EFSF and country bailouts: the European TARP or something more?

The EFSF (European Financial Stability Facility) is a special purpose vehicle that was created last year in order to provide support to troubled European economies. EFSF can issue loans backed by EU country guarantees and IMF loans. A maximum of €750 billion can be raised under the current agreement although much less will in order to keep its AAA rating.

EFSF’s creation was shadowed by market turmoil and public unrest. However, half a year later, it starts to show how an important tool can be for the European Union. According to its operating guidelines EFSF can provide loans to eurozone countries, recapitalize banks or buy sovereign debt. In EFSF’s first band issue as part of the EU/IMF financial support package agreed for Ireland €5 billion were raised at 2.89% which will be loaned out to 5.8%. Not that bad deal after all for the Eurozone. And in the meantime the whole crisis devalues the Euro much to the benefit of the export-driven European nations. No much doubt that the facility can be increased if need to take more economies under its wings. Although this European “bailouts” seem to face some political headwinds they make economic sense. On the other hand isn’t the EFSF effectively becoming the financing arm in the course of shaping a rather “invisible” common European economic policy? Countries that request support have to align their policies under IMF/EFSF guidance; the ones coming under the EFSF being probably are the ones that have lost their credibility. To take it a step further, isn’t the latest bond issue a type of Eurobond that so much discussion have been made about lately? Eurobonds may be some years away; in the meantime Germany and other healthy economies are keeping their financing ability and rating intact.

But let’s go back to the economic consequences from EFSF’s actions. In the European setting, buying back government debt, the “toxic assets” behind the European crisis, pretty much means recapitalizing the banks. European banks hold much of the European debt; they mostly had to, under the European economic model. That’s the case with the Greek debt held by large European banks and all of Greek banks. Restructuring Greek debt to 50% of face value, as current market valuations imply, would decimate the Greek banking system requiring massive recapitalization for its size to satisfy capital adequacy guidelines. One objection here would be that Greek banks hold most of the debt in their investment portfolios i.e. at book values so they might seem indifferent towards a buyback in the wake of having to take losses. Even so though, the main problem is that their market capitalization has evaporated during the crisis as well as their funding capability. In this way the EFSS buyback can free up capital to finance economic growth and push back the “toxic asset” issue: effectively growing Europe’s way out of the crisis. Isn’t this what TARP meant to do?

I guess the main issue would be the timing of such buyback and be the haircut. Probably this couldn’t happen earlier than market reforms have been implemented. In the case of Greece this will happen after the first half of 2011. As regards to the haircut, certainly this should be lower than the 50% markets imply for Greece. Probably, somewhere in the 25% range, considering recent rumors and the target effective government borrowing after refinancing at lower rates (discussions are for 25% discount on 15-20% of debt outstanding). Some might say that this would still maintain a high, not manageable, debt level for Greece. However should it starts growing again with a sound plan, which should be the main concern., and manage to get its finances in order by reducing useless, unproductive spending and get tax income finally flowing in, then, it will be able to serve interest payments. For those in doubt mind that this time the whole process is administered by the IMF/EU. As regards to the debt/GDP ratio this is only an indicator; it’s probably more useful to focus on the interest/GDP indicators. Furthermore one has to consider the country’s true wealth, what that actually should be for Greece considering its stealth economy? In the end Greece was surviving with 100% debt/GDP for years as did Italy or Belgium without raising concerns.

On the other hand: maxing up your credit card makes you more conservative as a buyer or at least limits your options….. So not bad as a self-restraining measure. This will be a good lesson; but will need some time to sit in with the people.

After all: Every cloud has a silver lining or from another view “You never want a serious crisis to go to waste”. I see the European stockmarkets, especially those of the PIGS to move lately. Would they know something?

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