Záchrana Itálie a EURA (dokument v AJ)

8/3/2019 Zchrana Itlie a EURA (dokument v AJ)

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ECONOMICS RESEARCH 24 November 20

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 12

EURO THEMES

What will it take to save Italy (and the euro)? We recently argued that Italian policy reforms alone would not suffice to bring

Italy out of the crisis; the country is also likely to need an external financial

shield to protect against destabilizing market dynamics. We now ask how large

this shield may need to be, and whether it is plausible that the required funding

can be mobilized.

Italys potential demand for financial support cannot be taken in isolation, sinceother European sovereigns have already received substantial support from Europe

and the IMF. Requirements to support Spain also need to be considered.

We do not think that Italy or Spain need to be taken out of financial markets, asIreland, Portugal and Greece were. Neither country has lost access to markets;

financial support should be designed to protect market access, not compensate

for its loss. And the larger the potential source of contingent finance, the

smaller the likelihood that this financial war chest will need to be used.

While there is no scientifically precise way to estimate the contingent fundingrequired to protect market access, we think 18-24 months of public financing

requirements is a reasonable benchmark. This amounts to a range of EUR 500

billion to EUR 800 billion for Italy and Spain together.

It is possible to come up with joint contributions from the EFSF, the IMF and theECB (via the SMP program) that add up to this amount. But the funding is not in

place for now, and things may need to get (even) worse before it is catalyzed.

The constraint that the ECB operate only in the secondary market does not

eliminate, but does weaken the force of its contribution to the program.

The odds of success in managing the euro area crisis depend to a large degreeon developing a more coherent vision of the post-crisis landscape. Both markets

and policymakers need greater clarity on the institutional endgame of the

European financial drama, without which markets are unlikely to settle.

Figure 1: Italy At risk

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Source: Bloomberg, Barclays Capital

Antonio Garcia Pascual

+44 (0)20 3134 6225

[email protected]

Michael Gavin

+1 212 412 5915

[email protected]

Piero Ghezzi

+44 (0)20 3134 2190

[email protected]

Thomas Harjes

+49 69 716 11825

[email protected]

www.barcap.com


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Barclays Capital | Euro Themes: What will it take to save Italy (and the euro)?

24 November 2011 2

WHAT WILL IT TAKE TO SAVE ITALY (AND THE EURO)?

Italy Quo vadis?

In the past week, market attention has been focused on political developments in southern

Europe, as technocratic governments in Italy and Greece have been formed and have begun

to organize themselves, and last weekends Spanish elections pave the way for a new

government in that important part of the peripheral European story. These political

developments are critical because, if successful, the new governments will revive the

economic reforms and fiscal consolidations that are required to restore confidence.

The major preoccupation of markets is now, of course, Italy, not because it is the only

country that is perceived to be at risk, but because it is the biggest, and a bellwether for

Europe. And there the new Monti government is certainly an important step in the right

direction. Since confidence lies at the heart of the Italian debt problem, we cannot rule out

the possibility that forceful policy actions by a new, reformist government may be enough

to put the crisis behind us. Nonetheless, for reasons that we have recently discussed in

some detail (Can Italy save itself?, 7 November 2011), as necessary as Italian economic

reforms may be, we doubt that they alone will be sufficient to rehabilitate the Italian credit

and eliminate the possibility of a confidence crisis that could overwhelm the positive effects

of a reform agenda, however well conceived and implemented. Our read of the historical

experience also supports the view that the self-reinforcing negative market dynamics that

now threaten Italy are very difficult to break, and have generally required external financial

support to provide a country that has lost market confidence with the time it needs to show

financial markets that it is indeed solvent.

Investors are focused on Italy for good reason; the countrys recent introduction into the

equation raises the stakes dramatically for Europe and the world. Italy is the 7th largest

national economy in the world and (at about EUR 1.7 trillion) its government debt

comprises the worlds third largest bond market. An Italian credit event would have

consequences for financial markets and the global economy that are almost literallyincalculable, because all we can know about the economic and financial costs of secondary

and tertiary damage that would be done by an Italian default is that it would be devastating.

This is true even if we set aside the EUR 0.7 billion in Spanish government debt that is also

at risk, but it is hard to see an Italian event leaving the Spanish sovereign intact.

