European policymakers are moving towards a plan that would enable the eurozone’s €440bn rescue fund to insure investors against some losses on government bonds, arguing it presents the fewest legal and political hurdles to increasing the fund’s firepower quickly.
Officials have focused on the insurance plan after European Union legal staff determined that other proposals - including turning the fund into a bank so it could gain access to unlimited funding from the European Central Bank - were not allowed under EU regulations. Jean-Claude Trichet, the ECB president, and senior German officials have also objected to plans that would lean on the ECB for financing, arguing it is not the central bank’s role to provide funds to an agency that many envision as a nascent eurozone treasury.
“The [ECB] governing council does not consider it to be appropriate for the ECB to leverage the [fund],” Mr Trichet said last week. “We believe that governments have all necessary capacity to leverage the [fund] themselves.”
Jean-Claude Juncker, the Luxembourg prime minister who heads the group of euro finance ministers, said after their most recent meeting that plans involving the ECB had largely been ruled out.
The insurance plan
Under the insurance plan, the eurozone fund, formally known as the European financial stability facility, would guarantee 20-40 per cent of losses on bonds for struggling eurozone countries, particularly Spain and Italy, instead of buying them, as the ECB does. Depending on how high the guarantees are, such a scheme could leverage the EFSF’s resources to between €1,000bn ($1,382bn) and €2,900bn, the latter proposed by German insurer Allianz.
“Issuing partial guarantees is signalling euro-area countries consider Spain and Italy to be fundamentally solvent and are willing to put their money where their mouth is,” said Sony Kapoor, head of economic consultancy Re-Define and one of the first to propose such a scheme.
Plans on how to use the fund’s limited resources more broadly have been debated for weeks, but officials are hoping to decide on a single scheme at a summit next week.
Analysts argue up to 4,000 bn need
When it was unveiled, the EFSF was viewed as a temporary firefighter in peripheral eurozone countries such as Greece. But if Slovakia signs off later this week, as expected, the fund will soon be used to shore up faltering eurozone banks and prevent runs on sovereign bonds of some of Europe’s largest economies.
Analysts have argued the EFSF needs anywhere from €2,000bn to €4,000bn for the new roles. Because more cash cannot be poured into the fund without threatening triple A debt ratings of countries such as France, officials have agreed to “leverage” the fund’s current assets instead.
Some fear that even with the new insurance plan, the EFSF’s resources will still be too small, particularly given moves to recapitalise banks costing as much as €200bn and the vast size of the Italian bond market.
Allianz: leverage up to 2,900bn Euro
A version of the proposal by Allianz, the German insurer, calculates that the €780bn of government EFSF guarantees - the total committed by national capitals in a complex formula so that the fund can lend out €440bn - could be leveraged up to about €2,900bn. The Allianz plan suggests investors in Greece, Ireland and Portugal be insured against the first 40 per cent of losses while those in Italy and Spain would be protected against 25 per cent.
Mr Kapoor’s plan is more limited, proposing only tapping the €440bn the EFSF actually can spend and guaranteeing the first 20 per cent of losses for one year. Given that the average bond maturity for Italy is about seven years, that could increase the leverage even more if yields of all bonds converged.
“The clever thing about using guarantees is you are giving your word but you don’t have to hand over any money,” says Gary Jenkins, head of fixed income at Evolution Securities.
Difficulties remain, including which countries are covered in the guarantee scheme. Thus far, the focus has been on five so-called “peripheral” countries - the three currently in bail-outs, plus Spain and Italy. But Belgium’s 10-year bond yields have risen to 4.26 per cent in recent weeks, not so far from Spain’s 5.10 per cent.
Another potential danger is in guaranteeing too many countries, particularly since the €780bn behind the EFSF includes big guarantees from Italy and Spain. “It is like you are guaranteeing yourself,” says Mr Jenkins.
Indeed, the financial firepower currently in the EFSF is already lower than the headline €440bn. Greece, Ireland and Portugal have all “stepped out” of the EFSF, lowering its funding by €30bn.
In addition, the EFSF is committed to lending Ireland and Portugal €44bn as part of their bail-outs and is likely to be on the hook for about €100bn in Greece’s next bail-out, meaning the amount it has to leverage is only about €250bn.
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