Forget debt restructuring. Or E-bonds. Or US-style quantitative easing.
JPMorgan have found a different way out of the European crisis.
The bank’s Joseph Lupton and David Mackie have switched some of the focus from fixing fiscal profligacy to reducing those market pumped-up borrowing costs — and have therefore incorporated into their solution the direct fiscal transfer that many people in the market have been pushing for.
First though — those rising rates:
Along with the primary surplus and the nominal GDP growth paths, the evolution of debt as a share of GDP depends crucially on the rate at which sovereigns can borrow. The relevant interest rate for debt dynamics is not the current market rate, however, but the average rate paid on debt. Average borrowing rates as of 2010 are well below market rates, with a 4.5% rate in Greece, 4.6% in Ireland, 3.8% in Portugal, and 3.5% in Spain. However, given the large gross funding needs of these countries—from both rolling over maturing debt and new issuance to fund large current deficits—these average rates would converge to market rates fairly quickly in the absence of subsidized liquidity support. If these sovereigns were forced back into capital markets from 2013, average borrowing rates would begin to move up sharply. This is our baseline scenario, with average borrowing rates rising by 2015 to over 9% in Greece, over 8% in Ireland, and just under 7% in Portugal and Spain.
Now Europe’s Financial Stability Facility (EFSF) was meant to solve some of this problem — taking troubled eurozone states off the market until 2013. But the EFSF, as it stands, isn’t exactly inexpensive with a rate of almost 6 per cent for those tapping it. Meanwhile, details about the just-agreed European Stability Mechanism (ESM) meant to replace it after 2013 haven’t exactly been forthcoming.
With that emphasis on borrowing costs then, here’s what JPM wants to see happen — subsidised borrowing rates, possibly via an updated/extended EFSF.
For instance, 100 basis points above equivalent German rates, which would be far cheaper than the 350bps spread currently being provided.
There’s a reason, though, that the EFSF wasn’t set up to be particularly cheap when it was hastily created in the spring. That would be moral hazard/politics.
Stronger members of the eurozone didn’t want to be seen giving weaker members a free ride, which means the EFSF as it currently stands looks like much more of a liquidity-provider (giving loans which eventually have to be paid back at those not-so-cheap rates) than a solvency-solving vehicle. Then there’s that whole market angle too — the markets, via higher rates, are clearly signalling that they see risk.
But JPM thinks it’s got (at least some of) that covered:
Although liquidity support is being provided currently at an interest rate that is below the market rate for each respective borrower, it is not an especially subsidized rate. The spread between rate the EFSF pays on issued debt and the rate at which it lends is around 350bp. No doubt, the reluctance to subsidize the borrowing cost of the liquidity support is the potential moral hazard this creates. Remaining on track in improving primary positions is the greatest risk to debt sustainability. Easier lending costs, while being key to aiding in debt sustainability, at the same time could ease the pressure on governments to continue to engage in fiscal consolidation. One simple solution to this problem is to make the subsidized borrowing rate conditional on good-faith efforts toward fiscal consolidation. This is precisely how the market should work. Our argument is that the current market rate has mispriced the true risk. But, this does not mean that there is no risk at all, nor that this risk should not be repriced as it changes.
The EFSF facility could appropriately price risks based on past moves in rates (during less tumultuous periods) and apply them to the conditionality of the subsidized rate. The benefits of this would be twofold. First, it would provide an incentive to the borrowing sovereigns. It would give policymakers in these countries the motivation to adhere to fiscal consolidation as well as provide a clear message that could be used to calm political pressure. Second, it would provide a type of insurance to the creditors of the program and thus lead to a larger buy-in.
Make no mistake, then, this is still a fiscal transfer.
But it might come at a smaller cost than other options.
JPM estimates that using it to fund Greece, Ireland, Portugal and Spain through 2020 would cost €111bn – or just 2.5 per cent of the combined GDP of Germany and France. And in the end you’d get those debt-trajectory paths actually falling.
Or something like this:
Thoughts?
Related links:
EFSF capitulation - FT Alphaville
Is there the will to save the eurozone? - Martin Wolf
Public and private in the Ireland bailout - FT Alphaville
Goodbye to the risk-free rate - FT Alphaville