Greek Disaster Averted Points To ERF’s Bridge For All Concerned

Bloomberg

While debt sharing in the euro area to stem the financial crisis has never been closer, German Chancellor Angela Merkel may keep it out of reach.

The European Parliament has inserted a provision into a draft budget law that would set up a fund to pool and help repay the debts of nations in the 17-member euro bloc. The proposal would link a policy opposed by Merkel to deficit-control legislation she has championed. Talks began July 11 and may last for months.

Supporters of the plan, including former Belgian Prime Minister Guy Verhofstadt, say it’s time for a new approach to save the single currency after more than 386 billion euros ($474 billion) of loan pledges to distressed euro states since 2010 failed to reduce borrowing costs for nations such as Spain and Italy. The bill calls for countries to transfer debt exceeding the European Union threshold of 60 percent of gross domestic product into a redemption fund, or ERF, and repay this money over 25 years, while cutting budgets and taking steps to promote economic growth.

“It’s a game-changer because what you do is create a real firewall and not a fire extinguisher,” said Verhofstadt, who now leads the pro-business Liberal group in the EU Parliament, in an interview. “Finally, we shall see that it’s the only solution for this crisis.”

The EU assembly, based in Strasbourg, France, introduced the amendment on June 13, four days before elections in Greece installed a pro-bailout coalition, averting the potential disaster of a government promising to renege on bailout terms.

Merkel Doctrine

Frustration is growing across Europe over a Merkel-led initiative to impose budget cuts on euro nations already in a recession. The austerity-first doctrine has deepened the bloc’s economic slump as well as the divisions over how to solve the crisis. Merkel rejected a June 26 blueprint drafted by EU President Herman Van Rompuy laying out a path toward even deeper debt mutualization through the creation of euro bonds.

In a sign that leaders are seeking to break new ground, European Central Bank President Mario Draghi has floated imposing losses on senior bank debtholders in restructurings, an option rejected by his predecessor, Jean-Claude Trichet.

With Greece, Ireland, Portugal, Spain and Cyprus dependent on a European financial lifeline and Italy battling to avoid becoming the biggest victim, the Parliament wants to offer relief by fast-tracking a move toward debt sharing.

To bolster its leverage, the assembly added its redemption- fund provision to a Germany-backed EU draft law to toughen controls on spending by euro governments. The legislation is the latest feature of a German-designed fiscal straitjacket that the EU has fashioned over the past two years, while saying a pooling of debt may be possible at a later stage.

German Politics

“It’s enough talking,” said Elisa Ferreira, a Portuguese member of the 754-seat Parliament and a negotiator of the new law with national governments. “We are in an emergency situation. It’s time to have a vision. It’s really the moment.”

Politics in Germany may dictate otherwise as Merkel gears up for 2013 elections. Her approval rating is the highest since 2009, according to a poll for ARD public television, helped by her handling of the European crisis. This has included a rebuff of calls by Italy and Spain for Germany to help underwrite the entire currency union’s debt.

Merkel has said that AAA rated Germany shouldn’t have to compensate for mismanagement in other countries and urged them to mend their spendthrift ways and revamp their economies.

“There will be no simple or liberating blow with which the debt crisis can be overcome,” Merkel said June 27 in Berlin. “No, if we manage to overcome the crisis in a sustainable way, there is only the possibility to go through a process of measures that go to the roots of the problem.”

‘Trojan Horse’

Malcolm Barr, an economist at JPMorgan Chase & Co. (JPM) in London, says a European redemption fund would risk becoming a “Trojan Horse” for the permanent issuance of euro bonds without more integrated fiscal policy and controls in Europe.

“Germany would be much better advised to recognize at the outset how difficult a euro-bond cat will be to put back in the bag once it is out,” Barr wrote in a June 18 report. “A debt redemption fund type idea would make most sense to us if presented alongside a timeline of negotiations over governance in the region.”

The EU Parliament’s amendment on an ERF is modelled on a proposal by Merkel’s own economic advisers. The German leader rejected the idea last year before agreeing to reconsider it to win backing from the opposition in Berlin for European bailout agreements.

‘Last Bulwark’

Merkel wants to present herself as the “last bulwark” against profligate southern Europeans before next year’s vote, Lars Feld, a professor of economics at Freiburg University and a member of Merkel’s council of economic advisers, said in an interview yesterday.

Verhofstadt says Merkel’s rejection is paradoxical given her concerns about the cost of taxpayer-funded bailouts and insistence that investors contribute to a second rescue of Greece earlier this year through the biggest debt writedown in history. A redemption fund would mean more help from bondholders, who would accept lower yields from the fund than yields exceeding 6 percent in Spain and Italy, he said.

“If they agree on this solution, they could explain it easily to the public,” Verhofstadt said. “It isn’t mainly taxpayers but bondholders who pay the bill. I think it’s a psychological problem.”

Fund’s Operation

A European redemption fund, to which the countries would provide collateral, would be based on joint liability and pool transferred debt totaling about 2.3 trillion euros in return for national budget consolidation. It would give breathing space to governments that face unsustainable borrowing costs by offering lower interest rates on this portion of their debt.

To repay their transferred debt over 25 years, the countries that take part would enter into payment obligations toward the redemption fund, which would sell its own bonds to cover the refinancing requirements of the participants.

Ten-year yields for the redemption fund would probably be between 2.5 percent and 3 percent, the German Council of Economic Experts said in late January. Germany’s refinancing costs, which have fallen “well below” normal levels during the region’s debt crisis, would probably rise to a comparable level, according to the German council.

Germany now pays about 1.2 percent to borrow for 10 years. The average for the past five years is 3.1 percent.

‘No-Go in Germany’

“Economically, it’s not a bad idea,” Daniel Gros, director of the Centre for European Policy Studies in Brussels, said in an interview. “Politically, it’s probably a no-go in Germany.”

Gros said clues to the legality in Germany of a European redemption fund would come from a planned Sept. 12 verdict by the country’s Federal Constitutional Court on the euro area’s permanent bailout facility. The facility is known as the European Stability Mechanism.

Lawmakers, academics and political groups have filed suits in Germany seeking an injunction against the ESM, arguing that it transfers constitutionally mandated authority from German parliamentarians to European authorities and undermines democratic rule.

Verhofstadt said a European redemption fund limited in time and in amount would be compatible with Germany’s constitution and wouldn’t require an EU treaty change.

‘Feasible, Effective’

“It is something that is feasible immediately, and effective,” he said.

Cyprus, which holds the 27-nation EU’s rotating presidency through December, will negotiate with the Parliament on behalf of governments.

“The Cyprus presidency, at this stage, does not wish to make any comment on the Parliament proposal,” said Nikos Christodoulides, a spokesman for the Cypriot government.

Verhofstadt said the Parliament would block the tougher spending-control rules unless the redemption-fund provision is included. The legislation would let the EU screen the budgets of governments earlier, monitor more closely countries such as Italy where rising borrowing costs threaten financial stability and impose tighter surveillance of nations after they exit rescue programs.

The draft laws build on six pieces of 2011 legislation that granted the EU stronger powers to sanction spendthrift euro countries. The latest rules, known as the “two pack,” also follow a European treaty aimed at limiting budget deficits.

“There is no two pack if there is no redemption fund,” Verhofstadt said. “We stick to that.”

Ferreira said she and her fellow Parliament negotiators would negotiate for “as long as it takes” with governments over the redemption fund.

“This is a landmark proposal,” she said. “We are prepared to fight for it. I don’t expect it to be easy.”

To contact the reporter on this story: Jonathan Stearns in Brussels at jstearns2@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net