Will the European Stability Mechanism create stability or yet more instability?

As you can now see from its front page Mindful Money has hit difficulties and I am not sure how long it will continue. As I have plenty to say and have plenty of plans for the future I wish to make it clear that I intend to continue blogging and should Mindful Money close my thoughts and analysis will return to.

http://notayesmanseconomics.wordpress.com/

European Stability Mechanism

Yesterday evening Eurogroup finance ministers pressed the button on the start of the European Stability Mechanism or ESM which will be the replacement for the European Financial Stability Facility or EFSF which has produced anything but! This being Europe the unstable lifeboat EFSF will continue for a while and indeed will remain for now the bigger partner to its baby brother.

It will also replace the European Financial Stability Mechanism or EFSM (apologies for all the acronyms….) of which more later.

What does the ESM bring to the party?

There is a basic improvement that the ESM brings to the party. It it is planned to have some capital to back its borrowings which the unstable lifeboat which is the EFSF never had.

However being the Euro area it is not that simple

Capital

Whilst having some capital is plainly an improvement there are three main problems with it as it stands.

1. The paid-in capital of 80 billion Euros is only going to be 11.4% of its total capital subscription of 700 billion Euros  and 16% of its maximum lending capacity of 500 billion Euros. This means that the following sentence by its head Klaus Regling can go straight into my financial lexicon. If we were playing Monopoly this is a do not pass go moment I think.

This gives the ESM a robust capital structure

2. Unfortunately the capital is going to be paid in over time when the need (Spain for example) is now. Originally the fantasists writing the documentation felt that 20% could be paid in for five years whereas it has now been speeded up to 40%,40% and then 20%. But the problem remains that it looks likely to face heavy drawdowns with much of its capital unpaid.

3. A backwards step was taken in assuming that countries in receipt of rescue programmes can contribute capital. The Mad Hatter was really enjoying his Tea Party at this point! So of it we get Greece at 2.82%, Ireland at 1.59% and Portugal at 2.51%  combining to 6.92% of the capital. Thus countries in receipt of loans will have to divert some of the loans to pay their capital share to an organisation which will then lend them money. Quite bizarre and an example of the sort of financing which got us into the credit crunch and therefore is exremely unlikely to help us get out of it.

The next problem is simply that Spain is a provider of 11.9% of the capital. Yes the same Spain which has required  a credit line of 100 billion Euros from its Euro area partners to  help bail out its banks. So exactly how will she find the money to pay her share of the first capital tranche of 3.8 billion Euros on October 23rd? Continuing with the same logic Greece will have to pay 902 million Euros,exactly how?

Should things go wrong which on the track record so far is rather likely then we see in the words of the head of the ESM that there are three responses.

A general capital call concerns payment of the initial capital and also, if necessary, an increase of paid-in capital which could be necessary, for example, to raise the lending capacity.

I will leave readers to mull the implication that the country which has caused the need for the lending capacity to be raised will have to borrow the money off the ESM to fund its share of the ESM’s capital. There seem to be a lot of plans for what would happen if things go wrong here as we also have the possibility of these two alternatives.

A capital call to replenish paid-in capital

an emergency capital call

Now making plans for possible trouble is sound work but I for one wonder about what announcing an emergency capital call in an emergency might do to sentiment! Particularly if the usual Euro area dithering takes place.

Tucked away in all this is something that should concern the stronger nations in the Euro area. What happens if someone- for example Spain- cannot pay its capital?

If any ESM member fails to meet the required capital call, one or more revised increased capital calls would be made to all ESM Members by increasing the contribution rate of the remaining ESM Members on a pro-rata basis.

There are dangers here for Germany as she could find her share escalating upwards quite quickly. So far the small relative size of the nations involved has limited this but Spain is different and could easily fire off her own domino effect. The effect of sharing out her 11.9% could easily put Italy (17.91%) in trouble and as I pointed out only last week France (20.39%) is not as safe as her bond yields are considered by some to imply. So the crisis could spread like wildfire and we have a lifeboat which may not be as unstable as the EFSF but is way below the standards of shipwrights and boat builders.

