There are many remarkable aspects of the most recent plan to resolve the European debt crisis. The first is the belief that it can be done with euro zone countries not committing one additional euro. The second is the use of discredited financial techniques that exacerbated the global financial crisis to enhance the European bailout fund. The third is the resort by rich developed countries to emerging nations to finance the bailout.
The euro zone proposal is that an enhanced European Financial Stability Facility (EFSF), Europe’s bailout fund, will provide loans to or purchase bonds issued by beleaguered member states to support the ability of these weaker countries to raise fund at reasonable rates.
The most recent plan does not increase the €440 billion size of the EFSF, because of the unwillingness of euro zone members to commit any new funds towards the bailout. After factoring in funds committed to bailout, the EFSF has unused capacity of €200-250 billion, insufficient for the task. Over the next three years, Spain and Italy alone will need to raise around €1 trillion to meet their financing requirements.
In order to enhance the capacity of the EFSF to around €1 trillion or more (effectively increasing it by four or five times), one proposal under consideration is to leverage the fund. Under this plan, the EFSF would guarantee losses on new bonds, up to an unconfirmed amount of around 20%. It is unlikely that the insurance scheme will achieve its intended objectives to support market access for and the lowering of borrowing costs of countries such as Spain and Italy.
Bondholders will still look to the issuer and assess its solvency and ability to meet its obligations. If losses turn out to be above the insured loss amount then the investor would be at risk. Technical details such as the trigger for the payment, how loss is to be determination and payment mechanism are complex. If the insurance applies only to new issues, it may create a two-tier market—one for existing bonds and the other for the new insured securities. As this partial risk insurance may be offered to private investors as an option when buying bonds in the primary market for a price, it is not clear why it would be preferable to alternatives already commercially available.
An alternative option under consideration entails the EFSF raising money from emerging countries such as Brazil, Russia, India and China (BRICs) or their sovereign wealth funds. The funds raised in combination with the EFSF’s own money would increase its resources to the targeted level, increasing its ability to intervene.
Emerging countries have been cautious in their response. To date, the Chinese position has been that Europe must get its house in order first and then China will assist. The current European position is different—China must give money to Europe to help get its house in order.
The emerging countries have a lot at stake. Continuation of Europe’s debt problems will have serious effects on their economies and investments. Europe is an important trading partner. A portion of precious foreign exchange reserves are invested in euros and European government bonds.
But it is not clear that the European proposal has sufficient chances of success to encourage the emerging countries to commit their hard earned treasure to rescue Europe. This is so especially as relatively wealthy European countries, such as Germany and France, are unwilling or unable to put up more money to the rescue plan.
The BRICs also face domestic problems—inflation partly as a result of the weak currency policies of the developed nations and attendant wage pressures that are reducing its competitiveness, bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. Their flexibility to act may be limited.
In any case, contributions from emerging countries, expected to be around €100-200 billion, are small relative to the total requirements. As their foreign exchange reserves have risen in recent years, these countries have purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF.
These purchases have not prevented peripheral European bond yields rising.
Any involvement would probably require additional support from the euro zone countries, which may be opposed by Germany and other countries. Emerging countries such as China, are inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.
Concerned about currency risk on its foreign exchange reserves, China has indicated that it might denominate any funding in renminbi. Other nations may also follow suit in their respective currencies.
The idea is dangerous, as Europe would incur currency risk, for example, becoming exposed to an appreciating renminbi, adding to its problems.
The entire proposal highlights the deep seated problems of the euro zone, the continued belief that debt can be used to solve the problem of excessive borrowing and the increasing shift in economic power in the global economy. The trouble is, even if implemented, it probably won’t work.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk
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