Euro zone bailout plans: origin and utilization

Economists, medias and politics are not really specialists in transparency and pedagogy, to explain the European sovereign debt crisis. it is said that above all, there is a need for reassurance, as the growth and development catalyst is confidence into the system. Actually, the growth and development catalyst is to instigate confidence to the economic agents, that means a strong credibility from the political and economic leaders. For instance, what is the purpose of doing stress-tests on the banking system, as it was done last year, concluding that fundamentally it is globally fine and spending time to recapitalize Irish banks and Spanish savings banks in the next months.

The best example of lack of transparency and pedagogy remains the confusion about bailout plans and the tens of billion Euros for a year now, to fulfill in the short-term the liquidity cases noticed in several countries of the euro zone (and not intended to solve their structural solvency cases)

We need to know that the euro zone insolvent countries are in this situation, because their economic expertise cannot generate any external surplus (no specialization in the export industries, but economies exclusively specialized in non-exportable services); the public or the private sector or both are therefore structurally indebted

By setting up solutions to maintain liquidity, the crisis is just delayed in time. It is therefore necessary to rethink about the solutions to end the crisis and consider structural issues:

• Policies aim to improve the potential growth (long-term issue)
• Implement a true fiscal federalism (politically difficult);
• Debt restructuring or partial defaults (to minimize systemic risk)
• Exit from the Euro Zone for some countries (electorally rewarding, but economically suicidal)

Let’s have a quick overview on these bailout plans since May 2010

The euro zone insolvent countries are in this situation, because their economic expertise cannot generate any external surplus the public or the private sector or both are therefore structurally indebted

Mory Doré

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GREECE MAY 2010

The European Union and the IMF grant a total amount of 110 billion € spread over three years and refundable at the beginning in five and a half years. Naturally, this support is conditional to the implementation of a restrictive fiscal policy and a growth policy to create the conditions for a greater competitiveness (How ? we still do not know about it)

The financial conditions initially set at 3-Month Euribor + 300 bp for the maturity below three years and at 3-Month euribor + 400 bp for the maturities above three years will soon become unsustainable for the Greeks finances; ie the cruel lack of solvency from the Greek government, then again, the rates and margin levels were not usurious (even with the 50bp flat commission extra to pay)

Thus since March 2011 pricing conditions have been revised downwards with a small margin of 100bp and the bond maturities have been extended to seven and a half years. Clearly, this is a near-bankruptcy situation that we try to solve using liquidity backing and through adjustments of the assistance granted.

We will see that it is the same scenario played over again today by studying a bit more advanced issues, with the same goal of delaying in time the problems. Why not for those cynically thinking that by then (When exactly, nobody knows), they will not be in control or naively thinking that new growth vectors will be find to generate tax revenues (as if this growth is decreed)

IRELAND NOVEMBER 2010

The Irish bailout plan had a total of 85 Billion €. 35 billion € destined to the Irish banks recapitalization, which succeeded the stress tests regarding their solvency four months ago (surprising, isn’t ?). From this amount, 10 Billion € should be used immediately to secure the country major banks and 254 billion € should be backed by a reserve fund. We can say that at the end of march 2011, this reserve fund will be fully siphoned since we will discover (or rather will pretend discover) that the country four major institutions Allied Irish Bank, Bank of Ireland, EBS and Irish Life need an extra 24 billion €. Customized stress tests will show that actually the four banks cumulative losses could reach 24 billion € in a standard scenario and 27.7 billion € in worst case scenario.

All that, without taking into account the toxic assets hold by the Irish banks , that should be transferred to a defeasance structure called NAMA by the end of 2011.

The remaining 50 billion € will allow the Irish government to cover the huge budget needs. More frankly, that means, as for Greece, meeting loans repayments for the 2 to 3 next fiscal years and attenuating last year huge budget deficit (estimated at 32% of 2010 GDP).

As for the Greece, the allocation of this 85 billion € bailout required some conditions: one hand, restructuring the banking system, and in the other hand an adjustment of the fiscal policy with 10 Billion Euros restrictions in spending and generating new revenues of up to 5 Billion €.

To avoid unsustainable interest charges for the country, the financing conditions have been upgraded: average rate around 5.8% annually.

PORTUGAL MAY 2011

In the case of Portugal, the bailout plan covers 78 billion € made over a period of three years , with a flexible redemption period between 4 years and half and 10 years.

The IMF will lend 26 billion € to customary conditions of the institution, ie the interest rate of special drawing rights plus a margin (to the market conditions of May 9, 2011, effective date of the signing of this plan, the rate was around 3.5%).

