Bailout programmes strengthen Eurozone

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

EUROZONE PROGRAMMES A SUCCESS

Despite

the

negative

connotations

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.