While the danger has risen dramatically, so has the scale of the rescue operation that may

be required to usher Italy and Spain into the safety zone. Certainly, the three previous

EU/IMF programs cannot be replicated for Italy. Those programs were large enough to take

the sovereigns completely out of the market for several years, while imposing tough

conditionality. Simultaneously, the ECB has provided banks with unlimited liquidity and

lends additional support with its securities markets programme (SMP). It would not be

feasible to scale the financial commitments made to support Ireland, Portugal and Greeceup to Italian and Spanish size.

Luckily, a program quite this massive is not likely to be necessary for Italy and Spain. In this

report, we examine how much financial support may be required to assist Italy and Spain in

the coming years of adjustment, and whether Europe (and the world) can muster the

financial wherewithal to provide that support. The question is, in our view, pressing in part

because pressure on French debt markets suggests to us that Europe is reaching limits in

the capacity of fiscally stronger sovereigns to support fiscally weaker ones. Is Italy too big to

be rescued? And if not, who has the balance sheet to save Italy?

Italys government debt

comprises the worlds third

largest bond market

Europe is reaching limits in the

capacity of fiscally stronger

sovereigns to support fiscally

weaker ones
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24 November 2011 3

Our main concern is with Italy, but we need to put financial demands that may be

associated with an Italian rescue operation into a broader European context that includes

commitments already made to support Greece, Ireland and Portugal, and additional

commitments that may be required to support Spain in the months to come. The financial

burden associated with a rescue of Italy may be the largest to come from Europe, but the

costs and policy risks associated with such a rescue are compounded by the fact that Italy is

only one of the weak links in the European chain.

What will it take?

We briefly revisit Italys debt dynamics to understand the magnitude of the fiscal challenge

that the government faces in light of the recent increase in bond yields, and to address once

again the question whether a plausible adjustment effort can reverse the deterioration in the

public debt dynamics. We also estimate potential financing needs for the next 3 years,

which gives us some insight into the magnitude of the financing risks that confront Italy

and Spain in the early stages of their adjustment and reform efforts, when weak market

confidence poses the most acute risk to the reform program. In a subsequent section, we

consider potential sources of funding, including the roles that may be played by the EFSF,

the IMF, and the ECB.

Italian debt dynamics redux

We discussed Italys debt dynamics at length in June 2011 (Italy: the time to act, 21 June

2011), before confidence in the Italian public credit began its abrupt slide. Before June 2011,

Italy was in a good equilibrium in which market funding costs were low, consistent with a

view that a credit event was very unlikely, making the debt sustainable. But in July, following

the PSI decision for Greece, markets moved Italy to the bad equilibrium, in which anxiety

about a potential credit event required interest rates that made the debt dynamics look

unsustainable, thus justifying the anxiety about a potential credit event. With public debt at

120% of GDP, Italy has become a victim of multiple equilibria.

One question that arises in this context is whether the interest rates that Italy is now being

required to pay on its public debt are high enough to put debt sustainability out of reach,

given plausible fiscal efforts. To answer this question, and shed more general light on the

new fiscal context, we have revised our debt sustainability analysis, assuming that interest

rates remain at 6.5% for the foreseeable future. The highlights of the analysis are as follows:

Figure 2: Public debt dynamics assuming a 6.5% financing rate

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Spain

Public debt-to-GDP (%)

Source: Barclays Capital

With public debt at 120% of

GDP, Italy has become a victim

of multiple equilibria


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So whats the problem?

This brings us to the natural question: how much financial support might be necessary to

help Italy and Spain over the hump? We begin with a few qualitative points, before delving

into the numbers.

First, neither Italy nor Spain has lost market access; with some help from the ECBs SMP,

debt markets have been damaged but have remained open for business, and both countrieshave been able to issue new debt, though expensively, to private creditors. Unlike Greece,

the rationale for official financial support to Italy and Spain is a precautionary one, not

grounded in an imperative to substitute for private financing that has vanished. The goal of

such support should be precisely to reduce the chance of a run by private creditors, not to

accommodate one. As usual in such precautionary programs, a case can be made that the

larger the potential source of contingent finance, the smaller the likelihood that it will need

to be used.

