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Fast-track to Fiscal Union in the Eurozone?

Fast-track to Fiscal Union in the Eurozone?

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Published by Edward Harrison
Morgan Stanley's post-Eurozone trillion dollar liquidity thoughts on the way forward in the Eurozone.
Morgan Stanley's post-Eurozone trillion dollar liquidity thoughts on the way forward in the Eurozone.

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Published by: Edward Harrison on May 10, 2010
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May 10, 2010
Europe Economics
Fast-track to Fiscal Union?
What's new in fiscal policy?
In an all night session, theEcofin Council finalised the details for a much larger-than-expected financial stabilisation package of up toEUR 750bn. There are three elements to the new fund:First, opening up the EU balance-of-payments facility toeuro area countries and increasing its ceiling from EUR60bn to EUR 110bn. Second, a European stabilisationfund amounting to EUR 440bn. Third, an additional IMFtranche for euro area countries of up to EUR 250bn. Thelatter two would make an emergency lendingprogramme like the one implemented for Greece a muchfaster decision by avoiding another lengthy ratificationprocess in national parliaments. In exchange for receiving emergency funding, recipients need to agreeto a rigorous austerity plan supervised by the IMF, theEC and, we would expect, the ECB.
What’s new in monetary policy:
The ECB hasannounced that it will intervene in public and private debtmarkets. The interventions will be sterilised and hencedon’t constitute quantitative easing. The amount anddetails are still to be determined by the ECB Council.Furthermore the ECB will switch its upcoming 3Mtenders back to full allotment and reinstate a 6M tender,allowing banks again access to unlimited term-funding.Finally, in conjunction with the Fed the ECB has decidedto reopen the USD swap lines, which allow Europeanbanks to obtain USD funding against EUR collateral.
Our take on the measures:
The stabilisation fund,which constitutes a first move towards a fiscal union, islarger than expected. If the emergency liquidity for theperiphery is not complemented by aggressive austeritymeasures, the underlying solvency problems willcontinue to fester – and eventually spread to the core.The ECB’s policy actions, by contrast, probably fallsomewhat short of market expectations for a big 1YLTRO and/or big bond buying scheme. With tonight’sECB decision to open the door to purchases of bonds,the bank is walking a fine line in terms of its perceivedcredibility.
Recent Reports
Title Date
Europe Economics: A Euro Area StabilisationFundElga Bartsch, Daniele AntonucciMay, 8, 2010Euroland Economics: ECB Watch: The Calmin the Eye of the StormElga Bartsch, Daniele AntonucciMay 6, 2010Euroland Economics: Our First Assessment of Greece’s Loan and Austerity PackageDaniele Antonucci, Elga BartschMay 2. 2010Europe Economics: Greece ActivatesFinancial Aid PackageElga Bartsch, Daniele AntonucciApril 23, 2010Europe Economics: Greece and EMU:Between a Rock and a Hard PlaceElga BartschFebruary 22, 2010Euroland Economics: Portugal and the EMUPeripheryDaniele AntonucciFebruary 15, 2010Europe Economics: Whither Greece?Elga Bartsch, Daniele Antonucci, SpyrosAndreopoulosJanuary 25, 2010
For important disclosures, refer to theDisclosures Section, located at the end of this report.
Morgan Stanley & Co. Internationalplc
Elga Bartsch
Elga.Bartsch@morganstanley.com+44 (0)20 7425 5434
Daniele Antonucci
Daniele.Antonucci@morganstanley.com+44 (0)20 7425 8943
MORGAN STANLEY RESEARCHMay 10, 2010Europe Economics
Fast forward towards a fiscal union in Europe …
Like the ERM crisis in the early 1990s spurred on politicalinitiatives to bring about the long-planned monetary union inEurope, it seems that the sovereign debt crisis could be actingas a catalyst for an ever closer union of European countries.The decisions taken this weekend first by European leadersand then by finance ministers mark a big leap towards a fiscalunion in the euro area, we think. Not only have countriesagreed to stand in for each other in an unprecedented extent,they have also agreed to foregoing some of their fiscalsovereignty and submit to rigorous fiscal consolidationprogrammes should they require financial assistance. At EUR750bn in total, the stabilisation fund amounts to a sizeable 8%of euro area GDP (equivalent to 10% of general governmentdebt). The size of the stabilisation fund is likely to go beyondthe expectation of most market participants as far as the fiscalstabilisation mechanism is concerned.
