Bond-buying Eurozone bail-out fund would soon run out of money
by Fredrik Erixon
27 July 2012
Neither the eurozone bail-out fund nor the IMF has the necessary €2 trillion firewall to pull Europe out of the economic doldrums - says think-tank
The eurozone agreement in Brussels in late June was hailed as a critical step towards solving the crisis. But it may be a Pyrrhic victory. If the single currency area spends its limited bail-out resources to purchase bonds, a strategy that was agreed in the summit agreement, it will soon run out of money. Equally important, other sources to help fund ailing governments will not be compatible with such an approach. This is especially the case with the International Monetary Fund, which has just completed a new round of fundraising; expanding its "firewall" up to approximately $450bn. In fact, if the eurozone moves toward what it calls a 'flexible use of resources' in the bail-out structure, it is unlikely that the IMF can team up with the European Union or single currency area governments in preventing default.
There are three factors that will separate the IMF from the new eurozone approach. The first one can be labelled as constitutional. The IMF cannot play a direct part in an operation that eases conditions for government borrowing by intervening on the bond markets. Nor can it bypass governments by lending capital directly to banks or to a pan-European bail-out fund. Only members of the IMF can borrow from the IMF and the debtor country's borrowing should be based on the treasury, the central bank or an equivalent institution. For the IMF to join forces with the eurozone, there has to be a joint programme with money disbursed directly with the debtor government.
The second factor concerns conditionality. A subject of controversy and reform, IMF conditionality remains based on the simple and understandable desire of the institution wanting its loans to be repaid. Conditionality programmes are consequently designed to ensure that a country will exit a period of IMF assistance with a better policy environment than when the loan was requested. Obviously, this is also a central part of the eurozone's collective thinking about conditionality. But that thinking is now about to change with the flexible use of its bail-out mechanism.
It remains unclear exactly what conditions that will be attached to possible assistance to Spain and Italy under the new "flexible" paradigm. The summit statement from the euro-area group suggested that an ex ante structure of conditions, based on compliance with the stability and growth pact and the country specific recommendations. Yet the atmosphere of the suggestions is that countries like Spain and Italy can be eligible for assistance without full programmes, and standard conditions, because they have qualified as ex ante.
It is not difficult to see why conditionality would be weakened. The eurozone is approaching a point of alarming distress. Actions then will not be so much about aiding countries under specific conditions but avoiding a breakup or breakdown. Assisting countries by purchasing their bonds would be tantamount to an act of desperation. But the envisioned ex ante conditionality is principally not compatible with IMF views on conditionality. True, the IMF also runs programmes based on ex ante conditionality, but neither Spain nor Italy would qualify under those programmes' ex ante conditions on fiscal policy and stability. The finger would point to a lending operation based on a full programme of traditional ex post conditionality. Both countries still suffer from structural deficiencies in fiscal policy and their current accounts. For the IMF to ensure it will be repaid, these counties will have to change.
Italy's fractured political system would also be difficult to square with the strong emphasis on ownership of reforms in the IMF's philosophy on conditionality. Understandably, the IMF does not want to get into a position where it effectively has to run the country to ensure that they still can disburse funding. Italy has a technocratic government because the parliamentary system could not produce a government with a responsible fiscal policy, supported by a majority of the parliament. In other words, ownership of reforms is a concept which is distant from current political realities in Italy. The European Central Bank as well as eurozone leaders have tried time and again but failed to use sticks to get Italy to behave more responsibly. The outcome of the next election looks unlikely to change the texture of Italian politics to the degree that there will be a responsible majority government, which would own the reform agenda. Arguably, this suggests that the IMF would not be prepared to engage in sizeable lending to Italy without balancing weak ownership by way of stronger conditionality.
A final point on conditionality concerns the size of the Spanish and Italian economies and the risk that the IMF would have to take by lending them money. Failed assistance to smaller economies will not break the bank but if lending to Spain and Italy fails, the IMF's own financial credibility will be in the danger zone. Consequently, the IMF would more than likely have to take greater precautions to ensure that any resources it lends is part of a programme with appropriate conditionality.
The third factor concerns likely IMF resistance to engaging fully with big eurozone economies, if the single currency bail-out funds are spent supporting governments via the bond market. A possible way around the two other factors is that the bail-out funds support countries via lending to banks and interventions on the bond markets, while the IMF sets up their own programmes with countries. That strategy, however, does not look appealing from the IMF viewpoint. The IMF would not start lending money without a clear and credible plan for how a country is going to finance itself in at least the next 12-18 months, probably longer.
And for a programme to ensure full financing of Spain and Italy, there must be more resources available to governments than what the IMF has to offer. The assumption behind the drive for new IMF resources has been that it would add resources that in combination with the eurozone's own bail-out funds would be a credible firewall. It has been clear for some time that the sums the two parts could raise would not add up to the €2 trillion seen by many as the necessary size of the firewall. But the sum of the two parts has been assumed to be bigger that the numerical value of the money raised. But if the duo is split up, that value looks likely to shrink.
Two conclusions can be drawn. First, the June summit deal may be a Pyrrhic victory if an unintended consequence of that deal is that the IMF cannot be fully engaged, in the event that Spain and Italy need support to avoid sovereign defaults. Second, the eurozone must soon come up with a credible answer about funding, if both Spain and Italy will need support. If it continues to fudge on that issue, the piecemeal improvements it makes - like bypassing the Spanish government in a package to the country's banks - will never buy the single currency area the time and space it needs to rebuild credibility through fiscal, financial and current account improvements.