But why should contingent finance be necessary at all? At the risk of repeating elements of

our earlier note (Can Italy save itself?, 7 November 2011), we outline some of the

arguments that also bear upon the question of how much contingent support might be

necessary. While we have argued that policy adjustments to consolidate fiscal positions andpromote growth are necessary, they take time. After months of turbulence, new

governments with apparently strengthened inclinations and political mandates to act are in

place in a number of the most affected countries, including Spain and Italy, but they have

yet to formulate an economic program and enact it through normal parliamentary

processes. Once approved, policy measures will then need to be implemented. And once

they are implemented, investors will need to be reassured that the adjustment and reforms

will not be so economically harmful in the short run that fiscal adjustment slips ever further

off into some hypothetical long run, as has happened in some spectacular adjustment

failures of the past. Investors are forward-looking, but they are not clairvoyant. Having seen

examples of both successful and unsuccessful stabilization programs; they may be forgiven

for adopting a wait and see approach to the ones that are underway in Europe.

While this is going on, Italy and (to a lesser extent for now, because of its smaller debt

stock) Spain will be subject to the intrinsic instability created by vicious circle dynamics and

multiple equilibria that threaten highly levered sovereigns. We cannot rule out that investors

will run simply because they are seized by a self-fulfilling fear that other investors will run.

Moreover, there is every likelihood that holders of European government bonds will be

shaken in the months to come by developments from elsewhere in the eurozone. Some

measure of financial distress and at least a mild recession are pretty much baked into the

outlook already. It cannot be ruled out that confidence in Italy or Spain may be undermined

in the months to come by further unsettling developments in Greece, Portugal, Ireland, or

some country that has yet to capture the headlines.

These financial risks are enormously amplified by the structural change in the eurozone

public debt market that has been caused by the eurozone public debt crisis, and which has

created an overhang of this debt on the books of many traditional holders ( Euro area bank

deleveraging: How much and how painful?, 22 November 2011). Most of the public debt

that is now held by institutional investors was accumulated in a day when investors were

encouraged to think that European government debt was largely without credit risk

(remember the convergence trade?). This presumption was reflected in bank regulatory

requirements which even now attach zero risk weightings to such debt. The presumption of

those days is, of course, long gone. The Greek restructuring exploded the myth that

eurozone sovereigns would not default. In fact, the structure of the private sector

Neither Italy nor Spain has lost

market access

Investors may run simply

because they are seized by a

self-fulfilling fear that other

investors will run

The Greek restructuring

exploded the myth that eurozone

sovereigns would not default
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involvement in Greece heightened perceptions of credit risk, because the losses were

concentrated on private bondholders, and the value of the credit insurance that investors

thought they held against the event was degraded by official efforts (so far successful) to

achieve a restructuring without triggering CDS contracts. European banks are now being

required to raise capital against their exposure to sovereign debt, in what may be

interpreted as a tacit admission that market pricing of credit risk is not utterly without

foundation. European governments have agreed eventually to include collective actionclauses in their bond contracts, the only plausible purpose of which is to facilitate sovereign

debt restructurings in the future. In short, its a new world, and many European banks and

other traditional holders of eurozone sovereign debt who owned it because it was

considered to be safe, and was treated by regulators as such, now find themselves with

much more of the paper on their hands than they can justify. This debt needs to migrate

from traditional, relatively risk-averse holders to investors whose main job it is to assess and

bear credit risk. But this process will take time, and in the meantime, fiscally stressed

governments, including Italy and Spain, need to roll over their maturing debt and finance

their still-substantial budget deficits.

Financing requirements

Italy and Spain have not lost access to debt markets, and there is no need for a program that

takes them out of financial markets, as was done for Ireland, Portugal, and Greece.

However, the possibility of a self-fulfilling run on the countries bonds poses a threat that

can only be eliminated if policy implementation is strong, and a last-resort lender instils

confidence among investors that they will have financing to ride out a period of market

disruption. The benchmark for the required size of the contingent, last-resort lending is the

public sector financing requirements that would need to be covered in the event of a bond-

market strike.

Figure 4: Public financing requirements for Italy and Spain (billion euros)

2012 2013 2014 Total

Italy 398 210 186 794

Short-term debt 144 144

Medium and long-term amortization 201 166 157 524

Net issuance 53 44 29 126

Spain (including regions) 191 106 100 397

Short-term debt 84 84

Medium and long-term amortization 60 71 73 204


Total 589 316 286 1191

Amortization 261 237 230 728


Source: Barclays Capital

Leaving short-term debt rollovers aside, the Italian governments gross funding

requirements for 2012 are just above EUR 250 billion; over the three-year period 2012-14,

they amount to roughly EUR 650 billion, with about 125 billion reflecting government cash

deficits. (The estimates in Figure 4 are based upon deficit projections consistent with the

debt-dynamics exercise discussed above, in which the primary budget surplus gradually

What are the public sector

financing requirements that

would need to be covered in the

event of a bond-market strike?