The European Union will lend the 52 billion € remaining as part of the EFSF (European Financial Stability Fund) with an interest rate indexed on 3-month-Euribor: margin of 200bp for the loans with maturities below 3 years and 300bp beyond.

Naturally, this assistance is also right there conditioned to the implementation of a real budgetary and fiscal discipline and structural reforms necessary for boosting the economy. As for the other two countries, we remain on this conditionality to the statements of principles since the European institutions still stumble on the following contradiction: a common monetary policy and many fiscal policies as the number of countries making up the monetary union.

As with the Ireland case, these assistances are not only used to cover the government budgetary needs( and mainly the repayment of debt annuities for the three fiscal years to come)but are also used to recapitalized a banking system in a bad way. Therefore 12Billion € will strengthen the Portuguese banks equities and 35 Billion € government guarantees will be planned on banking bonds issuances programs.

RE-GREECE JUNE-JULY 2011

Obviously the 110 Billion € of May 21010 (not yet fully released, we will see) are not enough. It’s always like this and it is not without reminding us of the banks recapitalization continually revised up during the financial crisis of 2007-2008. remember these American investment bankers leaders who came to show to analysts and shareholders the amounts of assets impairments and therefore the needs for their institutions to be recapitalized..and returning the week after to explain the need to multiply by 2 or 3 the estimates made several days earlier

For Greece, it’s the same and the lack of credibility of the European Union political leaders is comparable to the investment banking CEO in the subprime storm 3-4 years ago

We have just "discover" that the additional financial needs of Greece compared to what was estimated when the plan in May 2010 were about 120 Billion € until 2014.

Then we worry and redo the calculations: 20 Billion to 30 Billion privatizations (50 Billion look unrealistic); the official voluntary roll of Greek paper annuities by investors for about 20 billion; So it fails at around 80 Billion €. That’s about the amount that is currently under discussion between the troika EU, IMF and ECB and the Greek authorities, with a very strong media coverage of the new draconian austerity plan to be approved by the Greek parliament by June 30.

Either one is unable to estimate even roughly the budgetary needs of the state we're leading and then it is worrying, or we deliberate underestimate the deficits and therefore these needs, so that is very serious.

Mory Doré

Nevertheless, the lessons to learn about these successive and especially the evolution of the Greek situation are not there to raise our political leaders profile : for one of two things, Either one is unable to estimate even roughly the budgetary needs of the state we’re leading and then it is worrying, or we deliberate underestimate the deficits and therefore these needs, so that is very serious.

In any case, these brief reminders do not appear to us unnecessary to put some order in the understanding of what MoneyWeek call rightly the subprime sovereign. A reading of these successive bailout plans beyond the academic debate on the liquidity, the solvency, the necessary reform of the Euro Zone, the possible restructuring of certain sovereign debts, a number of simple questions and common sense are arising and coming back frequently.

 First Set of questions: Where are all those billions from ? How the money is finally distributed to the states rescued ?

 Second question : those billions are they enough to resolve the solvency problem of the states involved ?

 Third question : Those billions are they protected the banking system of these countries in the case of emergency recapitalization needs ?

WHERE ARE THOSE BILLIONS FROM AND HOW THE MONEY IS FINALLY DISTRIBUTED TO THE STATES RESCUED ?

In fact these sums could only come from three sources

 First, it could be created by the reserve bank. On these bailout plans, this source was not used. The European Central Bank has issued papers to buy government securities peripheral countries in need but not only it was not new money, since these purchases were for the most part, carried out on the secondary market; and furthermore, there was no quantitative easing itself, since these purchases resulted in sterilization of the money supply( that is to say the monetization of debt devices has been offset by withdrawal of liquidity from the central bank). In total, the ECB has purchased since June 2010, 75 Billion € of debt device without additional quantitative easing, thus maintaining almost unchanged the size of its balance sheet. This can be compared to what happened in the United Kingdom and the United States: 200 Billion GBP purchase of Gilts by the Bank of England since March 2009without sterilizing the money supply; 2300 Billion USD of Treasuries and other securities purchased by the FED, again without sterilization (1700 Billion of quantitative easing between March 2009 and September 2009 and 600 Billion between from November 2010 to June 2011)

 Second source in turn used to finance the bailout plans, the mobilization of ressources borrowed with the development of new vehicles.

To this end , the European Fund for financial stability(EFSF) created in May 2010 is a private company based in Luxembourg, whose shareholders are precisely hte 16 states in the Euro area. To receive the triple A rating, 100 € issued must be guaranteed by 120 € (enhancement mechanism), which means that the 440 billion € of guarantees allow to issue only 83% of this amount, ie 365 Billion € (less today since we should exclude the guarantees provided by the states rescued and the amounts previously issued to finance the bailout plans).

