Juncker's investment plan gets cool reception

This is the name which has been given to the long touted €315bn investment fund which European Commission President Jean-Claude Juncker has put front and centre of his programme to deliver jobs and growth. The key points of the proposal (EC press release, Juncker speech, Katainen speech) are:

• €315bn investment from 2015 – 2017. This is made up of a €16bn guarantee from the EU budget (a 50% guarantee from €8bn of the budget) and €5bn from the European Investment Bank (EIB). This money will be used as a guarantee to raise the targeted €315bn from private financing on the market.**
• Of the total spend €240bn will go towards long term investments and €75bn to SMEs/mid-cap companies.
• The EFSI will be under the umbrella of the EIB but will have different goals and do a different type of lending.
• In conjunction with the EFSI the Commission will create a “project pipeline” along with technical assistance to help identify viable projects for investment at EU level.
• The investment plan will also contain a road map to remove sector specific regulations that hamper investment, with a focus on the financial sector to tie in with the push towards a Capital Markets Union.

This is the opening salvo of a plan which has long been muted. Judging by the initial reactions, the plan leaves something to be desired. Some thoughts below:

• As an opening salvo, the plan has already been watered down from what many had expected it to be – a real attempt at fiscal stimulus. Whether or not you agree with that prospect, it’s clear this plan does not constitute such an attempt. As it now enters the negotiation phase with approval from the member states and European parliament needed it could still be restricted and fudged further.

• This process seems very similar to previous attempts to create such a fund in 2012 (discussed by us here) and the failed attempt to leverage the European Financial Stability Facility from 2011 (which fell down on the reluctance of the ECB to be involved and the level of public guarantees were not sufficient and too highly correlated with potential risks). History suggests pinning significant hopes on these sorts of plans is not usually a good approach.

• It’s not clear that this buffer will be enough to encourage private investors to take on greater risk. There are numerous factors which are leading to a lack of private investment, risk (at these levels) is only part of it.

• Furthermore, to the point above, reports now suggest that the €21bn will actually be used by the EIB to borrow €63bn in bonds and cash which will then be used as a first loss buffer for the private investors – however, this does not seem to be mentioned in the press release, factsheets or Q&A. Additionally, we’re not sure what rating these bonds issued solely as loss protection would get or who would want to invest in them (seems akin to the lower riskier mezzanine tranches of asset backed securities).

• The promise to review the regulatory issues and create a central system of projects could actually prove to be more important than the funds themselves. That said, we have often heard the first point and the Commission has never followed through. The latter project has potential but the focus will be around “EU value added” and “EU objectives”. We’re not sure why the EU thinks it has a better idea of the returns and benefits on private investment than the market more broadly. Furthermore, these objectives already cloud what should be a simple idea – promote economic growth.

• More generally, questions can be asked about how these funds will be targeted. The focus seems heavily on pan-European infrastructure. While there are sectors where this could be useful – energy and high-tech – such a rigid focus is not needed for a general fund. Many parts of Europe (notably Spain) loaded up on infrastructure in the boom years; they do not really need more of it. What is really needed across Europe is investment in human capital, (re)training and R&D.

• All this once again highlights the huge amount of waste inside the EU budget, which could of course fill some of these roles. It also raises questions about whether the EIB should rethink its investment priorities.

Overall, the response from all sides has been very lukewarm. The plan seems very similar to previous iterations and, for better or worse, does not involve new money. Negotiations are likely to further impact the structure, while questions can be raised about the target and agenda included in the fund. The accompanying proposals for a project pipeline and improving regulation could be useful and tie in with plans for a single market in capital. That said, the EU’s track record on these fronts is not good and will likely take some time for any real impact to be seen.

**Correction: A previous version of this blog post said €294bn would be raised from private finance. However, the aim will actually be to use the €21bn as a guarantee on issuing €315bn worth of bonds on the market, meaning the entire €315bn will be private financing.

Meanwhile, in the Far North

One of the consequences of the eurozone crisis is that media, pundits and market analysts have been forced to become experts of what previously would have been seen as the most obscure political events. Thus, the Finnish local elections now have international significance (although they are still not making any headlines) as they serve as a barometer for the extent to which "Europe" as an election issue can trickle through to the local level. The theory being that the closer the issue gets to citizens, the harder for EU leaders to sell more integration.

An opinion poll for Finnish public broadcaster Yle puts the anti-bailout (True) Finns party at 17.2% - three times higher than in local election in 2008. Compared to 2008, all parties except for the Green party and the (True) Finns party would lose voters.

With a majority of voters from all Finnish parties - apart from the small Swedish People's Party - seemingly opposing more eurozone bailouts, expect Finland to remain assertive. Starting with the rumoured leveraging of the ESM.

A new EU treaty, a December summit… Déjà vu anyone?

A key question for the future institutional arrangement of the Eurozone is whether further integration will happen at the level of all 27 member states, within the framework of the EU treaties, or whether the Eurozone will simply press ahead with an ‘inter-governmental’ deal, circumventing the acquis communautaire and non-eurozone members.