The Italian governments gross

funding requirements for

2012-14 amount to roughly

EUR 650 billion


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24 November 2011 7

rises to about 4% of GDP in 2014, consistent with an overall deficit slightly below 2% of

GDP in that year, before falling to 3% in the steady-state. We make no explicit allowance for

potential privatization proceeds in the projections.)

Moreover, bank bond redemptions are very large as well, about EUR 80 billion in 2012 alone,

and like substantial parts of the European banking system, the Italian system is likely to

need official liquidity support for the foreseeable future. There are no material risks to theItalian banking system beyond the stressed sovereign. Since the Italian banking system is

fundamentally solvent, the ECB through the extended fixed rate full allotment is likely to

continue to meet the Italian bank funding needs.

In Spain, the public financing needs are about half the size of Italys, amounting to EUR 107

billion in 2012, if once again we exclude the rollover of short-term bills. Over the 2012-2014

period, the gross financing requirement is about EUR 313 billion if short-term debt is

excluded, and just under EUR 400 billion if it is included.

How much of these financing requirements might need to be covered to reduce the risk of a

cash squeeze associated with a run on these sovereigns bonds? Here we have to admit

that we are leaving the realm of the scientific and entering the realm of market psychology.

The short, but not so useful, answer is that the financial war chest needs to be big enough

to convince market participants that the sovereign is insulated from a run. A more

operational answer is that the contingent support should be large enough so that the

endangered sovereign would have time to either allow the external source of an attack to

run its course, and/or to take the corrective action required to re-establish market access.

For the sake of concreteness, let us work with 18-24 months of financing requirements.

For Italy and Spain, this gives a range of about EUR 500 billion (18 months of financing,

excluding short-term bill rollovers) to EUR 800 billion (24 months, assuming that roughly

half of the outstanding stock of short-term bills would need to be covered as well).

Potential sources of funding

The EFSF alone will not suffice

As we wrote previously (EFSF 2.0: Nearly there, 6 October 2011), the EFSF is not sufficiently

funded to deal with the larger countries such as Italy on its own. Under the current

programmes for Greece, Ireland and Portugal, the EFSF would cover about EUR 143 billion

of funding needs, leaving EUR 297 billion for all the rest. If every remaining euro were

committed to support for Spain and Italy, the EFSF could cover something like 35-60% of

the financing needs that we identify above. But this would leave no reserve for unforeseen

(but not unthinkable) contingencies in the other programs, and would crowd out entirely

other uses for the EFSF, such as assisting in the bank capitalization effort, or coping with

another country that may fall into financial difficulties.

It is by now clear that the EFSF cannot be increased meaningfully, in part because ofpolitical resistance, but more fundamentally because the contingent liabilities associated

with the support program have already undermined confidence in some guarantor

countries. France, in particular, has come under market scrutiny in a way that most likely

prevents the country from undertaking additional contingent fiscal commitments on behalf

of financially weaker countries in the eurozone.

European policymakers floated some options to leverage these EFSF resources, including

credit enhancements to new debt issued by member states (probably in the form of first-

loss credit insurance) and new funding arrangements of the EFSF with a combination of

In Spain, they amount to

EUR 313 billion over the

2012-2014 period

For Italy and Spain, this gives a

range of EUR 500 billion to

EUR 800 billion for the next 18-24

months


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24 November 2011 8

resources from private and public financial institutions (including IMF) and investors, which

could be arranged through Special Purpose Vehicles.

As we explained in a previous piece (Leveraging the EFSF: Uses and Limits, 25 October

2011), we thought that these schemes to leverage EFSF resources had some positive

elements, but would have a more limited impact on debt-servicing costs than headline

leverage ratios may have suggested. The initiatives seem to have lost momentum, and wethink that the best estimate of support for Italy and Spain from the EFSF is the EUR 200 to

300 billion in unlevered resources that is left after previous commitments and potential

contingencies are accounted for. Financial engineering could conceivably increase the

headline number, while offering relatively little in the way of additional financial support.

