Bailout pro­grammes strengthen Eu­ro­zone

Financial Mirror (Cyprus) - - FRONT PAGE -

When a coun­try re­quests a fi­nan­cial sup­port pro­gramme from a supra­na­tional body, it is typ­i­cally a sign that the coun­try can­not stand on its own two feet. There is of­ten a stigma at­tached to a re­quest by a nonEuro­zone coun­try for fi­nan­cial aid from the IMF, or by a Eu­ro­zone mem­ber coun­try for aid from the Euro­pean Sta­bil­ity Mech­a­nism (ESM). The stigma has neg­a­tive legacy ef­fects on in­vestor sen­ti­ment, which of­ten trans­lates into wider bond spreads.

Aid pro­grammes are also un­pop­u­lar and this can have do­mes­tic po­lit­i­cal con­se­quences. Upon ex­it­ing their three-year fi­nan­cial as­sis­tance pro­grammes, both Ire­land and Por­tu­gal, for ex­am­ple, de­cided not to re­quest a pre­cau­tion­ary credit line from the ESM. This was partly to avoid hav­ing to com­ply with the con­di­tion­al­ity of a pre­cau­tion­ary pro­gramme. In re­turn for pref­er­en­tial fi­nanc­ing, aid pro­grammes are typ­i­cally ac­com­pa­nied by tough fis­cal and struc­tural con­di­tions. The EFSF or ESM for Ire­land and Por­tu­gal aimed to re­store fis­cal sus­tain­abil­ity, pro­mote re­forms fo­cused on restor­ing com­pet­i­tive­ness and job cre­ation, and in the cases of Ire­land and Spain, down­size, re­struc­ture and re­cap­i­talise their bank­ing sec­tors. This con­di­tion­al­ity had neg­a­tive short-term con­se­quences for em­ploy­ment and spend­ing, leading to a rise in pop­u­lar dis­trust. A pre­cau­tion­ary pro­gramme might have only ex­ac­er­bated these ten­sions.

Given the sta­bil­i­sa­tion of the three economies, we be­lieve the Ir­ish, Por­tuguese and Span­ish publics will con­tinue to show some tol­er­ance for these gov­ern­ments’ re­form agen­das, which are likely needed to place growth on a more sus­tain­able path. How­ever, as the re­cent Euro­pean Par­lia­men­tary elec­tions demon­strated, other than di­rect job cre­ation and worker train­ing, which re­main pop­u­lar, there is a risk of a loss of pub­lic sup­port for deficit-re­duc­tion and re­forms of labour and prod­uct mar­kets.

As long as mar­ket con­di­tions are be­nign, an ad­just­ment plan that is sep­a­rate from a pro­gramme might be po­lit­i­cally eas­ier to im­ple­ment. Un­em­ploy­ment in Spain, at a very high 25.3%, sug­gests that its dual labour mar­ket has still to be ad­dressed, while un­em­ploy­ment in Ire­land at 11.8% and in Por­tu­gal at 15.2% is a ma­jor source of dis­con­tent. With a grad­ual eco­nomic re­cov­ery, it will likely take years be­fore these coun­tries re­turn to full em­ploy­ment and close their out­put gaps in the pres­ence of highly in­debted pub­lic and pri­vate sec­tors.

Al­though coun­tries in dis­tress may in fact need even greater front­loaded ex­pen­di­ture cuts than they would in a pro­gramme, aus­ter­ity in re­turn for ESM loans in fact en­sures that dur­ing the life of the pro­gramme fis­cal pol­icy is pro-cycli­cal. Since tax hikes and spend­ing cuts serve as a drag eco­nomic growth, pro­grammes per­pet­u­ate busi­ness cy­cle in­sta­bil­ity.

Fi­nally, as of Jan­uary 2013, col­lec­tive ac­tion clauses or CACs are imbed­ded in the covenants of all new Eu­ro­zone sov­er­eign bond is­suances. CACs im­ply that pri­vate bond­hold­ers may be re­quired to take losses as part of fu­ture bond re­struc­tur­ings. In the fu­ture, when­ever a coun­try re­quests an ESM loan pro­gramme, pri­vate bond­hold­ers may be forced to lose value on the bonds they hold. If mar­ket con­di­tions are be­nign, this may not re­sult in a re­struc­tur­ing. How­ever, if mar­ket con­di­tions are dis­tressed, the

pres­ence of bonds with em­bed­ded CACs could lead bond­hold­ers to de­mand a higher in­ter­est rate to hold these bonds. This in turn could has­ten a coun­try’s re­quest for an ESM pro­gramme, thereby ac­cel­er­at­ing a cri­sis. on can






of lend­ing pro­grammes and the ESM’s in­sti­tu­tional lim­i­ta­tions, the pro­grammes for Ire­land, Por­tu­gal and Spain have been a suc­cess. (Of course, the Euro­pean Cen­tral Bank’s liq­uid­ity sup­port for fi­nan­cial in­sti­tu­tions has also played an im­por­tant role in sta­bil­is­ing the Eu­ro­zone.)

All three coun­tries gen­er­ally ful­filled the con­di­tions re­quired un­der their pro­grammes, and ex­ited un­der sta­ble mar­ket con­di­tions. Fi­nan­cial mar­kets have ig­nored any per­ceived stig­mas as­so­ci­ated with the pro­grammes, and bond yields have de­clined sharply.

De­spite charg­ing higher con­ces­sional rates than the yields on ESM or EFSF bonds, the ESM and EFSF pro­grammes rep­re­sented a show of trust by the Eu­ro­zone. The panic sell­ing of 2012 sub­sided and fi­nanc­ing was se­cured, al­low­ing these coun­tries time to rebuild their bal­ance sheets, re­duce their budget deficits, slow debt ac­cu­mu­la­tion, and pass struc­tural re­forms. In a vir­tu­ous cir­cle, this suc­cess has helped to re­as­sure fi­nan­cial mar­kets that the Eu­ro­zone is func­tion­ing, and mar­ket in­ter­est rates sub­se­quently de­clined. The cre­ation of the ESM has in fact cre­ated a stronger Eu­ro­zone, and it is safe to as­sume that if mem­ber coun­tries need fur­ther sup­port they will likely re­ceive it. The suc­cess of the pro­grammes for Ire­land, Por­tu­gal and Spain show that while there is lin­ger­ing un­cer­tainty over the strength of the re­cov­ery in the pres­ence of still highly in­debted pub­lic and pri­vate sec­tors, the prin­ci­pal be­hind the Eu­ro­zone is work­ing – the whole is in­deed greater than the sum of its parts.

DBRS’ recog­ni­tion of this prin­ci­pal partly ex­plains our AAA rat­ings on the ESM and the EFSF. It also partly ex­plains the sta­bil­ity of our rat­ings on Ire­land, Por­tu­gal and Spain. We did not down­grade Ire­land, Por­tu­gal or Spain when they re­quested a pro­gramme; nor did we up­grade them when they ex­ited their pro­grammes. We viewed their re­ceipt of fi­nan­cial sup­port as a sta­bil­is­ing fac­tor.

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