Wednesday, May 12, 2010

The European effort to "shock and awe"

So after all the reluctance and prevarication, and faced with inevitable sovereign defaults and the very real possibility of a global contagion (with a resultant double-dip global recession), the Europeans have finally acted. Taking a leaf out of the Obama administration's $700 bn bail out of Wall Street, the EU and IMF announced a $957 bn rescue package of Greece, Portugal and Spain, to "shock and awe" the financial markets so as to revive confidence in Euroland.

This new package follows the failure of the $140 bn EU-IMF bailout last week to enthuse the markets. In contrast, the latest, completely unexpected announcement, has brought cheer to the markets. Equity markets across the world surged in response to the rescue package.

The EU finance ministers agreed to provide $560 billion in new loans and $76 billion under an existing lending program, while the IMF agreed to give up to $321 billion separately. The package also includes the creation of a "special purpose vehicle" to disburse the 440 billion euros in new loans, should that support be required by member states in economic difficulties.

Further, the European Central Bank (again reflecting what the Fed did in the US) announced that it would intervene in the government and corporate bond markets to provide liquidity and prevent freezing of credit markets. The ECB, which has so far rebuffed calls to inject liquidity into the markets by buying back European bonds, announced that it would take whatever steps were necessary to smooth out the secondary markets for public and private debt.

And in a sign of the spreading anxiety about the crisis spilling over outside Europe, the Fed, along with the ECB and the central banks of Canada, Britain and Switzerland, announced the establishment of swap lines intended to make it easier for European companies, institutions and governments to borrow dollars when they need them. Under these swap lines, the Fed will be printing dollars and exchanging them for euros to provide more liquidity, and thereby help the ECB make dollar-denominated loans to European financial institutions.

The swaps are broadly similar to one that the Fed itself introduced in December 2007 following the sub-prime meltdown. Under that, the Fed provided dollars to central banks in exchange for an equivalent amount in foreign currency (the foreign central banks paid the Fed interest equivalent to what they made from lending the dollars; while the Fed did not pay any interest on the foreign currencies it took in exchange, having agreed to hold them instead of lending them out or investing them in the private markets), based on prevailing exchange rates, and the parties agreed to make the same exchange in reverse at a later date — anywhere from one day to three months later — using the same exchange rate as in the initial transaction.

Though the completely unexpected nature of the rescue announcement has "shocked and awed" the financial markets, whether it is adequate or not is another matter. While it may be a step in the right direction and around the requirement to restructure the debt liabilities of these countries (atleast for the time being), they will do little to avoid the inevitable fiscal austerity that these countries will have to undergo. I have blogged about this in an earlier post here.

Paul Krugman argues that while the bailout plan appears to confuse a solvency problem for a liquidity problem, the ECB's willingness to undertake expansionary policies is a welcome sign. The possibility of inflation in Eurozone due to an expansionary policy by ECB could reduce the extent of deflation required by the likes of Greece to regain their competitiveness.

Some have criticized the bailout for containing only new loans (to help Greece and Co raise money at normal rates so as to reschedule its debts) instead of any actual decrease in the debt burden. They claim that this will only delay the ineveitable default by helping these countries raise enough money to temporarily repay their debts coming due in the immediate future. Further, as Krugman pointed out, it overlooks the fact that some of the debtors may actually be insolvent and may not be able to repay them at any time.

While this arguement is surely correct, like the US bailout, the broad underlying premiss of such liquidity support bailouts is that by making available ample liquidity at lower than prevailing market rates, the beleaguered firms and countries may be able to buy enough time to repair their balance sheets and for normal economic activity to get restarted. In other words, hope that with time market confidence returns and everything will be back to normal.

I am inclined to the opinion that this line of arguement overlooks the fact that Greece (and others) would need more than just reschedule its debts to return to normalcy. I have already blogged about the more fundamental structural challenges facing these countries. The resuce package will sure help, indeed it is a small first step in the long road to recovery. In fact, as Simon Johnson and Peter Boone have shown, even with a rescheduling of debts, the numbers are so staggeringly dismal and even the medium-term economic prospects too bleak that nothing short of a default (with haircuts) will help Greece. And even with all this, fiscal austerity cannot be avoided.

Even accepting the importance of reassuring the banking system of European commitment to maintaining financial market stability, the creditors to these nations surely deserve to be penalized for their irresponsible lending decisions. The massive exposure to Greek, Italian, and Spanish debts by German, French and British banks cannot be justified based on any fundamentals-based evaluations. It is clear that they lowered their guards and indulged in irresponsible lending to governments and private agencies in the peripheral economies.

The present structure of the rescue packages, which effectively seeks to provide the ailing economies with more money to enable them to reschedule/roll-over their existing debts, is more beneficial to the creditor banks than the debtor nations. Their debt burden will remain unchanged, while the banks get away without any loss.

A more equitable approaach would have been to tailor a debt restructuring program, on the lines of the Argetine default of 2001, wherein the creditors take a "haircut". Another approach would have been to atleast impose a moratorium on interest payments and roll-over the loans for longer-tenors at the same rates. In both cases, the bankers would be held accountable for their lending decisions.

By setting up a special purpose vehicle to raise loans (not clear whether the loans would be raised with the sovereign backing of European governments, including German and French governments or at prevailing market rates and then given at subsidized rates to Greece and Co) and the lend to the the affected nations, the creditors are effeectively incentivized to exit with their principals, and leave the SPV to fill in the credit gap. If this trend plays itself out for all the peripheral nations, then $ 1 trillion could disappear very fast.

Update 1 (13/5/2010)

Economix has questions and answers with Simon Johnson, Yves Smith, and Carmen Reinhart here, here and here.

Update 2 (14/5/2010)
A summary of Vox economists on the Euro crisis.

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