IMF support likely limited in size as well

A complementary option is to bring in the IMF. Augmenting resources with funds from the

IMF could certainly help but with important caveats. The most important of these is that the

IMF only lends with seniority. It provides cash, but not credit, in effect concentrating the

credit risk on outstanding, privately-held debt. The reduction in the recovery value of

privately-held debt is reflected in the credit risk of newly issued debt, thus making it harder

for the beleaguered sovereign to return to markets than would be the case if the liquiditysupport were not senior to private creditors. Senior support of this sort has proven effective

in past IMF programs, but may require a more extended period of official financing than

might otherwise be likely.

The IMF has about EUR 290 billion left in uncommitted resources (its current forward

commitment balance) that could, in principle, be lent in the months to come. Among the

IMFs existing commitments are very large commitments to Greece, Ireland, and Portugal

that were extended in support of the eurozone rescue program for these countries. These

commitments amount, in aggregate, to roughly EUR 79 billion (Greece EUR 30 billion,

Ireland EUR 22.5 billion and Portugal EUR 26 billion), almost 20 times the three countries

IMF quota. This illustrates, on the one hand, that previously applicable constraints on

lending programs relative to borrowers IMF quota have been broken by the Europeanimbroglio. But it also demonstrates how exposed the IMF already is to Europe, which is

likely to pose the main constraint on the financial support that the IMF could lend to Italy

and Spain. If, for example, the IMF were to make EUR 150 billion available as a contribution

to a rescue effort for Italy and Spain (about 11 times their current quotas and about 6 times

their new IMF quotas approved in December 2010 and likely becoming effective in the next

months), it would be left with only EUR 140 billion of lending capacity to cope with potential

demands for IMF resources from the rest of the world.

The IMF could raise the resources available to it for lending, and just did so very significantly

and rapidly. But we very much doubt that there would be any appetite for a generalized

increase in IMF quota contributions after the doubling in quotas that was so recently

approved. China and other surplus emerging market economies do have funds, and might

be induced to lend them to the Fund in exchange for a higher IMF quota and the associated

geopolitical clout. Even then, however, the domestic political atmospherics of still relatively

poor Chinese workers and taxpayers being tapped to rescue over-dimensioned welfare

states in some of the wealthiest corners of the world could be problematic. In addition, the

concentration of IMF exposure to Europe that would be created by a massive extension of

credit could give the IMFs shareholders pause.

The IMF has about

EUR 290 billion left in

uncommitted resources


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On balance, it seems to us that a plausible scenario for IMF support for Italy and Spain is in the

range of EUR 100-150 billion. The EUR 150 billion is roughly 5-6 times the two countries new

quota. The estimate of about EUR 100-150 billion for possible IMF support for Italy and Spain

is about half the EFSF contribution, consistent with the precedent established in the programs

for Ireland, Portugal, and Greece, where the IMF also contributed roughly 1 euro for every 2

euros the European authorities contributed to the program.

All of this is necessarily speculative, of course, but it seems to us that the best estimate of

the financial support for Italy and Spain that could be mustered by the EFSF and the IMF

together is something like EUR 300-450 billion. This falls EUR 200-500 billion short of the

program that we calculated above.

ECB: The last-resort lender of last resort

This brings us, finally, to the ECB. In our view, the ECB has the balance sheet capacity to

support stressed European sovereigns substantially in excess of our (admittedly very rough)

estimates of what might be called for to complement sovereign adjustment and reform

programs. And the ECB has been offering support, although with some reluctance, and in

limited amounts. Although the new ECB President, Mario Draghi, emphasized in his first

press conference the limited and temporary nature of the SMP, in recent weeks, the ECB hasbroadly continued in size and frequency the sovereign bond purchases under the SMP

policy that was revived in August in response to increased pressure on Italian and Spanish

government bond markets. However, ECB leadership and important elements of the political

leadership in Europe have been anxious to discount a more explicit role for the ECB as

lender of last resort.