… and tighter surveillance of budget positions
The stabilisation fund clearly represents a move towards acloser fiscal union and towards the joint issuance of government bonds via the European Community (at least for the proportion of the fund handled via the balance of paymentsfacility). The key difference between the stabilisation fund and joint bond issuance lies in the conditionality. But thesurveillance mechanism will only be as good as its supervisors.Hence it was important to get both the IMF and the ECBinvolved too. If the experience of the Stability and Growth Pactis anything to go by there is reason for concern about theeffectiveness of the peer review process within the Ecofin withthe support of the European Commission. That said, the peer review process of the SGP might also be sharpened in thecoming months given the recent experience and the fact thatthere is domestic tax payers money on the line for emergencyliquidity assistance.
ECB, increasingly politicised, gives some more ground
As with the decision on the collateral eligible at its refinancingoperations, where the ECB already changed its rules twice, itbecomes clear that the ECB’s decision have becomeincreasingly politicised in the course of the crisis. As thedelineation of responsibilities between the common monetarypolicy run by the ECB and national fiscal policies run byindividual governments got more and more blurry, theindependence of the ECB started to be compromised. Tonightthe ECB decided to take one step further and – in addition toreinstating some of the measures it had already taken duringthe height of the financial crisis (term funding and USD swaplines) – also open the door to outright purchases of governmentbonds. These purchases will be sterilised and as such do notconstitute quantitative easing, i.e. an expansion of the ECB’sbalance sheet. So far the size of the intervention programmeand the details about which debt instruments the ECB is goingto buy are not known. This is a decision still to be taken by theECB Governing Council. Apart from the sterilisation, we wouldguess that the covered bond buying programme of the ECBcould be a blue print and would expect the ECB to reveal in duecourse the amount of the purchases it is targeting and thetimeframe over which they expect to conduct these purchases.In the highly successful covered bond programme, there werehardly any details given of which bonds they aimed to buy.
Exhibit 1
Consolidated Balance Sheet of the Eurosystem
As of April 30, 2010
2.1Receivables from theIMF66,5172.1Current accounts(covering the minimumreserve system)197,4962.2and securityinvestments, externalloans and other external assets145,1782.2Deposit facility251,6092.3Fixed-term deposits0
2.4Fine-tuning reverseoperations02.5Deposits related to margincalls0
4.1Balances with banks,security investmentsand loans17,503
4.2Claims arising from thecredit facility under ERM II0
5.1Main refinancingoperations75,597
5.2Longer-termrefinancing operations667,2455.1General government104,9445.3Fine-tuning reverseoperations05.2Other liabilities8,1425.4Structural reverseoperations05.5facility754
5.6Credits related tomargin calls36
8.1Deposits, balances andother liabilities14,4667.1Securities held for monetary policypurposes50,2438.2Liabilities arising from thecredit facility under ERM II07.2Other securities304,501
953,033835,57610161,4359247,00711249,2051,956,8191276,6571,956,819Total liabilitiesRevaluation accountsCapital and reservesCounterpart of specialOther liabilitiesLiabilities to euro areaLiabilities to non-euro areaLiabilities to other euro arearesidents denominated inLiabilities to non-euro areaOther liabilities to euro areacredit institutionsdenominated in euroDebt certificates issuedTotal assetsLiabilities (EUR millions)Banknotes in circulationLiabilities to euro area creditGeneral government debtOther assetsOther claims on euro areaSecurities of euro arearesidents denominated inClaims on non-euro areaLending to euro areaClaims on non-euro areaClaims on euro arearesidents denominated inAssets (EUR millions)Gold and gold receivables
Source: ECB
MORGAN STANLEY RESEARCHMay 10, 2010Europe Economics
Contrary to the covered buying programme the ECB might beshying away from buying bonds in the primary market. It isclear that the ECB has decided to give up some of itscomposure this weekend and embark on an unprecedentedcourse of buying debt instruments in order to reduce volatility infinancial markets and funding pressures in parts of the bankingsystem.
