Thursday, July 26, 2012

Eurozone - (desperate) attempt to load the bazooka?

Markets reacted cheerfully to Austrian central bank governor Nowotny’s comments on a possible banking licence for the ESM. Too cheerfully, in our view.

The latest escalation of market tension, elevated bond yields in Southern European countries and speculation about future bailouts in the Eurozone has again given rise to concerns about the size of the Eurozone’s rescue funds, the bazooka. Remember that, despite earlier attempts to find highly sophisticated but disappointing leverage options and the famous permanent rescue fund, the ESM, currently the only active rescue fund (besides the ECB) is the temporary EFSF.

How much money can the EFSF still use? The EFSF started with a lending capacity of €440bn. Up to now, the EFSF has actually disbursed €138.3bn for Ireland, Portugal and Greece. Shortly, €30bn will follow in the first tranche for the Spanish bank bailout. Additional €85bn plus up to €70bn for Spain have already been reserved for the remainders of the bailout programmes. If all reserved disbursements will be paid out, the EFSF would only have roughly €120bn left for any future bailouts or other actions. Obviously, this is not a lot.

The ESM, with a fresh lending capacity of €500bn, was supposed to bring some relief but this relief will, at the earliest, only come after the German Constitutional Court’s verdict in September. However, even with an ESM up and running, concerns about its size are likely to continue. This is why periodically new proposals to increase the Eurozone rescue funds’ fire power are circulating. Basically, there are only two ways to increase the EFSF/ESM’s size: either Eurozone countries increase their individual shares (currently highly unlikely in several core countries) or the ECB enters stages (either directly or indirectly).

One of the favourite options for indirect ECB participation is the so-called banking licence for the ESM. The aim of this idea is to increase ESM leverage through ECB liquidity. The label banking licence is actually misleading. The ESM does not need a banking licence. As stated in the ESM Treaty, “the ESM shall be exempted from any requirement to be authorized or licensed as a credit institution”. The only thing the ECB would have to do is grant the ESM access to its liquidity operations, as the ECB already did for the European Investment Bank in 2009.

Yesterday, the Austrian central bank governor Nowotny said that he could see arguments for this banking license idea. Interestingly, Draghi had earlier opposed this idea. Markets reacted positively to this statement. Too positively, in our view.

Although we principally remain in favour of ECB leverage for the ESM to increase its fire power, it would not be the new silver bullet, nor will it come any time soon. First of all, there is no ESM, yet. It looks highly unlikely that the ECB could grant anything to an institution that does not exist. Moreover, the ESM Treaty has put a cap on the ESM’s lending capacity at €500bn. ECB leverage would not automatically increase the €500bn. According to the ESM Treaty, the ESM could increase the maximum lending capacity but it is doubtful that this would happen immediately. Moreover, the sentence “Such a decision shall enter into force after the ESM Members have notified the Depositary of the completion of their applicable national procedures” indicates that raising the lending capacity might not exclusively be determined by the ESM. In addition, the German Constitutional Court could still increase the influence of the German parliament on such crucial decisions. Finally, there remains the unsolved issue of whether ECB leverage for the ESM would be monetary financing. In a legal opinion from March 2011 the ECB stated that "Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB."

Yesterday’s comments might have been a first step towards of another ECB shift. However, there are still too many unsolved issues to seriously expect that the ECB would take such an action before the ESM is up and running. In our view, the Nowotny effect should fade away very quickly.

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