This reluctance is not justified by balance-sheet constraints. The ECBs accounting capital is

small by comparison with the hypothetical lending operations, and with theoretical credit

losses that could emerge if the ECB were exposed to a sovereign debt restructuring. But

these potential (or even actual) credit losses are essentially irrelevant for the ECBs core task

of conducting monetary policy. The ECBs capacity to absorb loss is not limited to its

accounting capital, but also includes the value of future seigniorage earnings, whose netpresent value amounts to something in the order of EUR 2-5 trillion.1

In the event of a large sovereign credit event, the ECB might have to operate for some years

with negative capital on an accounting basis. But this would have no necessary impact on

the ECBs capacity to conduct future monetary policy. A vivid illustration of this is given by

Chile, whose central bank was rendered insolvent (to the tune of something like 15% of

GDP) by the 1982 financial crisis, and operated very effectively with negative net worth for

decades thereafter.

The ECBs reluctance to establish itself as an explicit lender of last resort to European

sovereigns is grounded not in balance-sheet constraints, but rather in tactical,

legal/constitutional/doctrinal, and conventional policy inhibitions.

The tactical constraint pertains to moral hazard, which in this case is grounded in theperception that market pressure is required to force governments to address their policy

deficiencies. The ECBs SMP operations therefore seem calibrated to prevent a

meltdown of peripheral sovereign markets, while permitting enough market pressure to

induce prompt policy action. This may be a risky policy, in light of the potentially

1 The eurosystems profits are about EUR 30 billion. If these grow at 3.5% per year and are discounted at an interestrate of 4.5% per year, the net present value of the earnings would total EUR 3,000 billion. Even if the relevant numberis half this, it is large by comparison with the size of operations that the ECB has been willing to make so far.

A plausible scenario for IMF

support for Italy and Spain is in

the range of EUR100-150 billion


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24 November 2011 10

unstable vicious circle dynamics that can affect bond markets, but until stronger

policies are in place, an adherent to this point of view would argue that there is no

realistic alternative.

The legal and constitutional issues are serious constraints on the form that ECB supportmight take, though not obviously on the magnitude. The ECB is prohibited from

(directly) financing governments, a prohibition that is grounded in the horrific interwarexperience with monetary finance, particularly in Germany. However, secondary market

operations have not been prohibited by this constraint, although the ECB is careful to

rationalize these operations on monetary-policy grounds.

Finally, there is a concern that engaging in very large lender-of-last resort operationsmay be inconsistent with the ECBs mandate to maintain inflation at low levels. We

should not forget that, until recently, the ECB was beginning to tighten policy to fend off

a perceived inflationary threat. Certainly, heedless, unlimited, unsterilized balance sheet

expansions would pose an eventual inflationary threat.

Given these capabilities and constraints, what can be expected of the ECB in the months

and years to come?

We now believe that further interest-rate cuts will follow the surprise cut announced atthe last monetary-policy meeting, justified by the darkening outlook for economic

activity and associated decline in perceived inflationary risks.

We also see a good chance that the ECB will announce more non-conventionalmeasures. It is even possible that the ECB will finally follow the U.S. Fed and Bank of

England and revert to quantitative easing, or credit easing if the policy rate reached its

lower, near-zero bound. This could involve a much bigger SMP, and possibly even an

announcement of the targeted intervention levels in advance. This should certainly lend

support to the Italian public debt market and others under stress, but it would be

communicated as part of the ECBs strategy to maintain price stability in the face of

deflationary risks or systemic stress in the banking sector.

More decisive ECB interventions in euro area bond markets are likely to be politically moreacceptable once the new governments in Italy and Spain make headway in their policy

agendas. (In this context, we find it significant that the Dutch Prime Minister and Finance

Minister recently stated that they would support the ECB stepping up its unconventional

tools, as long as affected countries carry out the required policy reforms.)

That said, we consider any unlimited commitment to intervene, or an explicit target levelfor government yields or spreads, to be highly unlikely. It is also hard to imagine the ECB

surmounting the legal prohibition against direct finance of governments. ECB support is

likely to take the form of an increase in the scale of intervention in secondary markets

or, more likely, communication to the market that such interventions may be in place for

the foreseeable future. In this context we note that the recently-floated cap of EUR 20billion per week on SMP operations allows for very consequential cumulative support,

although it would be spread over an extended period of time.

In short, we think there are grounds for optimism that reluctance to use the ECB balance

sheet to support sovereign debt markets more forcefully will ease, as inflationary

considerations give way to a need to support a weakening economy and manage the bank

de-leveraging that is underway in Europe, and as governments in the affected economies

establish a more reassuring track record of reform implementation. However, the de facto

Reluctance to use the ECB

balance sheet to support

sovereign debt markets more

forcefully may ease


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24 November 2011 11

lender-of-last resort operations will continue to coexist uneasily with the ECBs institutional

mandate, and institutional distaste for the operations is not likely to fade entirely. The ECB is

very likely to continue to confine its intervention to secondary markets.

