Sunday, May 9, 2010

Did the EU Agree on a Bailout or a Press Release?

In an effort to prevent more market panic over sovereign debt problems, the European Union's finance chiefs held an emergency conference in Brussels today. As Asian stock markets commenced trading, the EU began issuing press releases trumpeting a rescue package, which may be valued as high as 750 billion Euros (or close to $1 trillion). Asian markets have risen on the news, and U.S. stock market futures are up 2% to 3% as we write. However, there may be less to the EU's "bazooka" than meets the eye.

The central element of the bailout is a 440 billion Euro (approximately $560 billion) "special purpose vehicle" that evidently will lend to weaker EU nations or guarantee their debt. Participation in the SPV is voluntary and each participating EU member is responsible for only a pro rata share of the SPV's obligations. In other words, there's no certainty that all EU members will participate in the SPV, and its claimed 440 billion Euro capacity may turn out to be considerably less if grouchy EU members like Germany don't participate. The SPV will expire after three years (so longer term sovereign debt may continue to present an unresolved problem). Why would a voluntary measure be the centerpiece of the bailout? Because there's no established mechanism in the EU's governance structure for assistance to distressed members.

It will evidently take weeks, at a minimum, for the SPV to be created, funded and ready to roll. A lot can happen in weeks. Perhaps as an interim measure, the European Central Bank announced that it was prepared to begin buying sovereign and private debt in the secondary markets, something it's been avoiding as part of its overall anti-inflationary stance. The ECB said it would conduct "specific operations" to re-absorb the liquidity injected through these secondary market purchases. It's unclear how the ECB would do that. One way might be to sell good bonds it holds. But that could result in the ECB buying a lot of stinky sovereign and private debt while parting with its good assets. Who then would recapitalize the ECB?

Another potential result of ECB secondary market debt purchases is that it could end up buying debt bought by hedge funds and other speculators for cents on the Euro. It's likely that speculative traders have not only bet on the Euro falling, but may also have bought up distressed Euro-denominated debt to cover the possibility that the Euro makes a comeback. The EU's electorates would probably be displeased, to say the least, if the ECB ends up providing a profitable put to speculators.

The IMF has supposedly lined up to charge with the SPV into the valley, cannon to the right, cannon to the left, and cannon in front of them, offering as much as 220 billion Euros to SPV borrowers. But IMF loans come with strings attached, and there's no certainty that borrower nations will agree to the tough terms the IMF typically seeks. Greece has struggled mightily to achieve the political will needed to accede to the IMF's terms. Citizens of other debtor nations may have trouble seeing why they should make sacrifices for the stability of the Euro (and its consequent benefits for Germany and other wealthy EU nations).

Politics in the wealthier nations are also a complicating factor. Germany's ruling Christian Democratic Union lost a regional election today, weakening its ability to secure German participation in the Big Bailout. The U.K., which was standing on the sidelines because it hasn't adopted the Euro, may be headed for a mostly Tory-oriented coalition after last week's inconclusive election. In that circumstance, Britain will likely fortify the coasts of Kent and Sussex against an invasion of Continental financial flu, rather than be drawn into the bailout frenzy.

The need for a definitive resolution to the EU's problems couldn't be clearer. But EU continues to be hamstrung by the fact that, simply stated, it isn't truly a union.

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