Fredrik Erixon is director of the European Centre for International Political Economy think-tank, which is based in Brussels
The eurozone agreement in Brussels in late June was hailed as a critical step towards solving the crisis. But it may be a Pyrrhic victory. If the single currency area spends its limited bail-out resources to purchase bonds, a strategy that was agreed in the summit agreement, it will soon run out of money. Equally important, other sources to help fund ailing governments will not be compatible with such an approach. This is especially the case with the International Monetary Fund, which has just completed a new round of fundraising; expanding its "firewall" up to approximately $450bn. In fact, if the eurozone moves toward what it calls a 'flexible use of resources' in the bail-out structure, it is unlikely that the IMF can team up with the European Union or single currency area governments in preventing default.
There are three factors that will separate the IMF from the new eurozone approach. The first one can be labelled as constitutional. The IMF cannot play a direct part in an operation that eases conditions for government borrowing by intervening on the bond markets. Nor can it bypass governments by lending capital directly to banks or to a pan-European bail-out fund. Only members of the IMF can borrow from the IMF and the debtor country's borrowing should be based on the treasury, the central bank or an equivalent institution. For the IMF to join forces with the eurozone, there has to be a joint programme with money disbursed directly with the debtor government.
The second factor concerns conditionality. A subject of controversy and reform, IMF conditionality remains based on the simple and understandable desire of the institution wanting its loans to be repaid. Conditionality programmes are consequently designed to ensure that a country will exit a period of IMF assistance with a better policy environment than when the loan was requested. Obviously, this is also a central part of the eurozone's collective thinking about conditionality. But that thinking is now about to change with the flexible use of its bail-out mechanism.
It remains unclear exactly what conditions that will be attached to possible assistance to Spain and Italy under the new "flexible" paradigm. The summit statement from the euro-area group suggested that an ex ante structure of conditions, based on compliance with the stability and growth pact and the country specific recommendations. Yet the atmosphere of the suggestions is that countries like Spain and Italy can be eligible for assistance without full programmes, and standard conditions, because they have qualified as ex ante.
It is not difficult to see why conditionality would be weakened. The eurozone is approaching a point of alarming distress. Actions then will not be so much about aiding countries under specific conditions but avoiding a breakup or breakdown. Assisting countries by purchasing their bonds would be tantamount to an act of desperation. But the envisioned ex ante conditionality is principally not compatible with IMF views on conditionality. True, the IMF also runs programmes based on ex ante conditionality, but neither Spain nor Italy would qualify under those programmes' ex ante conditions on fiscal policy and stability. The finger would point to a lending operation based on a full programme of traditional ex post conditionality. Both countries still suffer from structural deficiencies in fiscal policy and their current accounts. For the IMF to ensure it will be repaid, these counties will have to change.
Italy's fractured political system would also be difficult to square with the strong emphasis on ownership of reforms in the IMF's philosophy on conditionality. Understandably, the IMF does not want to get into a position where it effectively has to run the country to ensure that they still can disburse funding. Italy has a technocratic government because the parliamentary system could not produce a government with a responsible fiscal policy, supported by a majority of the parliament. In other words, ownership of reforms is a concept which is distant from current political realities in Italy. The European Central Bank as well as eurozone leaders have tried time and again but failed to use sticks to get Italy to behave more responsibly. The outcome of the next election looks unlikely to change the texture of Italian politics to the degree that there will be a responsible majority government, which would own the reform agenda. Arguably, this suggests that the IMF would not be prepared to engage in sizeable lending to Italy without balancing weak ownership by way of stronger conditionality.
A final point on conditionality concerns the size of the Spanish and Italian economies and the risk that the IMF would have to take by lending them money. Failed assistance to smaller economies will not break the bank but if lending to Spain and Italy fails, the IMF's own financial credibility will be in the danger zone. Consequently, the IMF would more than likely have to take greater precautions to ensure that any resources it lends is part of a programme with appropriate conditionality.
The third factor concerns likely IMF resistance to engaging fully with big eurozone economies, if the single currency bail-out funds are spent supporting governments via the bond market. A possible way around the two other factors is that the bail-out funds support countries via lending to banks and interventions on the bond markets, while the IMF sets up their own programmes with countries. That strategy, however, does not look appealing from the IMF viewpoint. The IMF would not start lending money without a clear and credible plan for how a country is going to finance itself in at least the next 12-18 months, probably longer.
And for a programme to ensure full financing of Spain and Italy, there must be more resources available to governments than what the IMF has to offer. The assumption behind the drive for new IMF resources has been that it would add resources that in combination with the eurozone's own bail-out funds would be a credible firewall. It has been clear for some time that the sums the two parts could raise would not add up to the €2 trillion seen by many as the necessary size of the firewall. But the sum of the two parts has been assumed to be bigger that the numerical value of the money raised. But if the duo is split up, that value looks likely to shrink.
Two conclusions can be drawn. First, the June summit deal may be a Pyrrhic victory if an unintended consequence of that deal is that the IMF cannot be fully engaged, in the event that Spain and Italy need support to avoid sovereign defaults. Second, the eurozone must soon come up with a credible answer about funding, if both Spain and Italy will need support. If it continues to fudge on that issue, the piecemeal improvements it makes - like bypassing the Spanish government in a package to the country's banks - will never buy the single currency area the time and space it needs to rebuild credibility through fiscal, financial and current account improvements.
Fredrik Erixon is director of the European Centre for International Political Economy think-tank, which is based in Brussels
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