Final thoughts on the endgame

There is an optimistic way to read our assessment of the state of play. Combined withplausible support from the EFSF and the IMF, the ECBs contribution via the SMP could

plausibly be sufficient, on paper, to provide a financial war chest commensurate with the

scale of the contingent financing risks that might sensibly be addressed as part of the policy

package to restore Europe to financial health.

But doing so requires a patchwork of support from a variety of sources, none of them

actually operative at the moment, except the ECBs SMP, which is now being implemented

with some considerable reluctance, controversy, and arguably even distaste in European

policy circles. We see little room for doubt that contributions from the EFSF and the IMF can

be mobilized, but progress may need to be catalyzed by adverse developments. In other

words, it may (still) need to get (even) worse before it gets better.

The question arises whether the constraint on the ECB to operate in the secondary marketweakens significantly the value of the ECBs potential contribution. Here is how we think

about this. As long as markets are functioning and governments remain able to tap private

financing, there is an important degree of fungibility, and ECB operations in the secondary

market should catalyze private participation in private markets, by making room in private-

sector balance sheets and by providing some reassurance that the bond market is not on

the verge of a free fall. Secondary market interventions operate indirectly, and they may be

less efficient than participation in primary markets would be, but they should be effective.

When it comes to the tail risk of managing a buyers strike in which the sovereign loses

access to private finance, like Greece, Portugal, and Ireland have done, it is another matter.

Under these circumstances, investors are in a corner solution; they simply want out of their

exposure at essentially any price. In circumstances like these, secondary marketinterventions may simply take private investors out of their exposure, without promoting

any meaningful private support for primary market issuance. In this sense, secondary

market operations are a far less effective mechanism to help a beleaguered sovereign

manage a loss of market access.

In short, while it is not too difficult to identify plausible financial contributions from the

EFSF, the IMF, and the ECB that add up to a program that adds up on paper, the whole may

be somewhat less convincing to markets than the sum of its parts, and it may once again

come late enough in the game that it will fail to prevent economic fallout that could

plausibly have been prevented by a more pre-emptive approach. The patchwork of support

that is very probably available, but not yet in place, seems very likely to fall short of the show

of force that could induce financial markets to turn the page on the problem.

Another missing element is a clear sense of the end game of the European drama. It is

certainly to be hoped that the emergency policy adjustments and support programs are

transition mechanisms but transition to what? One possibility is to creditworthiness; call

this the Brazil scenario in which policy adjustments alone eventually transform

precariously-positioned European sovereigns into strong economic and credit stories. But

this scenario is, to us, unrealistic for a country like Italy, except perhaps on a 10-20 year

time frame. Brazil was able to de-dollarize its public (and much of its private) debt at the

same time that it engineered a fiscal consolidation and strengthened its monetary policy


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24 November 2011 12

framework. And when all was said and done, the public debt was closer to 50% of GDP than

100%. This is not an option for Italy, as long as it remains in the euro area, as we think it

should and will. After it has fixed its budget and implemented pro-growth reforms, it will for

many years have a public debt in excess of 100% of GDP, issued in foreign currency, and

without a true lender of last resort. Two or three years from now, investors may not view

Italy as dancing on the brink of insolvency but the sovereign will remain in an intrinsically

precarious financial position as long as this is the case.

Thus, without a reasonably specific and credible agenda at the euro-area level on what

EMU2.0 will be, markets are unlikely fully to settle. International investors are no longer

viewing many of the euro area sovereigns as risk free, including Italy and Spain. And they are

unlikely to return to these markets unless a structural change happens in Europe that involves

not only corrective policies in Italy and Spain, but also a reasonably clear path towards a less

precarious institutional framework, including for example more euro-area integration and

perhaps the issuance of Eurobonds. The ECB, too, and perhaps also the IMF, are also unlikely

to feel fully at ease assisting the euro areas transition if they have no clear sense of the

endgame. This is one crisis where the odds of success in managing the crisis depend to a

substantial degree on developing a more coherent vision of the post-crisis landscape.


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