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ESFS 3.0 - Evropský fond finanční stability (EFSF, dokument v AJ)

ESFS 3.0 - Evropský fond finanční stability (EFSF, dokument v AJ)

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Published by Ivana Levá

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Published by: Ivana Levá on Oct 13, 2011
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Any authors named on this report are research analysts unless otherwise indicated.Please see analyst certifications and important disclosures starting on page 6.
Europe Special ReportECB SMP and EFSF 3.0
EFSF 3.0 and the fate of the ECB‟s SMP
One key area of market uncertainty is the ECB's stated intention to suspend its SMP programme when the EFSF 2.0 is up and running, which could be later this month.
But the EFSF 2.0 is unable to execute this mandate.
However, we believe that an awareness of the structural limitations of EFSF 2.0 will mean that the ECB will maintain its SMP programme, we assume at a similar scale to that seen over the past six months albeit with the purchases remaining conditional on fiscal rectitude among recipient countries.
If we are correct, this would remove one key area of market uncertainty, but many will remain since we assume that SMP purchases will remain focused on providing the minimum liquidity support necessary to ensure that key non-core countries maintain market access.
We have framed the euro-area crisis in terms of governments and the market searchingfor a steady state solution, defined as a situation where the market no longer fears theincremental solvency risk of holding the debt of a euro-area sovereign. In our view, thereare three, often related, paths towards a steady state solution:1.
Fiscal union and/or the issuance of Eurobonds with a joint and severalliability structure.
The likelihood of this option has been significantly reducedfollowing last month's German Constitutional Court ruling against unboundedliabilities accruing to Germany as a result of its involvement in Euro-areabailouts.2.
Monetisation of non-core debt via an aggressive expansion of the ECB'sbalance sheet.
This option runs the risk of merely providing a large window ofmarket calm after which underlying solvency concerns would remain.Nonetheless, it would allow the ECB's unbounded balance sheet to be broughtto bear on the crisis which could be sufficient to assuage default risks for a longperiod of time. (While the ECB would only buy bonds on the secondary market,this should spur demand for primary debt since the bonds could be sold to theECB, limiting their downside). However, our view remains that the ECB isreluctant to increase the credit risk on its balance sheet at this time.3.
Default by selected countries and the potential for some Euro-areamembers to leave the euro.
This is naturally a market-unfriendly outcome andone that could result in multi-year economic and market disruptions before asteady state were reached.We recently analysed many of the latest policy proposals for addressing the euro-areacrisis that work within this framework(
,29 September), mostnotably policies which involve increasing the amount of financial resources brought tobear in the crisis by altering the structure of and/or leveraging the EFSF. Now we revisitthis analysis, and highlight the implications for the ECB's securities markets programme(SMP) from some of the proposed changes to the EFSF.
10 October 2011
Jens Sondergaard
+44 (0) 20 710 21969
Desmond Supple
+44 (0) 20 710 22125
Nomura Global Economics
10 October 2011
The planned ending of the ECB's SMP
a key area of marketrisk
Since the bond-
buying began, its effectiveness has been limited by the market‟sawareness that the ECB‟s commitment to the SMP has been ambiguous. First, the ECB
has repeatedly said that the
SMP is intended to be “temporary”. Second
, the governingcouncil remains heavily divided on the issue and the critical voices are well known (JensWeidmann,
Stark, Yves Mersch, Klaas Knot). A divided governing councilmakes the bond market interventions less effective.
The ECB is clearly not comfortable with the SMP
Four main concerns explain the ECB‟s unease regarding the SMP:
 1. The ECB bond purchases may be violating the Treaty of the European Union,Article 21.1 which prohibits the ECB from directly buying bonds from EUgovernments, i.e. the ECB cannot bail out governments in financial distress.There may be a legal loophole in that the ECB is buying bonds in the secondarymarkets (i.e. from financial institutions), but the intention of the treaty is clear:the central bank should not facilitate the deficit financing of the euro-areagovernments.2. Second, the ECB bond-buying has implicitly been conditional on thegovernments adopting the right policy mix of fiscal austerity and structuralreform. The ECB SMP is a
quid pro quo 
: governments take steps to ensure thattheir public debt is sustainable; the ECB intervenes to correct the mispricing ofbonds in the markets. If governments do not do their job, the ECB can (and has)stepped back from its intervention. This is a dangerous area for a central bank.
Bond purchases essentially become a “stick and carrot tool” where the ECB
takes a direct role in affecting fiscal policy across the euro area. It is hard to seehow central bank independence is preserved and how the ECB can separatefiscal from monetary policy concerns.3. We think ECB policymakers are worried about credit risk. A substantialcommitment to further SMP entails a substantial balance sheet expansion. Butpolicymakers worry that such a balance sheet expansion would increase thefinancial risks to their balance sheet. In other words: leveraging up the balancesheet exposes the ECB to potential capital losses. Policymakers may worry thatany significant capital losses would make the ECB technically insolvent. Thegoverning council does no