This is critical for the UK as under the latter option, Britain will have little to no leverage over future Eurozone integration, whereas under the former it’ll have a solid veto, which it can use to extract all kinds of concessions in pursuit of its national interest. Following Cameron’s veto to an EU-27 treaty change last December – which resulted in the intergovernmental fiscal treaty - a host of eurosceptics and status-quo defenders alike now tend to argue that the precedence has been set; Eurozone members can do whatever they want inter-governmentally, they say, and use the EU institutions at that. Britain has been reduced to the role of a spectator. The plot has been lost and the goose has been cooked.

From there, some eurosceptics reach the conclusion that Britain should withdraw altogether, whereas the status quo defenders say Britain should hop on the train towards more integration (at which point they cease to be status quo defenders and turn into brave souls advocating that Britain signs up to a euro superstate).

So has the goose been cooked?

Well, this week’s Spiegel magazine splashed with the news that the German governmet is pushing for a new EU treaty that will consolidate and expand Eurozone budget oversight powers – referred to in Germany under the euphemism of ‘political union’ - under a firm legal framework. Chancellor Angela Merkel is reportedly pushing for a convention – comprising representatives from national governments and parliaments, the European Parliament and the European Commission – to be formed by the end of the year, with a first meeting to be agreed at an EU summit in December. If the article is accurate, a ‘convention’ would be about a ‘full’ Treaty change, not the limited one agreed in December 2010.

One of the main changes sought is the provision for the ECJ to rule if national budgets comply with the EU's fiscal rules, with the option of credible sanctions for non-compliance, something Merkel failed to secure in the inter-governmental fiscal treaty last year – courtesy of French nervousness over loss of souveraineté.

It’s difficult to gauge how credible the story is – speaking on ARD Merkel said that “I am not calling for a convention… that’s not the point”. Though politicians’ denials count for zero these days, it’s probably right that December is not realistic as a start date for a new EU treaty. Apart from everything else that needs to be sorted first, EU leaders still remember how long it took to push through the European constitution/Lisbon treaty – which Europe’s citizens didn’t like that much (as for being a ‘crisis’ this was of course a mere prelude to what has come to pass since). And unlike the Lisbon treaty, codified central fiscal controls would be about decisions over taxation and spending – the bread and butter of national politics. Also, non-euro member states – such as Poland - oppose a new treaty at this time on the basis that it would widen the euro/non-euro divide with a negative impact on the single market.

But while it is clear that there is no great enthusiasm for it, it is difficult to escape the conclusion that at some point in the near future, the eurozone will need a new set of rules if it is to stay together in the longer term. As good as the EU is at fudging it, ploughing on incrementally with economic and fiscal integration is politically unsustainable. So the question for Britain’s leverage in Europe really becomes, how bad does the Germans want to anchor Ordnungspolitik in EU law. Well, as we argued in the Telegraph back in February:

 “The Germans in particular – ever conscious of their Constitutional Court– know that the current arrangement involving an ad hoc euro treaty is legally dubious. As long as the Germans feel uncomfortable, Cameron maintains his leverage.” 

This is key. For a range of reasons (see here, here and here), the Germans don’t have that much confidence in Eurozone inter-governmental arrangements, as it leaves them more at the mercy of the ‘Club Med’ and creates a grey zone between EU law and the German ‘basic law’ which is just too awkward to bear for many Germans. Sooner or later, there will be an attempt at EU treaty changes.

Does the UK know what it wants?

Why Germany just got more nervous about the prospect of the UK leaving the EU

Following last week's EU summit, we were struck by how the ambush by France, Italy and Spain demonstrated in practice how a closely integrated eurozone could work in the future, with Germany internally outnumbered by the 'Club Med' contingent. In a letter to the FT, we argue that:

“At last week’s summit, German Chancellor Angela Merkel may have got a taste of what an EU without Britain would be like. Backed into a corner and with her list of allies growing thin, she was forced to give way to the Mediterranean bloc – Italy, Spain and France – over direct recapitalisation of eurozone banks. Quite aside from the specific item up for negotiation, it illustrates the dangers for Berlin should Britain be pushed out of the EU altogether." 

"As Europe goes through a highly unpredictable – and testing – phase, Germany needs the UK inside the EU tent to balance the more protectionist southern bloc, and to uphold a rules-based system where goods and services can be traded freely across borders. It is therefore in Germany’s interest to support new terms of EU membership for Britain, which will be needed to reconcile British public opinion with continued commitment to the EU."

Over on the Guardian's Comment is Free, we develop this theme a bit further, arguing that: 

"Proportionally, Germany has far fewer friends inside the eurozone than in the EU as a whole, with the bloc's centre of gravity skewed by the more protectionist and high-spending southern states...Therefore, Germany has a very strong interest in keeping as many decisions as possible at the level of 27 member states."

"This means that, if push comes to shove, the Germans may prove more susceptible to UK arguments for revised membership terms than it is willing to admit publicly. A common response from EU-reform sceptics to any suggestion that the UK should seek a more flexible relationship with Europe is that other member states would never allow it, but this has never been credibly tested." 

