Saturday, October 1, 2011

Does Europe needs its version of TARP/TALF?

It is increasingly evident that the Eurozone stands at the precipice, with the serious danger of carrying the world economy down with itself.

The combined ECB-IMF bailout, operated through the European Financial Stability Fund (EFSF) appears too little to make any meaningful dent on Europe's growing list of problems. In simple terms, Europe is facing its Lehman moment. The markets are clearly unimpressed by the amounts provided under the EFSF and are ratcheting up the pressure on the peripheral economies. In recent weeks, the cost of insuring Greek and Italian debts have exploded, as have their bond yields and spreads with German bund. Europe clearly needs much more ammunition in its armoury to come out of this with the Eurozone intact and without suffering massive economic damage.

The obvious risk is the catastrophic cascading effect a sovereign default can have on the global financial markets, leave alone the European markets. More immediate danger, and one which is already playing itself out, is the credit squeeze being felt by most European financial institutions, as wary lenders from across the Atlantic and elsewhere are working out ways to pare down their Eurozone exposure.

A sovereign default by Greece, while theoretically manageable, is certain to amplify market uncertainty and risks across the financial markets, and thereby increase the pressure on countries like Italy. A run on Italy, leave alone a full-fledged default, will be well-neigh unmanageable. The European financial markets are most certain to seize as these dangers start showing up in the aftermath of a Hellenic default. And the impact of all these on the global financial institutions, on both sides of the Atlantic, including Germany, will be very damaging for their balance sheets.

The need of the hour then, as US faced in the aftermath of the Lehman default, is to immediately address the solvency and liquidity crisis that is brewing and threatening to go out of hand. The former requires a massive banking recapitalization program, while the later demands opening an expansive liquidity injection window. The Euro 440 bn EFSF, intended to inject capital into distressed banks and purchase sovereign bonds so as ease the pressure on their yields, may be too little too late to serve the purpose.

The EFSF will be able to lend up to 440 billion euros, or about $600 billion, and issue guarantees for 780 billion euros. However, a more realistic requirement is estimated at nearly 2 trillion Euros. Given the politics of Eurozone, this looks clearly unrealistic. Though announced more than three months back, the EFSF is yet to get approval in all member Parliaments, highlighting the difficulties of decision making in the Eurozone area. Even otherwise, with a total Eurozone GDP of 9.5 trillion euros, this would be more than 25% of the total GDP.

In the US in 2008, as part of the TARP and the TALF, the Treasury and the Fed carried out both operations, with the former in massive scale. Liquidity windows were opened, blanket credit guarantees provided, collateral standard relaxed, and the Fed even carried out massive purchases of certain failing assets in order to backstop the markets. The Fed almost tripled its balance sheet to emerge as an effective lender, insurer and even buyer of last resort to prevent the markets from fully seizing up.

Such aggressive actions may be required to soothen the markets somewhat and weaken the grip of widespread panic. If the liquidity infusions are in sufficient size and done without much delay, it may be possible to buy enough time for the beleaguered institutions to recover some lost ground, and bring some semblance of normalcy back to the markets, thereby preventing a full meltdown. One of the big policy successes, atleast in terms of its immediate objective, of the past four years has been the US financial market bailout initiated in late 2008. Addressing the deeper and fundamental issues of individual bank solvency and economic and financial market restructuring can be taken up once this stage is surmounted.

But there are serious doubts about the effectiveness of such policies in stemming the panic. The assumption is that equity injections and credit infusions will buy enough time for the Eurozone economies to restore market confidence, lower the cost of financing their sovereign debt, bring debt servicing burden under control, and put the economy back in a robust growth path. But critics have raised doubts about this optimism.

The biggest structural problem facing many of these economies, especially Greece, Portugal, and Italy, is the need to reduce their cost of production and regain competitiveness. This is traditionally done by devaluing domestic currency or cutting wages. The former is not an option as long as they remain within Eurozone, while the later will in all probability exacerbate the problem and push the economy further down. This could in turn trigger off a debt spiral, further increasing the debt-to-GDP ratio and sovereign debt servicing costs.

In any case, given all the aforementioned, if the Euro experiments has to survive, it is inevitable that the core economies step in with more explicit and larger support for the beleaguered peripheral ones. That support has to come either in the form of direct fiscal transfers or some mixture of monetary expansion, including some way using the Eurozone's combined balance sheet to finance the debt of the weakened economies, and partial defaults or haircuts. Preferably all of them. Further, the more this intervention is delayed, the steeper will be the recovery path and higher will be the price to be paid.

Update 1 (6/10/2011)

The ECB and Bank of England announced measures to support the financial markets. ECB said it would start offering banks unlimited loans (banks have to put up collateral like bonds or other securities) at the benchmark interest rate for about one year, up from the previous six months. The ECB also said it would resume buying so-called covered bonds, which are a form of debt secured by packages of loans and guaranteed by the issuing bank. Covered bonds are one of the main ways that banks raise money.

The Bank of England decided to retain interest rates at 0.5% and also announced the decision to widen its so-called quantitative easing program to £275 billion, or $425 billion, from £200 billion.

Update 2 (13/10/2011)

On what needs to be done for Europe, Martin Wolf writes,

"The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011."

But he identifies the formidable challenge of making crisis management compatible with fiscal adjustment,

"... there is an opposing risk, that forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.

No doubt, a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure."

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