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A bond-issuing EU stability fund could rescue Europe
EU governments’ responses to last autumn’s financial sector meltdown were too little and too late, warn Daniel Gros and Stefano Micossi, to avert more trouble ahead both in the eurozone and around its periphery. They urge the creation of a common European re-capitalisation fund to be financed by a new breed of EU bonds
The European economy is sinking quickly into deep recession under the impact of the financial crisis. The sharp drop in demand almost everywhere is due to two intertwined factors: the extreme volatility of financial markets is leading businesses to cut back sharply on investment, households are postponing purchases ranging from consumer goods to automobiles. There are also widespread signs that the so-called credit crunch is biting hard, with even creditworthy enterprises and households finding it increasingly difficult to finance investments or new mortgages.
This second factor, though, is no longer the centre of policymakers’ attention, yet we believe that Europe’s political leaders need to turn their attention back to the banking sector and to try and ensure its proper functioning.
Europe’s problems in started with last autumn’s banking crisis, when the financial meltdown of September and October showed how vulnerable the European banking system had become to the fallout from the sub-prime mortgage crisis in the United States a year earlier. This vulnerability stemmed from an excessive build-up of leverage in Europe’s larger cross-border banks. National regulators had allowed this because in most cases they saw their basic mission as one of allowing their own national champions to compete in the global financial market place. As long as the price of risk was low, European banks were able to follow a strategy of minimising the use of capital because this allowed them to maximise their return on equity. European banks had thus become vulnerable to a re-pricing of risk, even if they did not hold many of “toxic” U.S. assets.
When risk aversion returned after the U.S. housing bubble had burst, the European banks too came under pressure. At first it had been thought that Europe’s banks had by and large not been involved in America’s sub-prime lending frenzy, so confidence remained high and that in turn sustained the liquidity of the money markets. But this liquidity vanished when the collapse of Lehman Brothers showed that even major investment banks could go under; confidence in the inter-bank market dropped, and the liquidity on which European banks depend with their weak capital base vanished.
A complete collapse of the European banking sector was averted at the last minute when eurozone leaders agreed in mid-October to all adopt similar plans for supporting their national banking systems with a mixture of recapitalisation and guarantees for bank borrowings. While this was sufficient to stop the collapse of the banking system, it is now clear that it was not enough to stabilise financial markets.
When Europe’s leaders were facing the danger of a wholesale breakdown of the European banking system, close coordination was seen as desirable, not least because markets expected to see common actions. Now the sense of immediate danger of a systemic collapse has waned, the EU’s member countries are drifting apart. Different countries have been emphasising different policies to deal with the crisis and quite different ways to implement them.
But the key problem is that only a small fraction of the large sums announced initially have actually been committed. Close to two trillion euros in public funds to support Europes’s banking system were promised in early October, but by last December less than one tenth had been disbursed. This was mainly due to the fact that most governments on the continent have for political reasons tried to “punish” the bankers, making their rescue packages expensive and linking them to new forms of political control over the banks. Not surprisingly, the bankers themselves have not volunteered to be punished, and the result is that in Germany and Italy especially very little has been done to reinforce the bank’s balance sheets.
This could create a situation where banks receive just enough funding to keep them afloat. That in turn would result in their restricting lending while they rebuild their balance sheets. This is exactly the problem that has to be avoided.
It is also becoming clearer that the European banking market risks becoming “balkanised”, because conditions vary from country to country, with different guarantee schemes and with some EU governments now major shareholders. Europe’s Single Market will therefore need to be actively defended during the current crisis, and at the very least that means re-stating the broad outline of common rules.
The reality, meanwhile, is that in aggregate European banks have received little new capital, yet at the same time they are having to confront another problem in the shape of a collapse of the European “periphery”. Deteriorating foreign exchange and financial conditions of in the satellite countries of the eurozone – the Baltic region, eastern Europe, Turkey and Ukraine, not to mention Iceland – is weighing heavily on EU banks’ financial solidity. Major European banks are the backbone of the banking and financial systems in these countries, and so now find themselves vulnerably exposed to the consequences of capital flights and currency attacks there. These European banks hold over $1,500bn in cross-border claims on emerging European economies, out of a total of $1,620bn. And when these EU-based banks run for the exit – most have been refusing to extend further credit to their subsidiaries – they are in fact increasing their own losses and thus fuelling the need for further re-capitalisation.