"It won't be easy, but arguably, the Germans have more to fear from being left isolated within the eurozone than they do from a new bargain with Britain. If the choice is between the UK leaving or getting some EU powers back, Berlin may – after a lot of posturing, negotiation and bickering – go for the latter for fear of being left bowling alone in Europe. That is to say, that Britain has more leverage in Europe than it may think. Germany needs Britain and vice versa. No one likes being without friends."

Mr. Cameron, the ball is in your court...

The Draft Euro Fiscal Pact: Pretty Bad News for Cameron...

As negotiations on the new European fiscal pact resume today, we have managed to get hold of a copy of the new draft prepared by European Council President Herman Van Rompuy's office, and it makes for interesting reading. First on the scene (at least amongst UK commentators), we'll give our take below:

On the Today Programme this morning, David Cameron said that countries which sign up to the euro+ fiscal pact,

"Shouldn't be doing things that are about the single market or about competitiveness, and we will be very clear that when it comes to that you cannot use the European institutions for those things because that would be wrong."

See here for the background to the legal scramble that has followed in the wake of Cameron's veto back in December of an EU 27 Treaty, with the crucial issue always being whether the EU institutions could be used by the 17+, despite Cameron's veto.

It's not entirely clear whether Cameron actually will try to block the use of the EU institutions in implementing and enforcing the fiscal pact, or merely insist on the EU institutions not being used for single market issues (which never was a concrete proposal but a general worry over the EU institutions, particularly the ECJ, being used to push a eurozone-specific agenda), but what's clear is that the EU institutions are all over this draft proposal.

The draft makes over 20 references to the EU institutions (seven to the ECJ and nine to the Commission).

Here are some of the most significant changes from the previous draft (we got hold of a copy of the revised draft, see here - changes from the previous version are highlighted):

• The scope of the agreement is expanded, as it now involves "an enhanced governance to foster fiscal discipline and deeper integration in the internal market as well as stronger growth, enhanced competitiveness and social cohesion". Note here the references to the single market and social cohesion - a concession to the French and pretty bad news for Cameron.
  

• The wording of Article 6 has changed, and now reads, "The Contracting Parties shall coordinate their national debt issuance," instead of "shall improve the reporting of their national debt issuance". This clearly gives the article more teeth.

• Countries subject to an excessive deficit procedure should submit their structural reforms plans "to the European Commission and the Council for 'endorsement'";

• The treaty would enter into force after fifteen (not nine) eurozone countries have ratified it.

Particularly interesting is the section on the role of the ECJ. In particular,

• Article 8 stipulates that the ECJ would have jurisdiction over any violation of the entire Title III, i.e. on all the provisions of the so-called "fiscal compact". In the previous draft, the ECJ only had a say on Article 3(2), i.e. on whether national governments have correctly transposed the balanced budget rule into their national legislation;

• Furthermore, according the revised text the Commission "may, on behalf of Contracting Parties, bring an action for an alleged infringement of Title III" before the ECJ.

Some subtle but significant changes, despite Commission claims that the previous agreement would form the basis for future discussions. There are three very interesting points from the UK's perspective:

1) EU institutions are playing a large role: In this draft the role of the ECJ and Commission is significantly expanded. Despite David Cameron's on-going insistence that EU institutions would not play a role in enforcing the rules of the treaty, Article 8 does just that. If the final version sticks to this definition it would likely be a defeat for Cameron, with his decision to veto being seen to have stopped very little (although this is far from finalised). On a side note this also seems to be a loss for France, since it had previously opposed such a wide role for the ECJ. Could a Franco-British alliance be in the offing at the next round of discussions? Something to watch for. For the record, we maintain that the use of the EU institutions in this way is a massive legal stretch (hello, EU law) - and that the aim of Cameron's veto was correct (it was an overall strategy and tactics that were lacking).

2) Focus on the internal market: Article 1 stipulates that the signatories of the treaty will work towards "deeper integration in the internal market". This is interesting given David Cameron's comment on the Today programme this morning, where he suggested that the treaty would not involve any discussions on the single market. Again the draft clearly directly contradicts this. The UK is understandably keen to avoid the new treaty along with its regular meetings becoming a talking shop for single market regulation which still has a huge impact on the UK economy.

3) Incorporate the treaty into EU law after five years: Lastly, Article 14 states -

"Within five years at most following the entry into force of this Treaty...an initiative shall be launched...with the aim of incorporating the substance of this Treaty into the legal framework of the European Union."

In other words, as demanded by the Commission and MEPs, it looks like that the new pact will have to be incorporated into the EU Treaties in the medium term, something which will require the UK's approval - suggesting that this argument will continue for sometime. Cameron's veto did not put the issue to bed by any stretch of the imagination.

At least two out of these three points almost directly contradicts what the UK government would have wanted, while the third one could potentially go either way. This is still a draft and much can change, but at the moment it has put the UK onto the back foot.

Further reading: "The ten lessons the UK government should draw from Cameron's EU veto".

Is this what Merkel wants?

A very interesting paper drafted by the German Foreign Ministry has come to our attention, and is today reported in the Telegraph, which sets out concrete proposals for how exactly the Germans might propose to reign in the eurozone’s “debt sinners” (as they are commonly referred to in the German media) in the medium to longer term via an EU Treaty change. (Our full translation is also avalable on the Telegraph's live blog).

