The background of EFSF
Following the agreement of the Heads of State and Government of the Euro Area Member States to safeguard the Euro zone in February 2010 Greece received financial support of €110 billion both form the EAMS and the IMF.As part of the €750 billion package for the stability in Europe the European Financial Stability Facility was inaugurated at the beginning of 2011 for the support of Ireland and soon was also used for the assistance programme of Portugal. However, as Greek repeatedly failed to meet its targets and the world economy entered a recession, the EU finance ministers of the euro zone agreed in July to increase the effective capacity of EFSF and further widen the scope of activity of the EFSF along with the European Stability Mechanism (ESM). The efforts of the European policymakers however have so far proved inadequate at calming down the markets and as Greek debt is set to bulge further the current crisis calls for initiatives that outstrip the limits of the July EFSF agreement.
Proposals on the table
The U.S. Treasury Secretary Geithner proposed the vast expansion of the emergency bailout fund by leveraging it. According to this plan the current EFSF fund should be used as collateral to borrow as much as ten times more. Back in 2008 before the US implemented TARP there was a similar plan proposed but was soon aborted as it was considered to be highly risky. Considering, however, that at that time Geithner was the head of the New York Federal Reserve Bank, the proposal looks suspicious. A leverage-based plan seems to be merely addressing the liquidity issue and not the fundamental flaws in the economic union, allowing the policymakers to hide behind a bank that is not even exclusively owned by the euro zone. To make matters worse, the above strategy aims to limit the effect on the ECB’s balance sheet, which is the only thing that protects the union from going bust on the global economy.
Lately the single currency has been edging higher against the US Dollar on every speculation that the bailout fund is on its way to get beefed up, however, as S&P have already warned, an expansion of the EFSF could have potential credit implications in one of the two European core countries, France and Germany. If France is to get downgraded, then Germany shall be left alone to bear the burden of the European bailout. The impact of such a scenario on the EUR/USD pair could be immense. The euro would be likely to come under heavy pressure and test the year’s low at 1.2891.
A second option would be to establish a system similar to the Federal Reserve’s TALF, which was introduced to spur credit lending, by allowing for a broader array of collateral with the US Treasury indemnifying the Fed against losses on new repos. The ECB, however, accepts a wider range of collaterals and apart from isolated cases there has never been a shortage of acceptable collateral The ECB currently is indemnified against losses on repo operations handled by the ELAs in Greece and Ireland and although system wide indemnification strategy would be a good step to deal with large events, such as the Greek restructuring, it is not a panacea in itself and it is not bound to stabilize the sentiment in the euro zone.
A more realistic proposal entails the use of EFSF’s resources as guarantee for the credit risk associated with the ECB’s bond purchases. By indemnifying the SMP through the EFSF the ECB shall be more flexible in terms of market intervention, as there is no need for pre-fund, and would also be able to make quicker decisions on the nature and the size of the bonds to buy. Such a policy would allow the ECB to announce a schedule, in other words to commit for a certain level of intervention over a certain period of time, which in fact is vital to allow investors to get in and out of the market.
However, it looks like improving or enhancing the EFSF is not a viable solution, therefore the earlier introduction of the ESM should also be taken in consideration as a potentially viable solution to the current crisis. The launch of the EFSF’s successor is planned for June 2012, but as it is a more flexible structure and it can be increased in size relatively quickly providing greater protection to creditors and counterparties and allowing for more means of leverage, it might well prove to be the ace in the hole.
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