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The crisis of EMU’s sovereign debts

The crisis of EMU’s sovereign debts. International Economics Marcello Messori Luiss, Lesson 3. Outline.

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The crisis of EMU’s sovereign debts

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  1. The crisis of EMU’s sovereign debts International Economics Marcello Messori Luiss, Lesson 3

  2. Outline • First phase of sovereign debt crisis: three episodes based on different determinants: - Greece (end of 2009) = mismanagement of its public balance and misleading accounting even before the financial crisis; Ireland (fall of 2010) = collapse of its banking sector and consequent public intervention; Portugal (beginning 2011) = mix of elements (imbalances, banking failures, …). • Final results: market strain which prevents the allocation of public bonds, issued by these three countries .

  3. Outline • European Treaty does not allow redistribution of public debts between MSs. • Art. 122 allows other MSs’ interventions only if a country is in difficulty due to “exceptional reasons beyond its control”. Even in this case: ‘direct’ EMU purchases of public debt securities are not permitted. • Hence, the problem becomes: how to help firstly Greece, and then Ireland and Portugal?

  4. Outline The answer to the last question  this lesson examines four topics: (1) Narrative of the first interventions to face the sovereign debt crisis; (2) Narrative of the EFSM and EFSF interventions; (3) Weaknesses of these interventions; (4) The building of a new mechanism (ESM). Conclusion: New governance  management of EMU’s sovereign debt (European Council, March 2011).

  5. 1. First interventions • End of March – mid April 2010: financial aid to Greece from EMU’s MSs, in cooperation with IMF. • Form of the financial aid: three-years program of bilateral loans from each of the other MSs. Total amount of the loans: 110 billions euro. 30 billions euro in the first year. Terms of the debt contract: five-years loans at r ≈ 5,2% (based on IMF formulas). These terms were later revised (see below).

  6. 1. First interventions • After these bilateral loans: In May 2010: ECOFIN launches the European stabilization mechanism (EFSM); Few weeks after, EMU’s MSs launch the European Financial Stability Facility (EFSF). • EFSM and EFSF = first European mechanisms to support EMU countries in the management of their public debts. EFSF is not an institution belonging to EU or EMU but a SPV.

  7. 1. EFSM • EFSM and EFSF: financial support to MSs in difficulty due to exceptional causes which are beyond the control of the MSs involved (Treaty, art. 122.2). • EFSM allocation = 60 billions of euro that can be raised by the European Commission on the market (issues of bonds collateralized by the European budget). Temporary mechanism; “triple A” rating.

  8. 1. EFSF • Beginning of June 2010: creation of the EFSF as a temporary SPV based in Luxembourg. Time horizon: three years (or until the extinction of all the debt contracts). Maximum rating: AAA Allocation: 440 billions of euro (equivalent amount from IMF). EFSF financial provision: - issue on the market of financial assets, guaranteed on a proportional basis by non-users MSs of EMU. Implication: each issue  equivalent increase in the public debt of non-users MSs as a whole.

  9. 2. EFSM and EFSF interventions • EFSM actual loans = conditional to involvement of IMF and to specific commitments from the MSs in difficulty. • EFSF actual loans = conditional to commitments towards EU/IMF from the MSs in difficulty; these commitments must be approved by the Euro group. Due to the pro-rata guarantees and the “triple A” ratings of only a part of EMU’s MSs, EFSF actual lending capacity (L) is not 440 billions of euro but: 265 < L < 315. EFSM and EFSF = cannot purchase public debt securities on “primary” or “secondary” markets.

  10. 2. EFSM and EFSF interventions (1) End of November 2010 – February 1st 2011: support of 45 billions of euro to Ireland (total amount of the loans: 85 billions of euro); Terms of the debt contract: five years and six months loans, at r = 5,9%. (2) March 2011: revision of the bilateral loans to Greece: 7 years and 6 months, at r ≈ 4,2%. (3) May 2011 – End of June 2011: support of ≈ 40 billions of euro to Portugal (total amount of the loans equal to ≈ 78 billions of euro); Terms of the debt contract: five-years loans, at r ≈ 4,6%.

  11. 2. EFSM and EFSF interventions • 5-01-2011: EFSM first issue of its five-years bonds. Amount issued: 5 billions of euro. Interest rate to be paid: 2,59% (with a spread of 72,9 cents upon the return on German bund). Excess demand = 4 times the value of the supply. • Three weeks after: EFSF first issue of its five-years bonds. Amount issued: 5 billions of euro. Interest rate to be paid: spread of 50 cents upon the return on German bund). Excess demand = 10 times the value of the supply.

  12. 2. ECB role • Together with the bilateral loans to Greece and the support of EFSM and EFSF to Ireland and Portugal, ECB = moderate quantitative easing. This  acceptance of peripheral MSs’ sovereign bonds as collaterals in open market operations (problems of rating);purchase of peripheral MSs’ sovereign bonds on the secondary markets (old stock).

  13. 3. Weaknesses • EFSM and EFSF interventions = no solution to the European sovereign debt problems. • At least, five limits: - “Case by case” interventions; - “Last minute” interventions (implemented at the 25th hours and, hence, at growing costs); - Too high interest rates; - Too severe adjustment conditions; - Temporary interventions.

  14. 3. Weaknesses • These weaknesses made it clear that EMU had to build up: a more systematic financial support to peripheral MSs and a stricter coordination between : (i) management of EMU’s sovereign debt; (ii) monetary, fiscal, and macroeconomic policies. • In the meantime: changes in EU/EMU’s governance. Lesson 2 = analysis of the new fiscal institutions and of the design of macroeconomic coordination. In what follows: first organization of ESM .

  15. 4. European stability mechanism • End of October/end of November 2010 = Eurogroup and ECOFIN launch the ESM (that is: the European stability mechanism) Decision: ESM will become operative since June 2013. • December 2010 = European Council approves ESM with a marginal revisal of the European Treaty. • ESM = permanent mechanism to support EMU members in difficulty for exceptional reasons.

  16. 4. European stability mechanism This first version of ESM is modeled on the EFSF. However, ESM has a paid-in capital (financed by non-users MSs); hence, the issues of its financial assets on the market do not increase the public debt of non-users MSs. On the negative side, unlike EFSF: - ESM loans have a seniority over any private creditor position; - ESM intervention can imply a punishment of post-2013 new private bond holders.

  17. 4. European stability mechanism • March 24th and 25th, 2011: European Council introduces important changes in the working of ESM since June 2013. In particular, ESM can purchase new issued public bonds of MSs under aid program. • These features  - the first version of ESM does not solve EMU’s crisis of sovereign debt; - delay of > two years in its implementation  strong incentive to speculation.

  18. 5. The new scenario • European Council of March 2011 = crucial for the new European governance (see also lesson 2): - approval of the new SGP; - approval of the design on prevention/correction of macroeconomic imbalances (procedure to be completed at the beginning of 2012); - immediate entry into force of Euro Plus Pact; - strengthening of ESM’s role and functions. • In the meantime, the European semester is operative.

  19. 5. The new scenario • Hence, at the beginning of April 2011, EMU is characterized by: multiple equilibria. A subset of equilibria  stagnation; Another subset of equilibria compatible with an adequate rate of growth. • Problem: the selection of the actual equilibrium  current rate of growth.

  20. 5. The new scenario • International recovery (2010 last semester – 2011 first quarter): stronger than expected. • Euro area: moderate average rate of growth  increasing gaps between different MSs (peripheral countries = stagnation/recession). • In this open but fragile situation, the Italian economy becomes the crucial element which ventures the survival of the euro area.

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