The solution hammered out last week uses the EFSF – and its permanent successor from mid-2013, the European Stability Mechanism (ESM) – to try to head off contagion pressures for other sovereigns. Although the size of the EFSF has not been increased (yet?), its remit has been expanded in three very significant ways, allowing it to:
- intervene earlier with precautionary loans (i.e., before states are locked out of the markets) where countries have “good economic policies” but face contagion pressures;
- recapitalize banks via loans to governments even if there is no formal EU/IMF support program in place;
- buy sovereign debt directly on the secondary bond market, if the ECB gives the go-ahead and declares “exceptional circumstances”.
The precautionary lending measure makes the EFSF/ESM sound like an IMF-lite for the Euro-zone. The latter two steps take the pressure off the ECB for averting contagion and supporting struggling national banking sectors. They are essentially a back-door way for stronger 'zone states to make funding transfers to weaker members without having to admit such to the taxpayers or to rewrite EU rules.
Assuming all is approved as outlined, then the likelihood of Ireland and Portugal each needing a second bailout package is probably reduced, with Ireland in particular looking considerably less vulnerable than it did a week ago. Recall, Dublin’s big problem is the burden of its banking sector’s woes. If it can get additional EFSF help in the bank recap process if needed, then its vulnerabilities are much reduced. An extension in the terms of its €67.5 billion in EFSF borrowings and a reduction in the interest rates will further help ease the burden. It is not inconceivable that Ireland may return to the markets in some limited fashion next year – if all goes according to plan.
Portugal's issues are more structural and medium-term, more to do with an underlying lack of economic competitiveness. An expanded EFSF could be of some assistance, but the biggest help to Portugal may be the cheaper and longer-term loans. The need for a second Portuguese bailout package has not been eliminated but may be reduced.
But the key phrase here is “if all goes according to plan.” There are three major areas of risk to monitor going forward, any one of which could raise serious questions about the feasibility of Bailout #2 and potentially also the ability of the beefed-up EFSF/ESM to function as planned.
First, the devil will be in the details. The EU has a history of coming up with sweeping proposals that get stymied because one member state balks at something, requiring a tortuous period of re-negotiation and compromise resulting in a final deal that is in some way weaker than the initial proposal. Watch for domestic political pressures in one of the 17 Euro-zone members to throw a wrench into the works.
Second, a great deal is riding on the ability of Greek politicians (and to a lesser extent, on the politicians in Ireland, Portugal, Spain and Italy) to keep up the reform process. If reform implementation falters, questions about the sustainability of Bailout #2 will quickly surface.
Finally, there’s the outlook for the Euro-zone economy as a whole. The Belgian business confidence index – a leading indicator for Euro-zone growth about six months out – dropped for the fourth consecutive month in July, to a nine-month low. Germany’s Ifo business sentiment survey also fell to a nine-month low this month, indicating a slowdown is coming for the Euro-zone’s star economy. Weaker economic growth will make it harder for everyone to get their respective fiscal houses in order.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