What could go wrong?

Size

This is simply that the ESM looks to have a lending capacity which could easily be taken up by Spain alone. Indeed the support programme for Spanish banks will drain around 50 billion of the 500 billion capacity even under the rose-tinted analysis of her bank stress tests.

Seniority

This looks like being a missed opportunity and there has been a lot of debate over it.

This may seem arcane but it is actually very important. If ESM lending is as “senior” as that of the International Monetary Fund then as it lends more to a country private-sector lenders will get less and less should there be a debt restructuring as the ESM would get 100% back even if the value was say 60%. This would mean that the private-sector would have to have a restructuring where it got less than “value”. A clear example of this was what happened to Greece where private-sector holdings of Greek government debt accepted a much heavier haircut than if there had also been what is called official sector involvement or OSI.

It looks as though ESM lending will be senior in future -unlike its lending to Spanish banks- which means that should its lending to a country build up private-sector lenders are likely to exit fearing that they would face a disproportinate share of any possible restructuring. Unstable lifeboat alert again particularly if we combine it with the ESM’s capacity constraints.

Last night we got some insight into the implications of this as inspite of the debt restructuring the IMF forecast that in 2020 Greece’s national debt as a percentage of GDP under adverse circumstances or in other words reality would be 150% in 2020 i.e the whole episode was pointless mainly because official lending was excluded.

The European Central Bank

This is always manoeuvering in the background but let me point out that currently if we use the words of Arthur Daley it has found itself “a nice little earner”. Remember the LTROs where it loaned out just over one trillion Euros originally in return for at 1%  of interest and now 0.75%? As of yesterday it had 290 billion Euros of that back in deposits on which it now pays nothing or to be more precise 0%. But that is not the end of it as some 533 billion Euros decamped to its current account.

So by my maths should such a situation be maintained this would produce 6.2 billion Euros of profit a year. It is not only private-sector banks that benefit in these times!

Meanwhile the poor Euro area taxpayer takes the balance sheet risk should something that would not doubt be described as “unexpected” occur. I would imagine that 99.9999999% are unaware of what is being done in their name.

The UK is a better European than is often claimed

The nation that invented the word Eurosceptic is in fact supporting the Euro right now. I did say that I would return to the EFSM of which the UK has a 12.5% shareholding (2011). This is what was announced by the Eurogroup last night and the emphasis is mine.

the Eurogroup approved the next EFSF disbursement of EUR 0.8 billion and looked forward to the adoption by the Ecofin of the legal texts paving the way for the EFSM disbursement of EUR 2 billion and to the approval of the 1.5 billion disbursement by the IMF Executive Board at the end of the month.

Has there been any discussion over this further 250 million Euro potential liability readers have spotted? Here is the official view from the House of Commons Library.

The UK faces an indirect contingent liability through its participation in the EFSM, equivalent to its share in the EU Budget.

Those of a nervous disposition may be reassurred by the statement that it is “extremely unlikely” things could go wrong. What was that again that Sir Humphrey Appleby told us about official denials?

Comment

Oh what a tangled web we weave,

When first we practise to deceive!

(Sir Walter Scott)

 

This entry was posted in Banking Reform, Banks, General Economics, Greek Financial Crisis, Interest rates, Quantitative Easing and Extraordinary Monetary Measures. Bookmark the permalink.
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  • http://www.facebook.com/jason.aris Jason Aris

    Keep up the good work Shaun wherever you eventually land.
    On the subject of EFSF/EFSM/ESM I expect a form of ‘financial repression’ to be undertaken whereby under Solvency II regs pension companies will be forced to invest in these vehicles as they will be considered top notch securities, this is mine and your money so the public will shoulder the risk of failure either directly as taxpayers or indirectly as investors in pensions.
    They’ve got us one way or another

  • JW

    Hi Shaun
    Re MM too much ‘Greenpeace’ history for my taste. Coincidence their demise when some green energy support is being cut?
    Re ESM, I wonder what the next support vehicle will be called in the depths of a recession, European Growth Fund? or perhaps a sliver of reality and it will just be called Rettungsboot

  • Robert S

    Shaun,

    You mention that Greece needs to pay 902 million Euro into the ESM. Perhaps they could stop building the Formula 1 race track that’s reportedly costing 100 million Euro!