Update: Following several requests, see here for a pdf of the full text in English.

While many of these proposals have been hinted at before, this is the first time they have appeared together as part of a comprehensive framework in an official document, and in such great detail, including the relevant Treaty articles that will need to be changed. Here are what we consider to be the most significant and interesting aspects of the paper:

“Currently, there is no real possibility of imposing discipline on member states with massive budget problems. All previously existing options were premised on the voluntary principle. Moreover, there is no credible and workable solution to problems of excessive indebtedness, which can no longer be solved by the bailout package”

The main ‘solution’ to this problem suggested in the paper is greater budgetary discipline within the eurozone, enforceable by other member states and/or EU institutions. For example:

"The theoretical sanctions should be upgraded to real automatic sanctions. Sanctions in the event of excessive deficits would then be able to be directly initiated by the Commission, even without a referral from the Council...Council decisions taken by qualified majority must be replaced here by reverse qualified majority voting.”

Moreover, it is not just the Commission that would acquire additional powers, but the European Court of Justice would also be used to enforce the rules. The relevant section reads:

“Where the provisions of the Stability Pact are consistently violated, the possibility of a right of action before the European Court of Justice (ECJ) should be created, something which is presently explicitly excluded in the Treaties.”

One of the most striking proposals is for the European Stability Mechanism (ESM), the permanent bailout that comes into existence from 2013, to be radically strengthened and turned into a “European Monetary Fund”, along the lines of the IMF. This would give it rights both to intervene in the domestic budgets of member states if they request its assistance, and also to instigate an orderly default where a member state cannot meet its debt repayment, even with assistance:

“If a Member State accepts a support program from the ESM, this shall automatically lead to a restriction of its budgetary sovereignty in the form of a veto at the EU level before the draft budget is presented to the national parliament of the affected country, in the event it fundamentally violates the principles of sound financial management, thereby jeopardizing the success of the consolidation and reform programme. If such a country is unable to satisfy the conditions of the ESM programme, it can have concrete budgetary measures imposed upon it, for example specific spending cuts or the establishment of new revenue streams.”

Pretty strong stuff. Although such demands can be understood from the perspective of Germany and other creditor countries, it poses huge questions over the future of national sovereignty and democracy in the eurozone. Here is the section on orderly defaults:

“For member states that are covered by an ESM programme, but despite complying with it are unable to achieve debt sustainability, the possibility of budgetary interventions is not sufficient. Therefore, there must also be the option of an orderly default in order to reduce the burden on taxpayers (in the other eurozone states), and also to provide the affected country with an opportunity for a fresh start...The ESM should consider the request made by a member state for relief loans against the criteria of debt sustainability. If this is negative, the affected member state would instead receive loans for a limited time only, during which the procedure for an orderly default would be prepared”.

All the measures listed above require some level of political legitimacy, even during times of crisis. The paper therefore proposes to consolidate the economic and fiscal union with greater political integration as a next step:

“In addition to a change of the EU treaties to eliminate the construction of EMU deficits, a new open discussion about long-term and basic deficits of the EU (democratic legitimacy, efficiency, coherency etc.) has flared up. These questions should also be addressed in the medium term. The goal could be a fundamental development of the EU Treaties. The two initiatives are not mutually exclusive, but rather will follow on from one another. The debate on the way towards a political union must begin as soon as the course toward stability union is charted”.

So where does this leave the UK, which has said that it intends to explore the option of repatriating certain powers from Brussels in return for agreeing to Treaty change? Well, the 'good news' is that Germany appears committed to full Treaty change at the EU-27 level, which gives the UK certain leverage via its veto:

“Also for the basic further development of the ESM into a European monetary fund a change of the European Treaties would be the clearest way and would moreover allow the fundamental involvement of EU institutions...A limiting of the execution of the Treaty changes to the Eurozone states would make ratification easier, which would nevertheless be required by all EU Member States (thereby less referenda could be necessary, which could also affect the UK)."

The last sentence is no doubt a reference to the UK's 'referendum lock'. The German Foreign Ministry's plans would seek to limit the changes to the eurozone countries so that the UK would not need to put the changes to a popular vote. However, the paper does make the veiled threat that, if the UK were to block the changes, or perhaps demand too much in return for its agreement, Germany could explore an intergovernmental treaty just among the eurozone members:

“In case this is not politically feasible, an alternative treaty between the Member States [i.e. the eurzone] that is legitimate under international law ought to be considered.”

Germany’s demand for a Treaty change clearly presents a challenge/opportunity for David Cameron. Germany would prefer to make these changes to the eurozone via a deal agreed at the level of 27. Nonetheless, the UK would still have a veto at that level, which could present Cameron with the chance to demand concessions in return. However, there is also a veiled threat from Germany that it could seek a treaty outside the EU framework, stripping the UK of its leverage, if Cameron were to demand too much. With the prospect of further Treaty changes down the road to further develop "political union", there is clearly a delicate balance to be struck, but Merkel is daring Cameron to call her bluff.

This should make today’s meeting between the two leaders very interesting indeed...