There is no escape. The European Union will have to take responsibility for stabilising financial conditions in these euro-satellites, and it will need substantial resources to do that. It will need extra funds for emergency balance of payment assistance and also for the direct provision of good government paper in exchange for flawed private claims, just as the United States did with its Brady Bonds in the 1980s to resolve the Latin American debt crisis. At present, the existing funds for macro financial assistance that could be mobilised are much too small to have a substantial impact.
In this environment of continuing stress on the banking system, the case-by-case approach at the national level must be abandoned and an ambitious capital target must be set for all the main EU banks. Again, there is no need to tap national budgets to do this. EU government-backed bonds can provide adequate resources by making it possible to tap the gigantic global capital flows that more than ever are now in search of safety. The euro and European financial markets could benefit greatly from such capital inflows.
The message from the world’s financial markets is that investors everywhere have developed a strong preference for public debt. In the U.S. and Japan, public debt carries no risk because if government can always force its central bank to print the money needed to meet its obligations. But this is not the case in Europe as no national government can force the European Central Bank (ECB) to print money. For international investors there is thus no eurozone government bond in which they can invest as a way of diversifying their risk away from the dollar.
There is thus strong demand for “European” bonds and at the same time Europe’s own need for massive government capital infusions to prevent the crisis from getting worse within the banking sector and on the eurozone’s periphery. This is why the EU should set up a massive European Financial Stability Fund (EFSF) that would probably have to be at least on the scale of the Troubled Assets Relief Programme (TARP) in the U.S., say €500-700bn. It would issue bonds on the international market with the explicit guarantee of member states, and as the rationale for the EFSF would be crisis management, its operations should be wound down after a pre-determined period, perhaps of five years. For global investors, EFSF bonds would be practically riskless as they would have the backing of all member states.
Setting up a fund with a common guarantee does not imply that stronger member countries would have to pay for the mistakes of others, because at the end of its operations losses could be distributed across member countries according to where they arose. In all likelihood, though, the fund would not lose, but rather would make money because its funding costs would be much lower than those of individual member states’ fiscal stimulus packages and because its existence would stabilise European financial markets. Germany, which has so far opposed this idea, might well be its biggest beneficiary as German banks are likely to be its biggest customer. Germany’s automobile industry would gain most from the stabilisation of the European banking sector, and Germany’s exporters would gain most from the economic stabilisation of the European periphery.
This EFSF could quickly be set up as part the European Investment Bank, a solid institution which already has the necessary expertise. The EIB is itself an agency of EU governments and its board of governors includes the finance ministers of EU member states. With the new fund run by an existing European institution, finance ministers would be able to ensure it is wound down once financial markets operate normally again. By contrast, it will be much more difficult to end national support schemes, since no finance minister will want to be the first one to withdraw support for his or her national champions.
The resources available to the EFSF would be used mainly for bank recapitalisation, especially for those banks which prefer to “gamble for resurrection” rather than accept what they fear will be the presence of heavy-handed interference of a national government. The EFSF could also beef up the funding of existing EU instruments for balance of payments assistance in the European neighbourhood.
Another reason for issuing this new breed of European bonds is that this would remove a key obstacle preventing the euro from becoming the world’s leading reserve currency. The present constellation of separate markets for sovereign debt paper of unequal quality issued by European governments cannot compete with the U.S. market for the huge global financial flows in search of a safe haven. Until the EU develops a unified market for bonds denominated in euros and backed jointly by EU member states – or better still by eurozone governments – the euro cannot become the leading reserve currency. As a result, capital is not coming to Europe where it is badly needed to shore up the EU’s severely shaken financial system. And meanwhile the United States continues to dictate the agenda in international monetary affairs despite the colossal damage inflicted on the world by its misguided macro-economic and regulatory policies.
France’s President Nicolas Sarkozy has called for the creation of an “economic government” for the euro area. Under normal circumstances, the response would be that the economic governance of the eurozone was assured by the independence of the ECB and by the EU’s Stability and Growth Pact, the fiscal disciplines agreed in 1997 as an underpinning of the euro. This is clearly no longer sufficient now that Europe is facing the worst economic and financial crisis since World War II. The speed and depth of the crisis have clearly overwhelmed the EU’s usual decision-making mechanisms, with successive meetings of finance ministers of both the EU-27 and just the eurozone countries failing to produce tangible results, both before and after the full extent of the crisis had become clear. Europe needs quick action on a scale that can only be decided at the highest political level, and its first practical step should be the creation of a European Financial Stability Fund able to issue bonds that, with the backing of EU governments, would be a magnet for worldwide investors seeking safety.
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