The European Financial Stability Mechanism(EFSM) should take over from EFSF from mid-2013. The effective lending capacity will be 500 Billion € for 700 Billion € of Capital, thus providing a potential cushion of 40% with ease. This level of over-collateralization should allow the EFSM to get the AAA rating.

On these 700 Billion €, 80 will actually be issued by the new vehicle and the remaining 620 will consist of guarantees and non-subscribed capital and will be used in cases of stress on public finances for some states encountering troubles.

 Third source also used to finance the bailout, mobilizing "monetary" resources. Unlike the borrowed resources, issued on the markets by the vehicles described above, these resources already exist and are potential since they sit on the IMF special drawing rights. We know that each country has what we call Special Drawing Rights (SDR), according to its economic weight. These rights were created in 1969 to play the role of additional monetary reserves to the states. Thus Germany has 13 Billion SDRs, France by 10.7 Billion and the entire area, this amounts to 50.4 Billion SDR( with a parity today around 1.15 € for a SDR, a total of 58 Billion Euros). There is a rule that sets the funding limit to 10 times the quota, this means that the entire Euro Zone has the ability to theoretically raise up to 580 Billion €. For the countries assisted, we can say that this rule has been widely used.

For example, the financing by the IMF of 30 Billion €(10 Billion in 2010) for the Greek plan of May 2010 as a stand-by arrangement is equivalent to 3200% of the quota of Greece in the Fund. In other words the IMF finances the Greece using the quotas of other countries in the Euro Zone.

Similar situation in Portugal, as in the bailout plan in May 2011, the Extended Fund Facility is 2300% of the country’s quota in the IMF.

All this money issued or drawn on quotas is generally distributed over the water with a follow-up implementation of structural reforms and fiscal consolidation. For example, in Greece, the European assistance in May 2010 is in the form of single loans managed by the European Commission with quarterly disbursements. Today, Greece has already reached 53 Billion of the 100 Billion bailout plan. And, even before the completion of a new bailout plan, the news covers today the release of 12 Billion €, originally planned for the month of June by the Euro Zone and the IMF. This corresponds to the fifth tranche of the loan granted to the country back in May 2010.

THOSE BILLIONS ARE THEY ENOUGH TO RESOLVE THE SOLVENCY PROBLEM OF THE STATES INVOLVED ?

Politics have often discussed the possibility of unlimited support to countries in need. All of this make sense only if these countries are faced with a simple liquidity crisis. By cons, if an insolvent country receives unlimited support from public investors, he remains insolvent. The crisis is just delayed in time. To come after the EFSF in 2013, the Euro Zone governments want to move towards the creation of this EMSF, a sort of "European IMF", able to lend to countries very large amounts because its resources are monetary and not borrowed on the bond markets such as the EFSF (this is again and again to buy time but in a much more consistent quantity)

In any case, what is now known precisely form official sources are the borrowing needs of countries in the device with real or potential budget troubles on the horizon 2011-2013(2013 is the official deadline of the EFSF)

• Greece : 78 Billion €
• Portugal : 25 Billion €
• Spain: 135 Billion €
• Ireland : 16 Billion €

So beware of the contagion to Spain because of its size

THOSE BILLIONS ARE THEY PROTECTED THE BANKING SYSTEM OF THESE COUNTRIES IN THE CASE OF EMERGENCY RECAPITALIZATION NEEDS ?

Bailout plans are also designed to ensure the stability of national financial systems. This often happens as in Ireland by creating bad banks to transfer from banks to government structures, toxic assets to free up capital (often as inspiration sources Sweden, the United States and Japan in the late 1980s and early 1990s). resources must be provided to guarantee banks liabilities (in other words debt issued by banks or the interbank borrowing market)

It is naturally difficult to estimate the impact of financial crashes on assets impairments especially those from fragile banks, regarding their additional recapitalization needs unexpected. But even if we would put in place credible stress-tests, the real question is now whether the states fiscally weakest would be able to come back to save their national banking system, like what happened in the fall of 2008. The answer is no, which means that the sizes of the EFSF and the EFSM are probably poorly calibrated. We know, indeed, that these sizes were set based on funding requirements known from the governments. But additional needs and especially unexpected funding related to the situation of some European banks even today "hidden" needs in some jurisdictions (in Spain and even France) may require a resizing of the European funds.

To ensure adequate funding of the support in Europe, it is necessary to put on the table up to 2,000 billion according to some. Obviously, this amount is not spent and it would just be a cash reserve, though...Again, just a stopgap measure, we try to resolve liquidity problems, and ignore the structural problem of solvency