Dear All, There are a number of important events to monitor this week. In Japan, PM Noda’s will decide whether to restart nuclear reactors in Ohi against massive popular opposition. This is an important step to determine the future energy mix of Japan, the associated oil demand and the scope for additional global rebalancing stemming from Japan’s future current account position. In Europe, Spain remains in the limelight and the increasingly likely program to help recapitalize its banks, raises a number of important questions for all the stakeholders, including for the IMF and the ECB. President Draghi once again made a very explicit and bold call for a banking union but leaving to governments the responsibility of clarifying what it encompasses and not specifying the role that the ECB could play in the process. I will focus on: 1.Eurobonds and the proposals of the Goulard report, 2.The future Spanish program and burden sharing issues, 3.Deposit guarantee schemes
There are a number of important events to monitor this week. In Japan, PM Noda’s will decide whether to restart nuclear reactors in Ohi against massive popular opposition. This is an important step to determine the future energy mix of Japan, the associated oil demand and the scope for additional global rebalancing stemming from Japan’s future current account position.
In Europe, Spain remains in the limelight and the increasingly likely program to help recapitalize its banks, raises a number of important questions for all the stakeholders, including for the IMF and the ECB. President Draghi once again made a very explicit and bold call for a banking union but leaving to governments the responsibility of clarifying what it encompasses and not specifying the role that the ECB could play in the process.
I will focus on:
1.Eurobonds and the proposals of the Goulard report
2.The future Spanish program and burden sharing issues
3.Deposit guarantee schemes
1. Eurobonds and the proposals of the Goulard report
The discussion on Eurobonds has been somewhat accelerated by the inclusion of this topic at the last “informal” European Council meeting and by successive references to increased fiscal union by President Von Rompuy and other HoSGs (Monti, Hollande, Rajoy).
Sylvie Goulard (MEP), the rapporteur of the parliament on the matter, is presenting her report this week and is making two bold proposals that are likely to stir up the debate and force both the Commission and the European Council to make more steps forwad.
He proposals are generally consistent with the path to commonly issued debt that I had presented here a couple of weeks ago and it acknowledges the need to work on the sequencing and the combination of the many different proposals.
We agree that both the redemption fund and the eurobills are the two most suitable starting points to a proper issuance of common debt but that both options, taken individually are insufficient. I had presented two possible paths a couple of weeks ago, one starting with Eurobills, the other starting with the redemption fund.
The Goulard report instead proposes to combine both at inception. This is an interesting and potentially more effective proposal and allows overcoming the shortcomings of both proposals taken individually.
However, it seems to assume that there is no political cost associated with adopting both proposals concurrently instead of choosing one, while in reality there probably is, simply because guarantees involved would be cumulative (eurobills ≈10% of GDP of guarantees, and redemption fund is about 27%)
All in all, the report draws an excellent and ambitious roadmap stressing on what is achievable within the confines of the current treaty and highlighting the profound need for deep changes in primary legislation to achieve a complete fiscal union and the associated common issuance framework.
2. The future Spanish program and burden sharing issues
Despite public objections, there are now growing discussions about the possible contours of a Spanish program. This brings several unresolved and contentions issues to the fore. The first one is the extent to which policy conditionality should be limited to the banking sector or extended to fiscal policy in general.
It now seems that a broader program, involving fiscal policy would make European partners more comfortable and would be necessary if the IMF ought to be involved. Spain could have negotiated a precautionary program months ago and it decided that even a light conditionality and high access program (along the lines of the Precautionary Credit Line) was too politically costly then.
Meanwhile, with deteriorating conditions on the banking side and growing concerns of the control of regional public finances, there is no more scope for a precautionary program and admittedly limited experience at the fund (and elsewhere) to design a pure banking system related program.
On the part of the Europeans, the main concern is the extent to which European taxpayers should be exposed. I tend to think that whether the EFSF/ESM recapitalizes banks directly or via the sovereign is a mere technical detail if there is an understanding ex ante of the burden sharing involved with the banking restructuring exercise.
To comply with the current EFSF/ESM guidelines and statute, one could very well structure a program that explicitly allows for some burden sharing of banking losses through a future restructuring, with haircuts of the claims of the EFSF/ESM on Spain. Yet the recapitalization process in Greece and the reluctance with which the EFSF allowed the Hellenic Fund for Financial Stability (HFSF) to invest in Common Equity is a poor precedent.