    Robert S

  • JW

    Hi Shaun
    Thought you might be interested in the attached piece about possible legal option for the Bundesbank when faced with contributing to the OMT.
    http://blankfiendsew.blogspot.co.uk/2012/10/the-potential-legal-battle-over-omt.html

  • Rods

    That is why after 1997 and Gordon Browns pension tax grab, I stopped paying money into a private pension, having come to the conclusion, that by saving and having complete freedom with how I invest my savings, it stops the Government easily getting its hands on it.

    Also you have to pay UK tax on a UK pension, where if it is savings, I can pay my tax in a country of my choosing for retirement.

  • JW

    Hi Rods
    Not strictly true. Unless its regarded as a UK Government pension ( which includes the likes of police etc as well as civil service) which is taxed at source in the UK; all other pensions can and usually are taxed in the country of residence. There can be problems with lump sums etc in some countries like France, but there are ways round this. Private pension arrangements can usually be off-shored without too much trouble.
    However I completely agree that keeping your money as far away from ‘tax relief’ traps that just tie you in is very sensible given every government’s grab for your money.

  • James

    Shaun,
    Sorry about Mindful Money…
    Given the fact that the basis for any “action” in the Eurozone is based on a continuation of the current game thorugh obfuscation etc, i think that a likely scenario is
    1. The ECB pumps money into these organisations, as it can print the cash
    2. The Eurocrats invent a few more acronym-laden bodies to confuse the public
    3. Rules for holding and classifying sovereign debt will change so as to encourage banks to hold more and not write them down
    4. We are all told that the IMF/ECB/ESM etc etc have never lost any money
    5. There will be further reviews by the troika to ensure compliance with whatever is the flavour of the day
    6. We will sail into the sunset without taking any real action
    7. the politicians will retire on golden pensions

  • Rods

    Hi Shaun,

    Another excellent blob. With another unstable lifeboat, it sounds like now might be a good time to go long on life jackets!

    I think there are a lot of parallels in what is happening in the EU and what happened with the USSR. In the 1920s the USSR embarked on large industrialization and collectivization programs (both at great human cost!), which did increase output until about 1960. After this the limits of the system of government and the inherent inefficient allocation and use of capital and labour, made the system ever more inefficient compared to Western economies Some countries were better run and richer than others, like Eastern Germany and Yugoslavia. But in the end the system was so inefficient it was effectively bankrupt by 1991 and all countries very poor compared to the US and Western Europe. 20 years after the fall of the USSR most former communist countries are still poor compared to Western economies, with many more years of growth required before they may catch up.

    Now with the EU which has a similar system of government to the USSR, they embarked on a single open market, which increased trade between EU countries and overall wealth. Now with the role of the EU much more involved with countries, especially those in the Eurozone, where they are playing a major role in raising and allocating capital, which they are currently allocating to areas where it will be very inefficiently used. If this continues for along period with multiple bailouts from strong to weak economies, then the build up of liabilities by the weak nations, owed to the stronger nations, is going to drag all countries down, so eventually the whole area goes bankrupt. The EU is shrinking in terms of world trade and many countries PPP is falling. Are the EU countries going to be the new Eastern Europe, looking enviously at Asia and the BRIC countries and at the same time they having condemned several generations to poverty?

    Once Western Europe has lost it technology and manufacturing and sevice industry leads, along with the capital it needs to try and play catch up, it will be a long dark road to try and get them back.

    With Eurozone countries requiring multiple bailouts and I’m sure the capital requirement to stabilize Spain being radically underestimated, along with austerity led economic death spirals and unrealistic growth projections the omens do not look good.

