Putting an F into EMU?
10 May 2010
After weeks of prevarication, which had handed the initiative firmly to the markets, the weekend saw the euro area finally get ahead of the curve, agreeing to adopt a package totalling €750bn aimed at leaving markets in no doubt that policymakers will do whatever it takes to preserve the euro. In particular, EU Finance Ministers and central bankers agreed:
• A new European Financial Stabilisation mechanism. This consists of €500bn (€60bn of EU funds, and a new €440bn debt guarantee facility provided by euro area governments) that can be accessed by countries faced with financing difficulties. This €500bn is supplemented with up to €250bn of funds from the IMF.
• Bond purchases by the ECB. Having not even discussed the measure at its regular policy meeting last Thursday, the ECB has jumped into action and has begun buying public and private bonds “to ensure depth and liquidity in those segments which are dysfunctional”. This is direct intervention to reduce the cost of government borrowing, not QE to boost the money supply – the ECB has said that it will sterilise the purchases to ensure that they does not undermine monetary policy. However, given that the ECB also committed to providing unlimited liquidity, this sterilisation is more of a medium-term consideration.
• Unlimited liquidity for European banks. The ECB also postponed its planned exit from its “special liquidity measures”, re-introducing its crisis strategy of providing unlimited long-term liquidity, with a 6-month operation scheduled for this Wednesday, and a fixed rate to be applied at the regular 3-month operations scheduled this month and next.
• Additional budgetary cuts. Spain and Portugal have committed to taking additional fiscal tightening measures in 2010 and 2011.
• Dollar swap lines. The G7 agreed to reactivate the dollar swap lines it introduced during the crisis.
The euro area has therefore belatedly faced up to reality, jettisoning concerns over moral hazard, and pulling out all the stops to insulate Portugal, Spain, Ireland, etc – and, by extension, Europe’s banks – from events in Athens and febrile markets.
So, will it work? Markets clearly seem to be impressed, with stock markets surging and bond yields in the peripheral countries that were most under pressure falling very sharply. The one risk appears to be in gaining parliamentary approval in some countries for the €440bn of loan guarantees. However, the €60bn of new EU funds and approximately €250bn of specially earmarked IMF money, if required, amounts to a pretty hefty war chest by itself and could be disbursed with relatively little ado. But, most crucially, by actively getting involved in the bond market, the ECB has completely changed the dynamic – this morning, Greek 2Y yields have declined more than 1300bps from Friday’s close, while Portuguese, Spanish and Italian bonds have also rallied. For now, the euro area’s policymakers appear to have saved the single currency.
Lots of unknowns remain, however, including the scale, maturity and origin of the bonds to be purchased by the ECB. And the new package cannot on its own guarantee a happy ending for the Greek government or its bondholders. After all, if the Greek economy and social fabric further fray and the reform programme goes badly off track over coming months, debt restructuring might be back on the radar. However, policymakers have certainly provided some much-needed breathing space for Greece and the other periphery governments to tackle their public finances. They will have also inflicted deep wounds on market participants who, by shorting periphery bonds, had actively questioned their determination.
And from a longer-term perspective – by establishing programmes of government debt guarantees and central bank purchases of government bonds – euro area fiscal policy, including its relationship with monetary policy, has been transformed from that intended by its founding fathers. Many commentators in the run up to the creation of the euro said that EMU could not survive without fiscal union – the weekend’s events have moved fiscal federalism a large step closer. Indeed, with the European Commission working up proposals to ensure fiscal sustainability in the euro area, and some euro area governments sympathetic to closer fiscal cooperation, it may not be too long before we have to add an ‘F’ for ‘fiscal policy’ in EMU.
Chart 1: Greek sovereign yield curve
Source: Bloomberg
Chart 2: Euro area periphery sovereign spreads*
*2Y sovereign yields minus German 2Y yields. Source: Bloomberg
Chris Scicluna, Deputy Head of Economics
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