Two tales of a sovereign debt crisis
We have argued in the past that the sovereign debt crisis islikely to play out in two ways: as a credit story within the euroarea because the ECB isn’t allowed to monetise governmentdebt and as an inflation story in the UK and US where thecentral bank can and does monetise government debt. It nowseems that the euro area could be in the worst of both worlds.Like the emergency lending facilities that Europe has activated,also government bond buying by the central bank – whether itis pure credit easing (i.e. sterilised) or outright quantitativeeasing (i.e. unsterilised – often casually described as printingmoney), involving the central bank in stabilising governmentbond mainly buys the governments facing financial distresssome extra time. Contrary to earlier decisions taken by other central banks, this purchase programme is not meant to up theoverall amount of liquidity or lending. In other words, it is notquantitative easing. Hence, there is no additional money meantto be printed (at least not through the purchase programme).As result the potential longer-term inflationary dangers shouldbe more contained. But it will remain to be seen whether thefinancial markets come to this conclusion too.
Exhibit 2
Government Bond Holdings of MFIs and ESCB
10001100120013001400150016001700180019002000Sep-97 Sep-99 Sep-01 Sep-03 Sep-05 Sep-07 Sep-09EUR millionMFI Eurosystem
Source: ECB
Funding pressures in the financial system
 The sharp sell-off in some of the peripheral bond markets inrecent weeks will likely have had some repercussions on theeuro area banking system. Even where euro area banks haveallocated their government bond holdings to their hold-to-maturity assets, they still face a daily mark-to-market for bondsthat have been pledged to the ECB as collateral. Hence thesharp fall in some bond markets could have caused somestress on the funding side, rather than the asset side as such.For the overall banking system this should not be a major issuegiven the extent of overcollateralisation and the small share of government bonds in the overall collateral pool. But for individual institutions this might not be case. To the extent thatthe policy initiatives announced cause bond markets to rally,they will also help to relieve the funding stress.
EU balance-of-payments facility extended to EMU states
 The smaller part of the stabilisation fund is based on anextension of the existing balance of payments facility to euroarea member states. In addition, the facility is upped by EUR60bn to a total of EUR 110bn. The balance of payment facilityhas recently provided emergency funding to Hungary, Latviaand Romania. In these cases, the European Community (EC)came to the market to raise funds by issuing EC bonds that arebacked by all EU Member states and then lent the money on tothe countries in question under a joint funding programme withthe IMF. Typically, the lending is conditional on the countrydelivering on a number of policy areas, notably tough budgetcuts. Having a AAA rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, theIMF and the government concerned agree on measuresdesigned to overcome the country’s difficulties.Based on a Commission proposal, Ecofin approved the loansto Latvia, Hungary and Romania, usually at a five-year maturity.Subsequently, a Memorandum of Understanding is signedbetween the EU and the member state, setting out theconditions of the loan. Following signature of the Memorandumand the Loan Agreement, the first payment tranche is released.Countries that would like to use this facility would probably beprepared to make budget cuts similar to what the CEEcountries did and what Greece is doing now. Payments areusually made in instalments. Ahead of the disbursements of further tranches there is typically an assessment of theprogress made with respect to the policy measures taken. Sofar, about EUR 15bn out of the BoP facility have been allocatedto Hungary, Romania and Latvia (with around EUR 10bnhaving been disbursed already). Hence, there is at themoment about EUR 100bn of emergency lending available inthe BoP facility.

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