Why the ECB saving the euro is anything but simple

Our ongoing conference today in Frankfurt, on the current and future of the ECB in the eurozone, could hardly be more timely. We're posing two questions: should the ECB act as the eurozone's lender of last resort, and has the ECB acted within its mandate in this crisis?

In fact, all eyes are now on Frankfurt, as new ECB President Mario Draghi - an Italian and former banker - is faced with a quite awful dilemma: should he shore up his credentials with the German monetary establishment (which would involve hard money policies, staying well clear of any major ECB intervention on the bond markets), or appeasing markets by buying large amounts of Italian government bonds, described by some as a 'silver bullet' (which it isn't).

Draghi's decision the other week to cut the ECB's interest rate has already raised suspicion in some German quarters that the Italian can't be trusted. FDP MP Frank Schäffler - the most vocal critic of current ECB policies - simply stated:

"The hawk has become a dove on his first day in office."

At his first press conference, Draghi went out of his way to insist that its government debt-buying scheme - the Securities Markets Programme (SMP) was “temporary” and “limited”. But since then Italy has been sucked deeper into the crisis, and Draghi may not escape making a tough call on radically extending the SMP, which would lead to many in Germany asking for his head on a plate. Though the pressure on Italian bonds have eased slightly over the last two days - ten years bonds were at 6.7% this morning - and there's talk of the 'Monti effect', markets remain extremely nervous about the complete absence of a fire wall around Italy should the smelly stuff really hit the fun. With EU leaders unable to agree a top-up of the eurozone's temporary bailout fund, the EFSF (they cannot get more loan gurantees through their Parliaments), and with the IMF out of the picture, the ECB would basically stand alone.

To date, the ECB has bought €183bn of government debt through the SMP, including Spanish and Italian bonds. However, for the ECB to act as an effective lender of last resort for the eurozone, and to back stop Italy's €1.8tr bond market, it needs to go far beyond current levels of purchases. We're talking hundreds of billions - if not trillions - worth of government bonds (RBS, for example, estimates that €700bn could be needed to contain Italy).

So why doesn't the ECB step in and save the day? Its pockets are deep enough (it can massively expand its balance sheet as it controls the future supply of money) and doesn't have to go through slow-moving and unpredictable parliaments for approval (that pesky thing called democracy).

Well, there are at least three problems.

Economically: Whilst it clearly comes with some immediate benefits, ECB intervention would not deal with competitiveness gaps in the eurozone or actually solve the eurozone's debt structure in the long-term (as it would merely be passing debt from one balance sheet to another). All ECB intervention does is deal with short-term market jitters and liquidity issues. The ECB could also run into some problems if its financial position is compromised by taking on even more risky debt.

Politically: Large-scale ECB intervention would require nothing short of a major cultural and psychological shift in Germany. As we've noted repeatedly, an independent, strong central bank that stays well clear of any policy that might trigger inflation (read monetising debt) is one of the very founding principles of modern Germany. A central bank that serves as a tool for politicians to paper over cracks in the economy, by flooding the markets with cheap money, remains a hugely frightful prospect in Berlin, for well known historical reasons.

Much like in the internal CDU debate, the German discussion about the role of the ECB reflects a head-on clash between two vital German post World War II objectives: an unambiguous commitment to price stability, on the one hand, and an unambiguous commitment to 'Europe' on the other.

So for UK PM David Cameron to say that he does not 'understand' why some people in Germany are so opposed to the ECB playing a major role in propping up governments, is a bit like Angela Merkel saying that she does not understand why the sovereignty of the British Parliament is so important for the British (for example).

In essence, this would involve messing with some pretty fundamental principles here. Taking the ECB down such a slippery slope towards large-scale debt monetisation could mean that German support for the entire euro project would start to diminish.

Legally: According to the ECB's and the EU's rulebooks, can the ECB really engage in debt monetisation? Despite being limited in comparison to what would be needed for the ECB to shoulder the role of lender of last report, German President Christian Wulff has dubbed the ECB's actions "legally questionable".

German Professor Markus C. Kerber Kerber has already launched a complaint against the ECB with the EU's General Court in Luxembourg (the former Court of First Instance). In his booklet "Die EZB vor Gericht" (The ECB in the dock) he sets out his arguments. In addition to the SMP itself (established on 14 May 2010), Professor Kerber also challenges the ECB's decision to drop its quality requirements for the collateral that Greek, Irish and Portuguese banks can post with the ECB in return for loans (The decisions made on 6 May 2010, 31 March 2011 and 7 July 2011). He claims these that articles violate articles 123 till 125 of the EU Treaty, saying:

Here are the main legal arguments why Kerber thinks the ECB's actions are illegal:

- Art 123.1 bans the ECB and national central banks from buying bonds of member states, either directly or from secondary markets, when the purpose is not mere monetary policy but amounts to fiscal policy (propping up insolvent governments). Kerber cites several economic analyses (as for example this one by DB Research) to back up this claim that the SMP is driven by fiscal policy and therefore illegal.

