Thursday, 14 June 2012

Guy Foster: My eurozone policy wish list

As policymakers wrestle to get the eurozone crisis under control you could be forgiven for thinking that they don't know what they're doing. Perhaps they don't, but as EU policymakers are nationally elected representatives, and the ECB and IMF officials are appointments of elected representatives, we can expect policy to be swayed by a myriad of vested interests.

With that in mind I thought it might be worth detailing my own, politically-unfettered, policy wish list:

Effectively insure contingent liabilities

Various elements of the banking system need to be recapitalised. Chancellor Osborne yesterday, and the French today, are reported in the FT as pushing for capital injections to be made ‘directly’ into the Spanish banks. The rationale here is that in each nation’s banking system the banks tend to be substantial creditors of the government while the government has ultimate duty to recapitalise the banks (if needed). Therefore, particular weakness in either the national or banking balance sheets could be enough to start a negative feedback loop which can only be broken by bringing in new funds from a third party.

Back in September when discussing how the crisis could be resolved I pointed out the benefits of using the eurozone bailout fund to issue contingent convertible securities into troubled banks.

Contingent convertible securities pay a high coupon which rewards their creditors, if the €100bn Spanish investment had been made last September then the creditors would already have received at least €5bn back in interest by now – some good news for Angela Merkel to take back to her electorate.

‘Continentalise’ troubled institutions

The risk however is that the banks deteriorate further in which case the securities cease paying interest and convert into common equity, diluting the existing shareholders.  That would be expensive for the creditors but it would also give them control over those institutions. A banking union has been discussed as a potential source of strength for the European Union, aspects of it would, however, quickly be achieved by taking voting control of troubled financial institutions. I referred to this as “continentalisation” of the banking system.

Recant the official sector’s seniority

The fact that the current Spanish deal adds €100bn (9% of GDP) to the Spanish debt burden pushes it towards the crucial 90% debt to GDP ratio at which point growth becomes more severely impaired. This, however, is only part of the policy mistake. The rest relates to the dangerous precedent established in February when the Greek bond swap (default) saw private sector investments bear the burden of the public sector’s refusal to bear losses. The implications of this are that countries are weakened by public sector support, rather than strengthened by it.

That precedent should be reversed, even if it means losses being retrospectively accepted by the public sector in relation to Greece. Otherwise the implications of any resumption of the Securities Markets Program (SMP), or some more meaningful policy of quantitative easing, will weaken the eurozone further rather than strengthening it.

Create incentives for improving competitiveness

The final policy measure I would wish for would be a dramatic one although conceptually I believe it is entirely justifiable. The ECB should make an assessment of the economic competitiveness of all eurozone countries, it could indeed use the conclusions of recent IMF or World Economic Forum studies if it wished to emphasise its independence. Based upon the results of this it should announce an appropriate cost of long term debt for each country, making it clear that at higher yields the central bank would be a buyer. I don’t believe large purchases would be made (unlike the SMP) as the explicit statement that the bank will buy at that yield would implicitly cap potential losses for the private sector – encouraging them to participate at lower yields.

This arrangement would create a powerful incentive for the likes of France, Spain and Italy to align their labour policies with those of Germany and Holland.

The barrier to this is purely one of interpretation; does the ability of the public sector to suffer losses on government debt constitute central bank financing of national debt? In the UK our own quantitative easing is achieved through an indemnity granted to the asset purchase facility by the treasury against losses. The same ought to be true of the eurozone.

So that is my European policy wish list. This solution is devoid of moral hazard and could be easily implemented without the need for treaties or referendums.

Guy Foster
Head of Portfolio Strategy

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