Big Bazooka II–Updated!
November 17, 2011 10 Comments
The crisis has spread to the core. Not only have Italian and Spanish bond yields shot up to unsustainable levels, but Belgian, Austrian and French spreads over the comparable German bunds have risen sharply in recent days as well. If the EU, the ECB and the IMF do nothing and allow the markets to continue to drive this crisis, then the eurozone is likely to unravel in the next few months. Given that it is unlikely the ECB will step in as a lender of last resort (LOLR), the next best option for keeping the eurozone intact is to cobble together enough real, hard cash to create a Big Bazooka II.
What the Big Bazooka II should consist of
The first big bazooka, a leveraged EFSF, has clearly flopped. The last EFSF bond issue had to be delayed for concern about lack of investor interest, and when the bond auction was held it brought elevated yields. Investors were underwhelmed by the fancy financial engineering EU leaders used to create value out of a series of guarantees. A new Big Bazooka II must therefore consist of real, hard cash.
To be effective, the Big Bazooka II needs to be sufficiently large to take Italy and Spain out of the markets for three years in order to give the new governments in each country a chance to implement structural reforms and to have those reforms finally support growth. According to Citibank estimates, Italy and Spain’s financing needs in 2012-14 are around €1.3trn.
The new big bazooka would probably also have to support Ireland and Portugal in the markets once their bailout programmes expire in 2013 (Greece’s bailout programme lasts into 2014, and in any case I think Greece will have defaulted and left the eurozone by then). The borrowing costs for Portugal and Ireland minus the funding still available in their bailout packages amounts to around €60bn. Consequently the new big bazooka would ideally need to be around €1.4trn.
What the Big Bazooka II might consist of
Can eurozone leaders cobble together this kind of funding? Not quite, but they could put together enough cash to leverage the EFSF in a credible way. Through a combination of IMF funds, New Arrangements to Borrow (NABs), special drawing rights (SDRs), the EFSF and the ECB’s Securities Markets Programme (SMP), EU leaders could create a bailout fund worth around €600bn. Much of this is based on a bailout that was nearly agreed at the G20 summit in Cannes in early November. Here’s the break-down:
- The IMF has about €290bn as Forward Commitment Capacity (FCC). On top of this, the IMF can boost its quota resources through New Arrangements to Borrow (NABs). There are already €235bn in NABs included in the FCC. The NABs can be increased to a total of €420bn, which would bring the FCC up to a total of €460bn. The IMF lends to countries and not to facilities, so this pool of funding would have to go directly to member states. In theory, all eurozone member states could borrow from the IMF and then invest the funds in the EFSF. However, it is unlikely countries like Germany would be willing to borrow at punitive rates from the IMF in order to then take on a degree of credit risk by investing in the EFSF. Furthermore, the last thing most eurozone countries need is more loans at high interest rates. It is therefore more likely that only Italy and Spain will borrow from the IMF. The amount of financing a member state can receive from the IMF is based on the type of programme and the country’s quota. Flexible Credit Lines have no lending limit, but are for countries with “very strong fundamentals”. The IMF has considered expanding this programme but has already stipulated that Italy would not qualify. Under Stand-By and Extended Arrangements, a member can borrow up to 200% of its quota annually and 600% cumulatively. If Italy and Spain borrow 200% of their quota annually for three years, they could borrow around €83bn. This is just under one-fifth of the total FCC, a level that emerging market countries would probably still find politically palatable despite their aversion to using IMF contributions to support relatively rich Europe.
- The IMF could allocate additional special drawing rights (SDRs) to a big bazooka. Technically, contributor countries to the IMF can create SDRs at the stroke of a key, but there is a ceiling on this in the form of the US congress. If additional SDRs exceed US$250bn (€185bn), the US administration must have its portion approved by Congress, which would be extremely unlikely given that the US is on the precipice of its own double dip recession. Of this $250bn, only proportion would be allocated to the EZ to allow non-EZ countries to tap SDRs. It is reasonable to assume that the EZ could gain access to around 24% of the additional SDRs, in proportion with the EZ’s total share of IMF quotas. This would amount to around $60bn (€45bn) in additional SDRs.
- The eurozone could pool its existing US$60bn (€45bn) in SDRs to invest in the EFSF special purpose vehicle (SPV), guaranteeing first losses on bonds.
- The EFSF has around €250bn in funds remaining in it, excluding what has already been allocated to the Greek, Irish and Portuguese bailout programmes and to eurozone bank recapitalizations.