-The suspension of requirements specifically Greek, Irish and Portuguese government bonds to be accepted as collateral for banks which want to obtain ECB funding is in breach of the ban on privileged access to ECB funding of art. 124. It also goes against the legal rationale behind art. 125 (the famous ban on bailouts).

- The fact that the ECB and its President Jean-Claude Trichet have consciously taken on all this exposure, endangers art. 127, which orders that the primary objective of the European System of Central Banks shall be to maintain price stability. As an example, he cites the purchase of €45 billion of Greek government bonds at the end of 2010, and the emergency liquidity assistance programme, which allows the Irish or Greek Central Banks to rescue their own banks. He claims that because this exposure to European citizens has been taken on consciously by the ECB and its President Jean-Claude Trichet art. 127 which prescribes price stability has been violated.

This is pretty chunky stuff but it does show why large-scale ECB intervention could come against some serious challenges.

Responding to the ECB...again

So, the frank exchange of views with the ECB over our recent research into the ECB’s exposure to peripheral Eurozone countries rumbles on (albeit indirectly for the most part).

(See here for our previous response to the ECB)

Yesterday, the WSJ Real Time Economics blog covered comments by ECB Governing Board member Lorenzo Bini Smaghi suggesting that estimates such as ours were based on a "misunderstanding of the Eurosystem and its risk provisions" (we recommend reading the blog in conjunction with this post to make sense of it all).

Bini Smaghi makes three key points, which we try to address here: that the ECB’s revaluation account can actually absorb any losses it faces, that its stream of seigniorage from printing money adds to its financial strength and that only a default would really threaten the ECB’s balance sheet.

This seems to be a classic example of an EU institution trying to hide behind its own complexity. Frankly, we've seen it all before, and we're not overly impressed.

So here we go (excuse some of the technical language, we’ll explain it all further down).

Default assumption:

Bini Smaghi notes that both the bonds the ECB holds and the collateral it has taken on would only face losses if there was a default. Well, as you will know from reading our research, this was the very premise of our paper. Pretty much everyone, outside of the ECB and some Eurozone leaders, believes that Greece will need to default, in some form, in the near future. The ECB can continue to preach this line but we, along with plenty of others, believe they are living in a dream world. (Also stay tuned for an upcoming piece of research from us on the Greek crisis which should support this argument)

Revaluation account:

Firstly, the revaluation account was set up to help protect against losses on foreign reserves (including gold and dollar denominated holdings) resulting from changes in prices or exchange rates. As the value of these holdings changes any gains or losses are shifted to the revaluation account while the assets themselves remain listed at original prices. The idea is that these changes could be temporary and so it is financially prudent to add in this extra buffer (we agree on this point). Accepted, since the revaluation account is now over €300bn it is unlikely that all of this would be needed to buffer against price or exchange rate risks. However, it is not clear why, after being used for this purpose for over a decade, the ECB would switch to using it to account for broader credit and collateral risks. This also explains why we did not include it in our paper, since it is not defined as part of the capital base and was not created for the purpose now being suggested. Hence we stick by our comment that it would take only a 4.25% decrease in the value of assets to wipe out the ECB’s capital base (defined as capital and reserves, the standard definition).

More importantly though, this means that any money inside the revaluation account is unrealised (meaning it only exists on paper until the underlying assets are sold). Therefore, in order to cover any losses which appear in the ECB’s profit and loss account (realised losses) the ECB would need to sell some of these assets. So, the ECB would essentially be deleveraging to help cover its losses, a process which we’d expect might startle financial markets. This also means that Bini Smaghi is including the potential sale of assets as part of the capital base calculation, which seems far from normal. Including this money in capital and reserve buffers is very confusing since the revaluation account is listed as a liability while the actual holdings are listed as assets. These points seem to make it difficult for the revaluation account to be judged as a real backstop against the potential losses from a Greek default.

Additionally, since these gains are unrealised and the assets would have to be sold off for the revaluation funds to be tapped, the liquidity of the assets must also be considered. Given that demand for gold and dollars remains strong this may not be such a problem. However, these holdings will always be slightly constrained by their liquidity and will involve some transaction costs.

Furthermore, if Greece was to default we’d expect there would be significant turmoil in the financial markets, with money rushing out of the Eurozone and towards the 'safe haven' of the US. This would ultimately cause a massive drop in the value of the euro, likely wiping out a part of the revaluation account.

Seigniorage:

This is a highly technical issue, so bear with us. Seigniorage is essentially the income which the ECB and Eurosystem devise from being able to print money. Since they control the size of the monetary base now and into the future this income represents a significant financial strength, this is undeniable. However, it does have its limitations, particularly under a Greek default scenario. Firstly, it is dependent on the demand for currency, the interest rate and the inflation rate. These are all currently low, mostly due to the sluggish recovery in parts of the Eurozone, meaning that the level of seigniorage is limited. A paper published through the ECB last year notes that this income dropped to around €787m in 2009, and even at its peak was only around €2bn, not massive amounts considering our loss estimates of between €44bn - €66bn.

