European Student Think Tank

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European lead­ers have hailed the agree­ment on the European Financial Stability Facility’s (EFSF) capa­city boost to one tril­lion Euro – a mile­stone to insu­late EU mem­ber states against future instabil­ity caused by mar­kets bet­ting against them. The down­ward spiral that saw Greece, Por­tugal and Ire­land on the brink of bank­ruptcy should thus be stopped, and a “con­ta­gion” of other coun­tries as Italy and Spain pre­ven­ted. How­ever, there is no decision yet on how the EFSF’s lend­ing capa­city will be increased.

Two options are cur­rently dis­cussed, an insur­ance scheme and a spe­cial pur­pose invest­ment vehicle (SPIV) scheme.

ñ   The first option entails the idea of using the EFSF as a war­rantor of loans to other coun­tries. If, say, the EFSF would guar­an­tee a part of those loans (for example 25% of the total) it could boost the total avail­able credit sum to one tril­lion Euro.

ñ   The second pro­posal would see the cre­ation of an indi­vidual SPIV for every coun­try. The EFSF and other inter­na­tional investors, such as hedge­fonds, national sov­er­eign funds or states, would join forces to sup­port a coun­try. Such a SPIV would be used to buy up bonds on the primary and sec­ond­ary mar­ket and would then issue cred­its to the troubled country.

Both schemes could prob­ably be com­bined, as they share a core ele­ment: namely they will pro­tect a part of the “investment”.

Insur­ance is good for investors, but might be ris­kier for euro­zone coun­tries than any pre­vi­ous move of the EU to bail out troubled coun­tries. Should a coun­try, des­pite the efforts of the EFSF, default or receive a hefty “hair­cut”, investors will be able to retrieve the insured part of their invest­ments through the EFSF, but the EFSF itself will be drained off its reserves. Any coun­tries pay­ing into the EFSF will inev­it­able lose money.

Who’s going to pay?

The most urgent ques­tion has not been answered yet: Who is going to fin­ance the “booster”? A num­ber of can­did­ates, such as Rus­sia, China or the IMF, come to mind. Any involve­ment of an external part­ner though will come with a polit­ical cost. It will determ­ine to what extent the EU will engage with non-domestic creditors.

The most obvi­ous part­ner would be China, which is des­per­ately seek­ing to replace parts of its for­eign cur­rency reserves away from the US dol­lar. The Chinese gov­ern­ment has been sup­port­ing European efforts to bail out Por­tugal and might buy Italian bonds, and has repeatedly stressed the import­ance of a strong com­mon cur­rency. Its interest in a strong European eco­nomy is self-servicing, as the EU remains one of China’s major mar­kets. If the EU col­lapses, China’s eco­nomy will suf­fer from the drop­ping European demand. In return for its sup­port, Beijing will play tough. It might ask the EU to recog­nise its eco­nomic mar­ket status, thus mak­ing anti-dumping meas­ures more dif­fi­cult. As China will receive that status in 2016 any­way, another option could be China demand­ing the EU to refrain from cri­ti­cising its human rights record, effect­ively mut­ing the EU.

Another close can­did­ate could be Rus­sia, which might demand a fur­ther open­ing of the EU’s gas mar­ket. Moscow might push for Gazprom to acquire shares in down­stream dis­tri­bu­tion infra­struc­ture or shares in EU energy com­pan­ies. It’s less likely that Rus­sia will bother try­ing to silence the EU’s cri­ti­cism of its human rights record, but European lead­ers might be wary to accept Russia’s terms.

Other coun­tries, such as the Arab and Gulf states, could be con­sidered poten­tial part­ners, though it’s more dif­fi­cult to see why they should offer help. Regard­less of whether a single state bank­rupts or the com­mon cur­rency fails, they will con­tinue to rely on fossil fuels. It there­fore seems more likely that these coun­tries might use the oppor­tun­ity to shop around cheaply and buy into com­pan­ies and infrastructure.

Another, more inter­est­ing group needs to be men­tioned. Even though both China and Rus­sia have been dis­cussed in a bit more detail, the role of devel­op­ing nations might merit more atten­tion. Recently Spain and Por­tugal appealed to their Latin Amer­ican part­ners at the IberoAmer­ican sum­mit to sup­port their efforts to con­sol­id­ate their budgets. In what can only be seen as a fant­astic twist of his­tory, the former colon­ies have become a major part of the solu­tion. Coun­tries such as Mex­ico, Brazil, but also Indone­sia and India, might sup­port the EU through the IMF, but will demand a stronger role in the insti­tu­tion. They might force the Europeans to finally break with the tra­di­tional divi­sion at the head of the IMF – which has always seen a European as its man­aging dir­ector and an Amer­ican as first deputy man­aging dir­ector. This, how­ever, might mean that the IMF could turn its atten­tion away from the West and focus on other regions.

What about the ECB?

The ques­tions, which parties might join forces with the EU to boost the EFSF and what form it will even­tu­ally have, are still unanswered. How­ever, unless the EU decides to engage the European Central Bank (ECB) instead of external part­ners – a move Ger­many strongly opposes as it fears this could turn the ECB into a huge bot­tom­less pit feed with Ger­man money – it will have to con­sider the polit­ical costs of engage­ment with poten­tial part­ners like China or Russia.

It’s dif­fi­cult to pre­dict an out­come and as the EU has stated that the fin­ance min­is­ters are going to elab­or­ate on the plans till the end of Novem­ber, it’s hardly more than a guess to claim that this issue is not over yet. Mar­kets will con­tinue to worry, espe­cially over the state of Italy’s budget and Spain, the third and fourth biggest eco­nom­ies in the euro­zone. One tril­lion will not be enough to bail them out. Even­tu­ally, I believe, even Ber­lin will have to give way and con­sider the ECB option. Why? Because it has (almost) unlim­ited lend­ing capa­cit­ies and its cur­rent reserves alone amount to more than €5 tril­lion, enough to calm mar­kets and suf­fi­cient to save Italy and Spain twice. Fur­ther­more using the ECB would pre­serve the EU’s room for man­oeuvre vis-á-vis China or Russia.

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