- The ECB could continue to purchase bonds in the secondary markets through the Securities Markets Programme (SMP). It seems reasonable to assume that the SMP could purchase up to 10% of Italian and Spanish GDP, as per the upper limit of credit lines permitted under the EFSF guidelines(top of p.9). While we don’t know the exact composition of debt the ECB has purchased through the SMP, I estimate that the SMP could pick up around €160bn more in Italian and Spanish debt to reach this upper limit.
The approximately €600bn cobbled together would only cover Spain and Italy’s funding costs through the first quarter of 2013. However, these funds could be used to significantly decrease Italian and Spanish bond yields in the markets. First, SMP purchases would push down both countries’ borrowing costs. Second, the SDRs and EFSF funds could be used to guarantee EFSF first losses. A first loss guarantee scheme for the EFSF failed previously, but there are two key differences with this Big Bazooka II. First, there is real cash on hand to leverage the EFSF that could be used if necessary. Second, there is enough cash to cover around 30% first losses, compared with the meager 20% first loss guarantee that was previously on offer.
Could it work?
A Big Bazooka II could work in theory, but there are a number of potential impediments. The biggest likely spanner in the spokes is political. The plan to use the IMF and SDRs to create a bazooka for the eurozone was already on the table at the Cannes G20 meeting in early November. The Bundesbank rejected it resolutely because it did not want to accept any kind of credit risk to its balance sheet. The credit risk that Germany would have to accept is the same in this proposal as it was at the G20 meeting. The big difference is that there is now a credible threat that Italy will be forced to restructure its debt, whereas that threat had not yet materialized two weeks ago. The IMF may also decide that it is not within its mandate to tape and glue the eurozone back together again.
There are a number of economic risks with this plan as well. If Italy and Spain do not succeed in implementing harsh structural reforms and growth is not restored by the end of 2014, then both countries would have a difficult time returning to the markets. Even if structural reforms are executed, both countries could find themselves in the negative austerity-recession feedback loop from which Greece currently suffers. With GDP falling and Italy and Spain taking on bridge loans for the next few years, both countries could come out of the programme looking more insolvent than they did when they entered it. If Italy and Spain lose market access, default and eurozone exit would be likely.
Furthermore, a Big Bazooka II would do little to accelerate the process of internal devaluation or Italy and Spain’s return to competitiveness and growth. It could take Italy and Spain a decade to finally regain competitiveness, and there is a chance that, faced with the choice between a decade of austerity and recession or eurozone exit, they might choose the latter.
Investors might shun the EFSF even if there is hard cash on hand to provide 30% first loss guarantees. This could occur if there is a credit rating downgrade of France and Austria, which would probably result in the EFSF losing its AAA status. If the EFSF is rated AA, this would not be a deal-breaker. However, credit ratings downgrades are a slippery slope and if the crisis were to continue to spread to the core, one downgrade could easily lead to others. Investors might also shun the EFSF if there is significant social unrest. In Italy, this could be sparked by anger over the democratic deficit, with a technocratic government pushing through a number of very painful austerity measures. In Spain, this could be sparked by a youth unemployment rate exceeding 40%.
Considering all of the potential pitfalls of this plan for a Big Bazooka II, I wouldn’t hold my breath for it to work. However, the alternative is a series of debt restructurings and eurozone exits. If there is even the slightest chance a Big Bazooka II could succeed and if eurozone leaders are sincere when they say they want to keep the euro area together, then this plan certainly deserves a shot.
UPDATE: On November 22nd, the IMF announced a new Precautionary and Liquidity Line (PLL) for countries that have strong fundamentals but due to external shocks are facing a liquidity crisis. Accessing a PLL would not involve accepting the strict conditionality required by the Stand-by and Extended Arrangements. Borrowing from the PLL is capped, unlike for the Flexible Credit Line that also comes with no conditions. For 6 month progammes a country can borrow up to 500% its quota and for 24 month programmes a country can borrow up to 1000% its quota.
Is this a game changer? Hardly. For starters, this is not new news. Alan Beattie broke this story three weeks ago in the Financial Times. It is unclear whether Italy or Spain would even qualify for the PLL, as IMF head Christine Lagarde said they would not be eligible for the similar Flexible Credit Line. If they did tap the PLL, Italy could borrow up to around €90bn and Spain around €45bn for a total of €135bn. This would be instead of the scenario I described above, in which Italy and Spain would borrow a combined €83bn in a Stand-by or Extended Arrangement. The PLL would give Italy and Spain access to more funds, but the difference is by no means a game changer.