The ability to control future money production is important, but our point is more that the immediate hit which the ECB and Eurosystem will take from a Greek default would be passed through to taxpayers. Even with a large future potential income from printing money this cannot really be overcome without printing money immediately, which would be inflationary, as we suggest. Furthermore, if the ECB did draw on future incomes it could undermine the future financial strength of the ECB. Ultimately, our point was that the immediate hit which the ECB would take under a Greek default could cause it to need to be recapitalise or ramp up its printing of money (above the point where it is non-inflationary) and these costs would be passed onto taxpayers.

If you’ve stuck with us until now, thanks for hearing us out. Our research into the ECB was an attempt to scratch the surface on what is an incredibly opaque and complex issue. Once again, given its response, the ECB appears to remain in a state of denial over the problems it faces.

Update 16/06/2011 8pm:
As a keen observer has pointed out, the weakening of the euro would in fact increase the revaluation account. This is because the assets, such as gold or dollars, would be able to be sold or exchanged for a larger amount of euros. There might be an inflationary aspect to this, as with any devaluation, although we doubt that it would be large enough to have much impact. An admitted mistake on our part, though certainly not a vital part of our argument in any case.

ECB blues

The Open Europe team has spent a couple of weeks delved into the books of the European Central Bank. Trying to get to the bottom of what's actually on the ECB's books is a bit of a mission, given that the institution is so opaque that it would probably violate the EU's Transparency Directive on virtually every single point.

In any case, last week we published a report cataloguing the exposure of the ECB to weaker eurozone economies. We estimate that its exposure to Portugal, Ireland, Italy, Greece and Spain has now reached €444 billion - €190 billion of which is to Greece. The point being that this is a hidden potential cost to taxpayers of trying to save the euro (as the ECB is underwritten by taxpayers).

The findings stirred things up a bit - and we got plenty of feed back (overwhelmingly positive for trying to shed some light on what is a dense and poorly understood area). Below are some clarifications and remarks in regards to some of the feed back we got - it's a bit long-winded but please bear with us.

• "The ECB's losses will be shared between national central banks so it won't be a cost to the ECB itself." We heard this from a couple of people but it's actually not countering anything that we're saying. In fact, we're making the very same point in the report. Any losses will always be shared out between national central banks (particularly as it is national central banks that accept the collateral for banks in return for giving credit). There are, however, a few possibilities for how such losses will be shared in practice (either the ECB's reserves can take the hit directly, meaning it will most likely need to be recapitalised, or NCBs will take the hit directly with the ECB technically only shouldering 8% - see p.9 of the report for a discussion on this). But regardless, the cost will ultimately be passed on to taxpayers.

• "The ECB should be able to withstand losses arising from a sovereign default, even if it needed further recapitalisation by its NCBs." Related to the above, this is the conclusion that an article in last week's Economist, citing our report, seemed to draw. In other words, a Greek default would not wipe out all of the ECB's reserves. Again, as we argue in the report, this is true but is sort of missing the point we're making. "Even" in that sentence is the crucial part. A recapitalisation from NCBs would effectively constitute a cost to taxpayers - which is precisely what we're trying to flag up in the briefing.

• "The central bank in the country that defaults will take most of the hit". This is what ECB executive board member Lorenzo Bin Smaghi said in an FT interview the other week, seemingly suggesting that the Greek central bank would take most of the hit from a Greek default. As we've argued here, this is implausible. How would the Greek central bank, backed by the country's cash-strapped national treasury, be able to absorb such huge losses? And if it had to face such losses, then bail-out money would have to take up the slack, which again would take us back to taxpayers. And as we note in a letter to today's FT, Bin Smaghi's claim has been contradicted by Dutch executive board member Nout Wellink, who told Dutch television last month that Dutch taxpayers were on the hook for €4bn via the ECB should Greece default (using this as an argument against Greek restructuring). This suggests that the losses would indeed be shared out amongst NCBs. Incidentally, Wellink's projections line up almost exactly with our higher-end estimates for how much a Greek default would cost the ECB (we estimate €65.8bn in total under with the Dutch central bank would be on the hook for €3.9bn).

• The ECB's "vehement objections to a restructuring may be as much about credibility as its assessment of the risks it faces". This is from the same Economist article cited above and is also probably true, though as we argue in the report, it's difficult to separate the two. As a paper from the ECB (published right before the ECB started to buy governments bonds), notes:
  

"The perceptions of a central bank’s financial strength have an impact on the credibility of the central bank and its policy. If it is expected that the central bank is not capable of or willing to incur losses, then costly objectives and policies are not credible and the target cannot be achieved or only at a higher cost to the economy. Financial strength helps the central bank to protect its independence, which is a crucial component of credibility."

• "Other central banks are even more leveraged than the ECB". This is, in essence, what Commission President Jose Manue Barroso said when presented with our findings. Barroso is actually correct. Both the Bank of England and the Fed are leveraged around 50 times (which is itself a bit concerning - but that's a different discussion), compared to the ECB's 23 times (though other central banks such as the Swedish and Swiss ones are only 5-6 times leveraged). The ECB's leverage itself is not as controversial as what's actually behind it, and differs from that of the Fed and the Bank of England in some vital respects. In particular, the ECB's acceptance of risky paper, such as Greek bonds, is effectively transferring risk from investors to taxpayers, and from weaker, debt-challenged euro-zone economies to the richer economies, like Germany's. This isn't what the ECB should be about.

