The Spanish bailout has triggered a big ongoing debate on the issue of seniority for public creditors. Certain commentators and market actors claim that it is because the European Stability Mechanism (ESM) sees itself as a preferred creditor that the announcement of a Spanish bailout has led to rising spreads. They say that seniority means that once the ESM comes in, it reduces the effective claims of the private bondholders in the event of a restructuring.
This piece exposes the flaws in this thinking both in the general case and more particularly in the case of Spain. We conclude that if the EU wants to rescue Spain, the trick is not to remove seniority from the ESM but 1) to remove all uncertainties around the future of the Eurozone 2) make conditionality more growth friendly 3) channel the bailout directly to needy banks without going through the sovereign.
Note: This is an English Version of my Op-Ed Riesig groß und doch zu klein that appears in the Financial Times Deutschland on the 26th of October
Last year we proposed that the EFSF offer bond guarantees not loans, eliminating the need for it to first borrow and then lend, cutting extra costs. Retaining market access, albeit with EFSF support, could provide useful feedback on reforms and help countries get back on their feet faster.
Facing headwinds on the expansion of the EFSF necessary to restore confidence, we suggested, in January 2011, that the EFSF could resort to partial guarantees to increase effective size. Rather than lend Euro 10 billion to a country facing high borrowing costs, the EFSF could cajole sceptical lenders to lower their rates by offering them credit protection – say up to a third of the borrowed amount. The same amount could support Euro 30 billion of lending. Magic?
The EFSF is supported by the 17 Euro area Member States who have guaranteed to repay any of its liabilities up to a maximum of Euro 726 billion with each country offering a percentage of this. Germany’s share of the guarantee is Euro 211 billion and France’s is Euro 158 billion. Because a decision was taken that the EFSF would seek an AAA rating its capacity is limited by the amount of guarantees it has from AAA rated member states which is only Euro 440 billion.
This is enough to support Greece, Ireland and Portugal which are all small but not Spain and Italy which are also now facing unsustainably high borrowing costs. There is ZERO political will amongst member states to increase the size of their support for the EFSF so the challenge is to find a way of increasing its effective firepower without increasing MS support. The only way of doing this is to increase the RISK that the EFSF takes. One way of thinking about this is that now that MS have promised Euro 440 billion which they had intended to be used as ‘debt’ which is relatively safe and turn this into ‘equity’ which is far more risky. The size done not change, but the risk goes up.
This is an excerpt from Building a Crisis Management Framework for the EU that we wrote for the Crisis Committee of the European Parliament and then presented at the European Commission. Much of the discussion in this paper remains highly relavent and provides a useful guidance to policy makers about what they need to do after stemming the panic in the markets so you would want to read it.
Despite the fact that the discussion of the euro area crisis has focused primarily on issues in the sovereign debt market, it is instructive to remember at the outset that this crisis is not primarily a sovereign crisis but one that originated in the private financial sector. As often happens in credit crises, private sector debt is taken on to public balance sheets which makes them fragile and can, as in this case, result in serious dislocations of the sovereign debt market.
Re-Define commentary on the statement from the Euro Leaders' Summit
We reaffirm our commitment to the euro and to do whatever is needed to ensure the financial stability of the euro area as a whole and its Member States. We also reaffirm our determination to reinforce convergence, competitiveness and governance in the euro area. Since the beginning of the sovereign debt crisis, important measures have been taken to stabilize the euro area, reform the rules and develop new stabilization tools. The recovery in the euro area is well on track and the euro is based on sound economic fundamentals. But the challenges at hand have shown the need for more far reaching measures. (Re-Define Comments are in italics. For Press Release Click Here and for a PDF version of this commentary Click Here.)
The recovery in the Euro area is not well on track and in fact remains very fragile with some possibility of a double dip. Moreover, our banking system remains weak both in terms of structural maturity mis-matches in funding and capital adequacy.
We may have better economic fundamentals than some other economies at an aggregate level but our decision making has been exposed as being far too slow and has seriously dented our credibility.