It is quite likely in fact, that the demands of safeguards expressed by northern European countries will explicitly avoid or limit burden sharing. In that case, and given the general reluctance for official sector involvement, financial markets will conclude that they would become junior creditors of a country whose banking system restructuring would increase the chance of a rapid recognition of large banking sector losses.
This ought to restrict substantially access to primary market and would increase exponentially the pressure on the secondary debt market and as a result would increase the need to take Spain out of primary markets completely.
As a result, the choice is the following:
- Either Europeans explicitly agree on a ≈100bn euros program specifically designed to restructure and recapitalize the banking system and accept to share losses arising from this exercise along the Spanish government (under a 50/50 sharing rule for instance or any other that is consistent with Spain keeping a non explosive debt/GDP trajectory).
- Europeans refuse the principle of burden sharing of banking system related losses and in that case, they need to design a much bigger program that would take Spain completely out of the primary market for the next couple of years and would involve a forward commitment in excess of 200bn and ultimately potentially bigger losses than under scenario 1.
Option 1 appears superior on many levels and would accelerate the formalization of the banking union that is now on every lip. But it might well be too daring for most European leaders at this stage. Yet both Greece and Spain are forcing us to face up to the issue of burden sharing between European taxpayers. Evading this unavoidable reality will only delay the resolution and make the implied transfers larger.
3. Deposit guarantee schemes
Of the many elements of a banking union, the deposit guarantee scheme is the one that appears the most reachable. First because it responds to the urgency of the ongoing bank run, or bank jog as Mohamed El Erian refers to it.
There are several important questions related to the shape and form of any possible supranational guarantee scheme. The skeptics argue that, so long as it doesn’t address redenomination risks, these schemes would have limited effect.
I tend to disagree because concerns over euro exit seem to be limited to one country where they indeed drive deposit attrition. But in other countries like Spain, Portugal or Italy, deposits have remained, on aggregate, broadly stable and what has taken place is a flight to safety from perceived bad banks to good banks, within the country.
So long as bank jogs remains only moderately driven by risks of currency break up, a supranational banking deposit scheme can be effective.
The second problem is whether a completely supranational system needs to be created from scratch, whether a backstop of existing national ones would suffice, whether all countries should be covered and finally whether it should be backstopped by the ECB?
- A supranational one, backed jointly and severally by all euro area member states should be the ideal (For the sake simplicity, let’s leave the UK out of this for now, although there should be real debate as to whether this mechanism is a feature of the single market for financial services (ie. EU27) or a feature of EMU17?).
- In the meantime, it is probably difficult to abandon all national schemes that are quite diverse in nature, some have vested assets, others don’t, some are privately run, other fully public, some are based on an insurance model to which banks pay a premium, that varies across countries, and in general, all of them have pretty limited resources compared to the deposits. Hence, it might be necessary to let those live, at least during a transition phase until the creation of a real supranational one based on an agreed and shared framework that would probably involve the collection of a higher premium from banks on their deposits (they are now paying from 0.625% to 0.0175% of guaranteed deposits depending on the country).
- The question of coverage is important and the tempting idea of excluding countries under a program and Greece in particular is dangerous. Although, the single biggest sign of commitment to the integrity of the euro area that policymakers could send would be an effective guarantee of Greek deposits. The strength of this commitment would in and for itself contribute to stability. Although, it would undoubtedly bring forward debates over fiscal solidarity and the fiscal union.
- Indeed, although the risk of these being ever triggered are small, deposit guarantee schemes effectively involve notional amounts of public sector guarantees that are extremely large (total euro area deposits are 17.4 trillion euros).
- As a result, given the incomplete nature of the fiscal union in the foreseeable future, the question is whether even a joint and several guarantee of a disparate, fiscally stretched and ever disagreeing group of countries is credible enough in the eyes of depositors. The answer might be that at least, in the transition phase, the implicit or explicit backstop of the ECB might prove necessary.
- The simplest form it could take would be, to have the ESM guarantee national deposit schemes and the ESM securing a banking with effective access to ECB liquidity should it prove necessary. This is probably the single most efficient supranational deposit guarantee scheme that can be created over a weekend.
But over the medium term, this question of deposit guarantee scheme is inextricably linked to that of supranational supervision. The euro area had this debate in 2009 (with the De Larosiere report) and concluded that one could only achieve so much centralization of these functions.
These conclusions have to be revisited and it paradoxically, increasingly seems that the “incestuous” relationships that many banks entertain with their respective sovereigns and supervisors across the euro area are the essential hurdles standing before a decisive step in the resolution of the banking crisis.
Happy to have your thoughts as usual,
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