t have the right to ask for an increase in the ECB‟s
capital base. That is the responsibility of the European Council. Of course, thereis no theoretical problem with a central bank being insolvent if there is sufficientconfidence that policymakers will not implement an overly loose monetary policyas they seek to accumulate profits by printing money (seigniorage) and ridingthe yield curve. In the current context in Europe, we doubt many investors wouldbe alarmed if such a scenario emerged. Nonetheless, central banks remainstrongly opposed to depleting their capital.4. The ECB is concerned about the possible inflationary impacts of a large-scaleSMP intervention. Can the ECB sterilise the inflationary impulse from a largebalance sheet expansion? If not, then SMP could conflict with the price stabilitymandate, depending on the economic outlook for the euro area.
The ECB‟s appetite for its SMP has also related to its own agenda regarding economic
governance in the euro area. It has explicitly talked about the need for closer economicand in particular fiscal integration within the euro area, and is aware that market pressureis pushing policymakers down this path. Without this market pressure, the ECB fears that
the momentum towards “the ever closer union”
will falter. An unconditional commitmentto SMP removes market pressure and would imply a lost opportunity to substantiallyimprove the foundations of European Monetary Union. However, the balancing act for theECB is providing an SMP which is viewed as sufficiently conditional on fiscalconsolidation in recipient countries and a partial solution to a count
s funding pressures,
The ECB’s commi
tment tothe SMP has beenambiguous
Nomura Global Economics
10 October 2011
 but on the other hand providing sufficient liquidity to ensure that key countries, such asItaly or Spain, do not lose market access. If they were to do so, the survival of the euroarea would become more uncertain. So, the SMP needs to provide a minimum backstopuntil a sustained solution is found.
ECB is scheduled to pass the SMP baton to the EFSF 2.0,which is unable to grasp it
Given the ECB‟s obvious restraint in terms of its SMP intervention, the scheme has had a
success proportionate to the modest scale of its ambition. It has played an important rolein helping to maintain market access for countries such as Italy and Spain since it haslimited the rise in yields, but the scheme has clearly not been large enough to transformmarket sentiment towards the semi-core countries since it is not a solution to the debtcrisis. While maintaining the current SMP is not a substitute for a credible and broad-based EU policy response to the crisis, were the ECB to halt its programme the risks ofItaly and Spain losing market access would increase significantly. In this respect, the
outlook for the ECB‟s SMP is a crucial area of market risk.
 Unfortunately, there are question marks about the longevity of the SMP. As we wroterecently(
,6 September 2011), the ECB currentlyplans to halt its SMP and to hand over responsibility for secondary market bond-buying tothe EFSF once Euro-area parliaments approve planned changes to its structure. This is aconcern because the proposed new structure of the EFSF (EFSF 2.0) is ill-suited to the
task of taking up the baton of the ECB‟s bond buying program
in our view. At
440bn inusable/investible resources,
147bn of which have already been allocated to bailoutprogrammes, we think it is too small to comprise a significant buttress against marketweakness in non-
core debt. Moreover, the EFSF lacks the ECB‟s flexibility since it would
need to pre-fund its interventions, and there is uncertainty about how the EFSF wouldchoose which bonds to buy.
Does the EFSF 3.0 option change our view of the ECB's SMP?
When looking at the many and varied options for EFSF 3.0, below we divide them intotwo broad categories: (1) options which by definition address the issue of the SMP bymaking this scheme a central component of the new EFSF; and (2) options such asleverage-based options which require a separate view on whether or not we expect theSMP to be maintained and in what size.
Category 1
The ECB indemnity option
(29 September 2011), we noted that of the proposedchanges to the EFSF, one of the most appealing could be to transform the EFSF into amechanism for indemnifying the ECB against losses from its bond holdings. The benefitsof this approach would be threefold:
More efficient use of EFSF capital
. This scenario would not need the EFSF toissue AAA debt for the purpose of its indemnification operations. Hence the fullvalue of guarantees
could be utilised rather than the
440bn whenthese assets are over-collateralised to form
440bn of investible funds.
SMP uncertainty is removed
. Under this scenario, the SMP becomes a central
element of the EU‟s EFSF
-related plans for addressing the euro-area crisis. Thisoption also addresses (depending on the scale of the indemnity provision) theECB's concerns about the credit risk implicit in its SMP.
Bank recapitalisation
. The plan also allows for EFSF funds to be allocated toadditional uses, such as bank recapitalisation, and hence for the policyresponse to comprise a more comprehensive package of measures.We explore this option first as it would allow us to quantify the potential impact on theSMP.
SMP has helped limit therise in yields, but is nosubstitute for a crediblesolutionEFSF funds can be usedto indemnify the ECB forits bond purchases

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