  • forbin

    where’s there gold , there’s a thief about

    Forbin

  • Anonymous

    Hi Rods,

    I think it’s unsound to claim collectivization increased output. The man made famines of the 1930s were caused by collectivization. The USSR had to import lots of food, despite the huge acreage available in the Ukraine.

    To lump the EU in a single mass is also unsound. The EU is in a mess caused by political hubris – “currency union is irreversible”

    There is an important difference between 1930s Ukraine and 2010s Eurozone. Joe Stalin had many divisions and a ruthless NKVD – I believe Brussels has neither.

  • Anonymous

    A Mad Hatters Tea Party indeed! Sometimes economics can be quite amusing! I had wondered about this very issue for some time ( countries contributing to their own bail out fund) but had assumed I had missed something somewhere. Clearly I haven’t!! I bet very few Germans are aware of this but they soon will be.

    I have book marked your alternative site should this one close. Keep the blogs coming!

  • Anonymous

    Like the link. German real estate is starting to bubble. A booming jobs market will further push up rents and house prices. This should signal failing price stability, regardless of the worthless inflation numbers generated by HICP.

  • JW

    Hi ExpatinBG
    This is another sign of divergence across Europe, rather than convergence. Holland house prices are cratering, and it very likely France will follow suit soon. Just when German’s get a bit more credit availability and wages edge up, with the effect you describe in their housing market after years of flat-lining.

  • DaveS

    Too true – I realised a couple of years back that ordinary middle class citizens ultimately can’t protect themselves from the state.

    Argentinians experienced this when their pensions and US dollar bank accounts were seized. Americans had their gold seized in the 1930′s.
    The Irish are having a little fore-taste with a “temporary” tax on their pension assets. We will soon have wealth taxes, pension taxes – no doubt ISA taxes one day. I’m afraid you can’t escape the bankruptcy of a country when you are resident in it. The rich will be long gone….

  • JW

    Hi DaveS
    I believe there are plans to ‘passport’ taxation within the EU, ie you are taxed by the country you have your passport with, rather than residence. No doubt with US assistance they would then try to make this ‘worldwide’.

  • Rods

    Hi ExpatinBG

    I’ve no figures for Soviet grain output from 1920 to 1940, but I do agree that production fell in most areas of agricultural production during collectivization However the Ukraine Holodomor of 1933 was a total artificial famine by Stalin where the farmers resisted collectivization. Where my wife comes from the Cherkasy region, they were badly affected, and her family only survived after having their crops and animals confiscated because there were an unusually small family (2 children) and they kept bees and had some cherry tress in the garden. They just survived on a diet of cherry tree leaves and honey. Stalin at this time was exporting grain.

    http://en.wikipedia.org/wiki/Holodomor

    This report show grain production from 1946 to 1980, showing that is went up considerably during this period, but not enough to feed the population.

    http://www.nass.usda.gov/Education_and_Outreach/Reports,_Presentations_and_Conferences/Yield_Reports/Grain%20Production%20in%20the%20USSR%20Present%20Situation,%20Perspectives%20for%20Development%20and%20Methods%20for%20Prediction.pdf

    Western economies with their more efficient and ever increasing productivity, technology and distribution system meant there was an ever increasing wealth gap between Western and communist societies Communist industry and agriculture did improve, but their distribution systems remained very inefficient and wasteful.

    “To lump the EU in a single mass is also unsound. The EU is in a mess caused by political hubris – “currency union is irreversible”"

    Yes and no, the Eurozone is in a much worse position than the rest of the EU, but EU wide social, employment, work place, harmonization and green legislation to name but a few affects all EU countries.

