Euro symbol by the European Central Bank headquarters. Image by Getty.
When the idea of leveraging the European Financial Stability Facility to increase its firepower was touted as the solution to the European sovereign debt crisis at the International Monetary Fund meetings last weekend, markets rallied sharply. They saw this (rightly) as the first sign of a policy initiative which might actually be large enough to get ahead of the deteriorating crisis. But I commented here on Sunday that there was no real indication that Germany was ready to embrace the scheme and, sure enough, Wolfgang Schäuble, finance minister, yesterday described the approach as “a silly idea” which “makes no sense”.
Germany’s public opposition to increasing the size of the EFSF may be partly tactical, given tomorrow’s key vote on the fund in the Bundestag. But it is also based on a crucial sticking point. The strong economies fear that increasing the size of the fund would result in them losing their own triple A status and they have consistently given a greater weight to these costs than to the less certain, but potentially much larger, costs of a euro breakdown.
Therefore the key question is whether the EFSF leverage plan would overcome this obstacle. In my view, it does not, but it changes the trade-off. A leveraged EFSF would increase its chances of solving the crisis, but only at the risk of increasing the long term fiscal transfers which Germany and the other strong economies would have to make if things went badly wrong.
There are many versions of the plan under discussion, but they all boil down to two basic options. Both of these would involve using what is described, in hedge fund parlance, as “OPM” – other people’s money. In the first option, the OPM would come from foreign sovereigns like the BRICs, and maybe some private investors. In the second, the OPM would come from the European Central Bank, which would print money to fund the larger EFSF.
The first version would turn the EFSF into a kind of giant CDO fund. (Yes, I know that the debt problem was caused by giant CDO funds in the first place, but these are desperate times.) This fund would raise money by issuing notes, perhaps to the overall value of (say) €1,500bn. The senior notes would be protected by the member states, to the tune of the promised €440bn. The remainder would be funded by other investors, who would be induced to make the investment by the fact that the first €440bn of any losses incurred by the entity would be covered by the member states, thus making their own investment theoretically less risky. All the money raised by the leveraged entity would be available for recapitalising European banks and buying troubled debt.
Would this arrangement attract a large amount of extra money from the likes of the BRICs? That depends on the terms. After all, the BRICs can already build for themselves a very similar portfolio of risks by buying German and Italian bonds in similar proportions to the first and second tranches of the leveraged EFSF. In order to induce their participation, they would need to be offered a better deal than they can currently get in the bond market. This would require a larger guarantee, primarily from Germany, than is available as part of the €440bn tranche.
This immediately means that Germany would be increasing the size of the potential fiscal transfer which it is underwriting. It is true that Germany would not initially have to increase its guarantee pro rata to cover its share of the entire €1,500bn, but what if things started to go wrong? If the market value of the troubled debt purchased by the EFSF started to fall (as it has done repeatedly in the case of Greece), the strong economies would have to increase the scale of their guarantees to the EFSF to stop the fund facing melt-down. This, remember, is what happened to a lot of CDOs when the value of mortgage securities plummeted in 2008/2009.
Would the involvement of the ECB alleviate this problem? Only up to a point. In the simplest version of ECB involvement, the EFSF would turn itself into a bank, and would use its bonds as collateral in repo borrowings from the ECB. The ECB would be protected from losses by holding this collateral, which in turn would be partly protected by the original €440bn on offer from the member states. If the bluff worked, the money might never be needed, as the confidence of private investors might be restored.
But this could all go very wrong. In the case of rising default risk in Italy or Spain, the ECB might still suffer losses, and member states could ultimately be forced to recapitalise their central bank. The burden would mainly fall on the stronger economies, increasing the eventual fiscal transfer from Germany and others.
It is true that both the US Fed and the Bank of England have gone down precisely this path and no-one seems to worry very much about that. In a single nation state, the ECB would be likely to follow suit, since the problem of cross-border subsidies via the balance sheet of the central bank would not exist. But in the eurozone, it does exist. Furthermore, the board of the ECB seems to view such activities as contrary to the treaties. Nor does it see the case, on monetary policy grounds, for a massive dose of QE at the present time.
The use of Other People’ s Money is always appealing, which is why the option of leveraging the EFSF has been put on the table. But it is inescapable that upside and downside risks would both increase, as always happens when leverage is used. Germany still looks very reluctant to assume these risks.
Related reading:
Fear and loathing in the eurozone – Martin Wolf, FT
Rolling coverage of the eurozone crisis – The World, FT blog
