Sunday, April 3, 2011

Towards financial stability in the Euro Area

The European Summit held over March 24th and 25th ratified the creation of a permanent financial stability facility. Beginning in mid-2013, the European Stability Mechanism (ESM) will replace the European Financial Stability Fund (EFSF). The ESM will have a lending capacity of 500 billion Euro, backed by guarantees and cash.

However, the summit failed to endorse the full 440 billion Euro lending capacity of the EFSF. Elections in Finland due mid-April will delay the signing of this agreement until the next Summit in June. In the meantime, the EFSF will remain sufficient for a bailout of Portugal, but further emergency measures would be required if another country (e.g. Spain) were to require assistance.

The ESM has been established to finance EMU countries who get get themselves into financial difficulty. It will be activated by mutual agreement of the member states to preserve the stability of the European Monetary Union (EMU). Each Euro Area member has a right of veto. Mutual agreement is also required on the key components of any assistance including: whether or not financial assistance is granted, the terms and conditions of the assistance and the size of the loan.

From June 2013, Collective Action Clauses (CAC) in all new bond issues will allow for the possibility of public debt restructuring. How this will work will not be determined until later this year. The participation of the private sector in resolving financial crises via the restructuring of debt will occur when a country is deemed to be insolvent. Whether a country is insolvent will be based on analysis of the sustainable level of public debt undertaken by the European Commission and the IMF in liaison with the ECB.

That's all fine for debt issued from 2013, but what about Greece? We have said all along that we believe there will be a restructuring of unsustainably high debt levels in Greece, and this may have to happen prior to 2013. In the meantime we would not be surprised if Greece has to request further assistance as it's initial 110 billion Euro package is used up.

Progress was made around what is now called the "Euro Plus Pact". This is the third iteration of what started life as the "Pact for Competitiveness" a few Summits ago. Importantly, the member countries of the EMU (and a handful of others) have agreed to take on EU budgetary rules into domestic legislation. While this will take time to implement and the nature of the legal form is up to individual states, the criteria include a brake on debt, and rules on the primary balance and expenditure. This is a significant breakthrough and is an important step towards fiscal convergence across Europe.

There is no doubt this is a painfully slow process and at times the problem has almost got away on the politicians, but this latest outcome gives some hope that an enduring solution is in the making.