• "The ECB also bails out banks and governments in a third way". This relates to the discussion regarding the Eurosystem's Target2 system, which some economists, head of the Ifo institute Hans-Werner Sinn in particular, have argued constitutes a separate stealth bailout from the German central bank to peripheral central banks. The impact of the Target2 system is far from clear but we are of the view that it is, at most, looking at the same problem from a different perspective. The argument that these Target2 imbalances have been crowding out lending in the core or funding peripheral current account deficits also seems misguided. This debate will likely rumble on, but ultimately Target2 is a settlement system and as the interbank lending market in Europe recovers these imbalances should retreat (although this could take some time). In the meantime, any losses would still be shared out amongst Eurosytem members as we laid out in our paper. The real risk is still best represnted by the extensive loans which the Eurosystem has made to peripheral banking sectors and the dodgy collateral it has accepted in return.
  

The prize for the strangest response to our report, however, goes to the Brussels correspondent of Spanish financial daily Cinco Días who (in addition to suggesting that we want to ban Brussels sprout) concluded that the reason for us publishing the report on the ECB's exposure was because....wait for it...we have invested in a massive amount of Credit Default Swaps on Greek debt. In other words, should Greece default, we'd be rich.

Now, if only that was true.

The dark side of the ECB

Lots of people have been focusing on the recent ECB rate rise, but the ECB’s role in this crisis has really been determined by its other – more opaque and less publicised – role: as lender of last resort. This has got the ECB into a near untenable position. It faces huge exposure to peripheral eurozone countries, it aims to maintain price stability, but has also acted to stabilise the whole eurozone economy, and it has underwritten a bloated and inefficient banking sector with unlimited cheap money.

The ECB has lent massively to the struggling European banking sector. Although this may have been viable and necessary to halt the systemic risk from the financial crisis it is now out of control. It has propped up banks that should have gone bust and created banks addicted to ECB funding. A mechanism for reining in lending and winding down banks should have been in place from the start. The ECB essentially dug itself a hole without bringing a ladder to get itself out again.

Let’s not forget, these actions also helped fuel the sovereign debt crisis by creating perverse incentives. These banks could take on cheap ECB loans and then invest in high yielding but relatively safe assets (peripheral sovereign bonds at the time), in order to turn quick profit and increase capital. This fuelled the level of government debt and when it became clear just how bad the sovereigns' finances were, markets panicked and the debt crisis hit (but with more debt and more banks involved/exposed than before).

The ECB tried to fix this problem by throwing more liquidity at it (through its bond buying programme). This just increased its exposure to risky economies, distorted bond markets and rightly raised questions over its independence and impartiality (not to mention being potentially inflationary).

Lastly, the ECB has overseen the build up of huge imbalances in the eurosystem of central banks. Some, like Ireland or Greece, borrow huge amounts but contribute little. The loans to these countries are underwritten by other central banks in the system, making them even more exposed to a peripheral default.

The ECB has played a huge role in the cycling of debt around the eurozone, and put itself in a very exposed and compromising position. Its interest rate policy is massively important but the darker side of ECB policy has debatably played a more important (and negative) role in this crisis.

To be fair to the ECB this was not all of its own making, since it was forced into this situation by eurozone leaders inaction, which is further illustration of the politicisation of a once proudly independent central bank.

Double standards on leverage

The excellent WSJ Real Time Brussels blog notes that EU Budget Commissioner Janusz Lewandowski isn't entirely happy with the amount of money that potentially can be lent to struggling governments, using the EU budget as a guarantee.

Mr. Lewandowski told a group of journalists: "That is worrying me...[the EU must] be realistic about the budget as a guarantee." In case of danger, he said, "we should be very watchful" about the maturities of the various pieces of debt issued to countries.

So what exactly is the Big Lewandowski on about?

Well, besides the €440 billion eurozone bailout package, which does not include the UK and is guaranteed by eurozone governments, the EU also agreed in May to a separate €60 billion fund. This fund is to be raised by the Commission on the markets, and then lent to eurozone countries in trouble, using the EU budget as collateral. The loans would therefore be guaranteed by all member states, including the UK, since all member states pay into the budget.

Added to the pre-existing fund for non-eurozone members, which totals €50bn, the EU budget can therefore potentially be used as a guarantee for €110bn in loans. And given the state of the economies on the receiving end, these loans can only be described as sub-prime (with some exceptions).

The size of the EU budget is roughly €123 billion euros this year (set to rise by €7 billion if MEPs get their way), so should countries max out these bailout funds, the bloc's debts could reach 89% of its equity (the EU budget).

Ironically, the Stability and Growth Pact stipulates that no EU country is allowed to have a debt higher than 60% of GDP. We know it's not the same thing, but Lewandowski is certainly making a good point. €110 billion is actually massive exposure.

In addition, isn't this potentially causing the EU - as in the legal entity not individual countries - to break the very same rules that the Commission now wants to beef up?

But then again, on leverage as well as fiscal prudence, the EU isn't exactly known for leading by example.