Wednesday, August 3, 2011

Worsening euro crisis may force bigger rescue fund



(Reuters) - A worsening euro zone debt crisis may ultimately force the bloc to expand its 440 billion euro ($625 billion) bailout fund, despite political opposition in key contributing countries, some officials and analysts say.

An emergency summit of euro zone leaders last month agreed to let the fund, the European Financial Stability Facility, deploy its money in new ways to fight the crisis. But it did not take a major step for which investors were hoping: give the EFSF more firepower.
Since then, the euro zone's debt problem has become even more worrying, threatening to move beyond small countries such as Greece to engulf large states such as Spain and Italy.
The spread of the Italian 10-year government bond yield over German Bunds jumped to a euro-era high of 3.85 percentage points on Tuesday, a level which, if sustained over the long term, could prevent Italy from borrowing in the markets at affordable rates.
To convince the markets that this will not happen, rich euro zone governments may have no choice but to override opposition among their taxpayers and pledge to contribute to a drastic expansion of the EFSF -- perhaps doubling or tripling it.
"You need to convince the world that Europe is going to sort itself out," said John Fitzgerald of the Economic and Social Research Institute, a Dublin-based think tank.
"A way of saying that is to have the fund so large that it can handle anything that comes its way. It would stop speculation in Spain and Italy," said Fitzgerald, who sits on the board of the Irish central bank.
OPPOSITION
Since the euro zone summit on July 21, Europe's refusal to commit to expanding the EFSF has emerged as a key factor behind the meeting's failure to calm markets, along with slowing global economic growth and doubts that a rescue plan for Greece can cut the country's debt enough to avert a large-scale default.
Opposition to enlarging the EFSF at this time is strong in several key governments. German Chancellor Angela Merkel has not ruled it out, but agreeing to it could damage her support among disgruntled German voters; Berlin does not want to be sucked into pledging ever-growing sums to weak European states.
"Everybody is aware this is a no-go scenario for the Germans, so no one is putting that on the table really," said one euro zone policy maker, who declined to be named. Berlin's scepticism is shared by Finland, Slovakia and the Netherlands.
France has also been opposed, apparently because further commitments to the EFSF could strain the French government's finances. A senior French official played down any need to expand the EFSF, noting that most of it had not yet been tapped.
The mathematics of the EFSF are not reassuring the markets, however. Rough calculations suggest the EFSF, which borrows its funds from the markets backed by guarantees from euro zone states, might conceivably cope with a bailout of Spain but there would be little room for error, while it would not have enough ammunition if Italy needed help.
The EFSF shares the burden of Europe's contribution to bailing out Ireland and Portugal with the European Financial Stabilisation Mechanism, another emergency fund. It is already committed to providing 17.7 billion euros in emergency loans to Ireland and 26 billion to Portugal.
In addition, the EFSF will take over the remainder of Europe's contribution to an initial bailout of Greece, which is likely to require 25 billion euros, and it is expected to provide two-thirds of a 109 billion euro second bailout of Greece announced last month.
It may have to stump up even more if the International Monetary Fund does not contribute one-third of the second Greek rescue; the IMF has provided about a third of past euro zone bailouts, but some emerging market stakeholders in the Fund are increasingly unhappy with pouring large sums into Europe.
Taken together, the EFSF's current commitments total at least 142 billion euros, leaving it only 298 billion euros to cope with future challenges.
A multi-year bailout package for Spain might cost more than 290 billion euros, estimates Gilles Moec, an economist at Deutsche Bank, while a rescue bill for Italy could total almost 490 billion euros. With IMF help, the EFSF at its current size could conceivably handle Spain, but not Italy.
Last month's euro zone summit agreed to give the EFSF sweeping new powers; it will be able to buy governments' bonds from the secondary market, provide precautionary credit lines to countries before they lose access to the markets, and recapitalise banks in states that are not receiving bailouts.
But these powers will not inspire confidence if the markets doubt the EFSF has enough money to use them quickly and aggressively.
"There are lots of additional measures that they gave to the EFSF," said Cagdas Aksu, analyst at Barclays Capital. "If you want these measures to have more credibility, some kind of increase would help, no doubt about it."
OFFICIALS
For this reason, some European Union officials continue to believe a major expansion of the EFSF is necessary and may well happen eventually -- if not in the next few months, then perhaps next year. A further rise of bond yields in Italy and Spain could bring forward that decision.
"To me it appears unrealistic to say it's enough," said one senior EU official, adding that it would be difficult for the EFSF to exercise its bond-buying powers without being topped up.
Another official who advises top EU policymakers said he had recommended the EFSF be doubled or even tripled, via larger guarantees by euro zone governments, to provide a stronger defence against market jitters spreading to Spain and Italy.
The official acknowledged that expanding the EFSF could be a double-edged sword, since it might suggest to some investors that governments were anticipating bigger problems down the road. However, he believed the measure would underline the euro zone's resolve to defend its currency.
Another potential problem with enlarging the EFSF is that countries receiving bailouts may opt out of their commitments to guarantee EFSF funding. If both Spain and Italy did this, the burden on contributing euro zone states would rise considerably.
But Alessandro Giovannini, an analyst at the Centre for European Policy Studies, an EU think tank, says the EFSF should be boosted to 1.5 trillion euros to convince markets both Italy and Spain could be saved. If markets believed this, bond yields might stabilise and the money might never need to be spent.
"The costs of a bailout of those countries are stratospheric and could not be met with the planned resources," he said.
Prominent supporters of the idea of a larger EFSF include Nout Wellink, who until July headed the Dutch central bank, and the IMF, which publicly urged euro zone leaders before the summit to expand the fund.
The IMF's position could ultimately be important in swaying euro zone leaders, who want the global lender to share the financial burden of resolving the region's crisis and to continue backing bailouts with its expertise and reputation.
For now, any high-level discussion of a larger EFSF appears to be on hold, with many national leaders and top EU officials taking their summer holidays.
"It was basically a summit so that everyone could go on holiday without being called back in August," said one EU diplomat. The willingness of leaders to take vacations during the crisis has itself contributed to investors' unease.
However, another EU diplomat said the debate on the EFSF could be revived quickly if the crisis demanded it. "We want to keep that ammunition in reserve. I have no doubt if it was needed, it could happen very quickly."
(Additional reporting by Daniel Flynn in Paris, Jan Strupczewski in Brussels and William James in London; Editing by Andrew Torchia)


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