    This is a speech by Vaclav Klaus, President of the Czech Republic in May 2012:

    http://www.telegraph.co.uk/news/worldnews/europe/eu/9244156/Eurozone-debt-crisis-Europes-nations-must-break-free-from-the-Brussels-straitjacket.html

    The point on similar Government systems I am trying to make is not the states security apparatus, but that power for economic and political decision making is in a very few hands, which means that a small number of brains have to be all seeing to make good objective decisions without political dogma and of course this is impossible. This also applied to the USSR. The EU’s Politburo consists on 28 members, the communist Commission President Borosso and 27 commissioners and they are the only people allowed to introduce legislation and Directives (Diktats) so you have 28 brains and their staff ruling over 500 million brains within the EU. Personally, I prefer and trust the diversity and wisdom of the 500 million to make good local decisions and who directly vote for more local governments who are answerable to their populations, than that of the 28. The democracy deficit and this concentration of power will be one of its down falls. The EU parliament has very few powers and mainly rubber stamps directives with a few amendments.

  • JW

    Hi Rods
    Thank you for your insight from your family’s experiences. And also thank you for the Klaus speech link, I missed that. Klaus is probably speaking for the majority throughout the EU who bother to ‘think’, but their voice is seldom heard over the doctrinaire babble.

  • Anonymous

    I agree that the European commission is a complete disaster, a self serving unaccountable bureaucracy which is incompatible with democratic governance. The basic setup where the 27 national leaders each have a veto is fundamentally unworkable and dysfunctional.

    At some point a local revolution will occur. Brussels cannot squash it like Budapest in 1956 or Prague in 1968 …

  • forbin

    I guess then having dual nationality will become quite common for the uber wealthy!

    DaveS – people forget history or are not bothered with it – even supposidly intelligent people. I have read what happened in the past – I see that we will repeat it , unless……….

    Can we prove Humans are smarter than yeast?

    my position is now one of spectator , I have tried to call it as I see it and involve out leaders but they have done a good job of ignoring me ( no doubt countless others) – I’m not in the “inner party” or indeed the “outer” one……

    so its a ring side seat and popcorn for me

    Forbin

  • Anonymous

    Yes – German house prices have been stable for years and now they rocket up, just like Spain, Ireland, the US and the UK did a few years ago. The ECB is failing to deliver price stability. Germans should be raising interest rates to prevent their housing bubble getting too frothy, but the ECB has set them way too loose. Deja vu ?

  • Anonymous

    Hi Jason
    Thank you. There have been a few examples of that sort of thing over time. The Minimum Funding Requirement for UK occupational pensions was considered to push funds towards government bonds. Also these days they usually have a zero risk rating in formal bank stress tests encouraging banks to hold them.
    After all,what could go wrong? :)

  • Anonymous

    Hi JW
    Re MM I think that is a coincidence. However there is always scope for some wry/gallows humours in something that wins Best Commercial Innovation in the 2012 Online Media Awards failing so quickly…
    Wasn’t that the job of young entrepreneur of the year? And should I put it in my financial lexicon?

  • Anonymous

    Hi Robert
    I had seen mention of the formula one track. With its once a year use (if lucky as for example Silverstne has a times looked like it might lose its Grand Prix) I suppose it is a better structure than the Greek Olympic (lack of ) legacy. But it is hard to see it thriving in these times is it not?
    And the 902 million Euros will have to be paid in again next year followed by 451 million in 2014 as the pain and debt build up continues.

  • Anonymous

    Hi James
    Thank you. I think they will struggle with point four but I agree that they will give it a good go!

  • JW

    Hi Shaun
    I do recall that my (fairly knowledgeable) criticism of their overly ‘green’ editorials on energy investments were met with aggressive response. Not exactly ‘balanced’ in their view in my opinion.

  • Anonymous

    Hi pavlaki
    I think that even Lewis Carrolls impressive and justly lauded gifts of imagination might not have been enough to cover some of what is happening now. You have no money so you have to borrow but you have to give some of it back to help pay for not only your future borrowings but some of theirs!

  • Anonymous

    Ah a green agenda yes I agree. Sorry I thought that you meant “green” backing…

  • JW

    Hi Shaun
    Social Business Group seem to have a ‘track record’ in this area.
    http://www.herecomeseveryone.com/2006/10/social_media_ac.html
    Didn’t like being told ‘wind power’ was a load of incredibly expensive rubbish.