European policymakers began discussing new ways of boosting the capacity of their €440 billion bailout facility, in the clearest sign yet that the eurozone is getting ready to rescue a big country such as Italy or Spain from the unfolding debt crisis.
After a weekend of being told by the United States, China and other countries that they must get more aggressive in their crisis response, European officials focused on ways to beef up their existing €440 billion rescue fund.
The EU economic commissioner, Olli Rehn, said on Saturday that as soon as the region’s governments confirm new powers for the bailout fund – the European Financial Stability Facility – attention would turn to how to get more impact from the existing money.
The new powers are expected to be ratified by mid-October. Germany’s parliament votes on them on 29 September.
Germany opposes contributing more money to help countries it sees as profligate and the focus has now turned to ways to leverage the existing bailout fund, possibly through the European Central Bank.
Eurozone officials acknowledge that the EFSF is not big enough to handle a bailout of Italy or Spain, the region’s third and fourth largest economies. Analysts say a bailout fund of around €2 trillion would be needed if the crisis spread to Italy and Spain.
A senior European official hinted that kind of firepower was being contemplated.
“We need to find a mechanism where we can turn one euro in the EFSF into five, but there is no decision on how we could do that yet,” the official said.
But there is no clarity on how the fund could be raised without more guarantees.
Lorenzo Bini Smaghi, an Executive Board member at the European Central Bank (ECB) said on Monday (26 September) that the existing money could be used as collateral to borrow from the ECB, making more money available for crisis fighting.
One idea is for the fund to act as an insurer, guaranteeing the first portion of losses on Italian or Spanish debt. That could “leverage” its capacity four or five times, but the legality of such a scheme remains to be established and nothing has been put to eurozone finance ministers.
Another proposal would be to turn the EFSF into a bank, which would allow it to access ECB funds, meaning that it would effectively have unlimited capacity. But the ECB has raised concerns about such a step, which would politicise the bank’s operations and put it on the line for massive liabilities.
Below are some ways the eurozone could make better use of the money already available to the fund. Discussions are still at a preliminary stage and several options are being considered.
1) The EFSF could become a bank
This is an idea presented by Deutsche Bank Chief Economist Thomas Mayer and Centre for European Policy Studies chief Daniel Gros. They argue that if the EFSF were a bank, it could refinance itself at the European Central Bank.
With its €440 billion, the EFSF could buy bonds of countries under market stress on the secondary market and then use these bonds as collateral to borrow cash from the ECB in the central bank’s liquidity operations, as other banks do.
In this way, the EFSF’s money would be multiplied without governments adding extra funds and the ECB would not be directly involved in financing the fiscal policy of governments.
The problem with this solution, already voiced by Bundesbank President Jens Weidmann, is that obtaining a banking license for the EFSF could be problematic – the fund is hardly a bank, it is a special purpose vehicle set up to help finance governments.
EU law forbids the ECB to finance governments, directly or indirectly through a special purpose vehicle like the EFSF. Such a solution would also expose the ECB to losses in case of default of a country whose bonds it holds.
2) Pushing forward the ESM
Some officials believe it could be easier to get a banking license for the European Stability Mechanism (ESM) – the €500 billion permanent bailout fund that is to replace the temporary EFSF in mid-2013.
Rather than being a special purpose vehicle like the EFSF, the ESM will be a permanent financial institution with its own paid-in capital of €80 billion.
But some central bank officials are equally skeptical about refinancing the ESM as the EFSF, since the ultimate purpose of both was the same – to help finance governments.
Germany has proposed to push forward the launch date for the ESM from mid-2013 to early 2012 – basically as soon as all the eurozone countries will have ratified the already agreed upon legislation to create it.
3) EFSF as an insurer for ECB bond purchases
This is an idea building on elements of the US Term Asset-Backed Securities Loan Facility from 2008.
The EFSF and/or ESM could use its funds to cover potential losses the ECB could incur on its purchases of bonds of countries under market stress – up to a certain amount.
In this way the ECB would have a guarantee it would not lose money on the bonds it buys to smooth out market turbulence under its existing program aimed to improve the transmission mechanism of monetary policy.
Depending on the assumed loss, the money at EFSF disposal could guarantee bond purchases many times its size. Like an insurer, it would only pay out in case of a default – an unlikely scenario for Spain or Italy.
For example, the EFSF could say it would cover the first 20% of losses that the bank could suffer in case of a default – multiplying the EFSF’s firepower fivefold.
The problem with this solution is that it would require the ECB to continue buying eurozone government bonds, which the bank does not want to do, as it can be perceived as helping finance government fiscal policies.
4) EFSF as insurer for investors
Instead of guaranteeing to cover potential losses for the ECB, the EFSF could insure bond purchases of other financial market actors, possibly even charging a fee.