the Sovereign
2. Sovereign has taxing powers over its subjects and companies in order raise cash to repay the debt.
3. The equity holders in this case are the voters who democratically elect the government (Board of directors) to tax them and raise the cash to repay the debt. This is one of the most fundamental principles of our western liberal democratic system. NO TAXATION WITHOUT REPRESENTATION.

Thus, for something to be called a proper Eurobond the three aforementioned principles must be satisfied. If not then we do not have a Eurobond but a Eurobond look-alike.

For example, lets have a look at the bonds the EFSF has issued:

The EFSF was incorporated in the Duchy of Luxembourg and has registered capital of €28,440,453.35. The shareholders are the states of Eurozone and has the right to take on debt of €440bil because the states have issued credit guarantees totalling this amount. Interestingly the Luxemburg central government seems to be exposed to the EFSF risk[1].

EFSF, thus fulfills (1) and partially (3) but not (2). In other words EFSF is a legal entity and has been classified as a “public sector entity” but has limited means to earn cash or any business activity that can generate the required money to repay the issues. The trading activity that is basically allowed to enter in is not a main business activity. In fact, as far as I can see, the EFSF has no business activity. It is just a shell company that can issue debt. Principle (3) is partially satisfied as the EFSF takes its orders for issuance from the commission (unelected body) and the IMF (not an EU institution) once the country in need has signed an MOU. EFSF has no specific statutory requirement for accountability to the European Parliament.

In other words, the EFSF bonds are not Eurobonds in my definition. It is for this reason too, that the EFSF bonds even though are AAA rated; they are trading at almost 200bp above the respective German bonds.

Real Eurobonds can exist

A real Eurobond would not just have the credit guarantees of the EZ countries but would have income from tax revenues and a democratically accountable way to spend this cash. Europeans should not allow the raising of cash and subsequent spending of it by unelected bodies or officials. Even if these officials are indirectly elected. This seems to be what is on offer currently by the Franco/German politicians. Of course this means, passing some sovereignty from the national parliaments to the European one. This is anathema to most local politicians who would see their power diminished. But it can start by having some pan-European indirect tax.

For example, a levy on tobacco, alcohol, gambling and possibly on speculative financial transactions could raise enough cash per year to support coupon payments on bonds with notional up to €1trillion or more.

Indeed, this means some form of fiscal union, but right now this is the only way forward if the EU experiment is to survive the crisis. An EU with just a monetary union and no elected treasury is no longer an option. All other solutions will be temporary and would not address the core of the problem, which is how we can build a democratic and stable union.

Democratic Deficit
Europe along with the financial deficits suffers from an even bigger democratic deficit. The European Parliament, which after all is the only directly elected European institution, has limited powers. Any bond issuance and any restrictions that do not pass through a democratic process take Europe back few centuries.

To have the commission or the European Council or Ecofin impose strict fiscal or other financial straitjackets in return for funding should be unacceptable unless it is done with the consent of the people of Europe. If Europe is to have a Eurobond then the only way to do it is for the European parliament to vote for a minister of finance and to be given certain tax raising powers. The European parliament would then decide how to spend this money and on which country. It can further impose fiscal stability rules to the country that has strayed from the financial prudency path. JC Trichet said so in his last speeches before retiring. He should have been more vocal.

A great country across the big pond (USA) was created on the premise of NO TAXATION WITHOUT REPRESENTATION. European politicians should not forget this history lesson.

Indeed, no taxation without representation, something which is lost in the European parliament where unelected Eurocrats are wasting European taxpayers' money. Watch clip below (h/t Fred).

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