Requiem for a euro zone bailout

BRUSSELS, Belgium – Barely a month ago, Europe’s leaders heralded a bailout fund known as the European Financial Stability Facility as an insurmountable bulwark against the widespread sovereign default that threatens their currency. At a planned 1 trillion euros — about twice the size of America’s Toxic Asset Relief Program, or TARP — the fund seemed impressively large.

But it was apparently not large enough, or not well-enough conceived for the investors who hold the fate of Europe in their trading decisions. In early November just days after its latest iteration, Italy’s bond prices came under renewed attack.

Now, as leaders meet over the next two days for yet another critical summit, to forge yet another fool proof plan to save the euro, the EFSF appears increasingly irrelevant.

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The EFSF suffered another blow on Tuesday when the ratings agency Standard & Poor’s placed it on CreditWatch, meaning its AAA rating was in jeopardy, alongside that of Germany, France and the other euro-zone nations backing it.

The EFSF has had a tumultuous history. It was created in May 2010 to provide loans for countries in difficulties. It was hoped that its very existence would act as a preventive palliative, calming markets so that no bailouts would ever be needed: The 17 euro zone member states initially agreed to guarantee up to 440 billion euros in lending capacity, which would be raised on the open debt markets.

In early 2011, however, it was activated to support Ireland and Portugal to the tune of almost 44 billion euros.

Not everybody was pleased. Slovak politicians, unhappy that their country had to cough up funds for the richer Irish and Portuguese, brought down their government over participation in the fund, but eventually gave it the green light.

Some have suggested that the EFSF could actually be counterproductive to the countries it was set up to help, by competing with their bond issues when it went to the markets to raise funds.

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As the crisis spread to major euro zone economies Spain and Italy over the summer, it became clear the EFSF was simply not big enough to provide a safety net.

In October, an emergency EU summit therefore announced it was transforming the facility into what British Prime Minister David Cameron called “a big bazooka” capable of leveraging 1 trillion euro.

“These decisions are a major step forward to install a firewall that will prevent the crisis spreading to other members of the euro zone and beyond,” French President Nicolas Sarkozy said at the time. “I think the whole world will greet them with relief.”

Sarkozy said he’d be speaking to the Chinese and other emerging powers to secure contribution to the beefed up EFSF. At a rain-soaked G20 meeting on the French Riviera however, China, Brazil and the other new powers showed little interest. By Nov. 29, EU finance ministers meeting in Brussels acknowledged that the EFSF looked like falling well short of that magic 1 trillion euro target.

“A lot of countries have difficulties raising the resources, so we are looking at private resources, private leverage, but it is still very difficult to reach somewhere in the region of 1 trillion euros,” said Dutch Finance Minister Jan Kees de Jager. “Maybe we can reach half of that.”

The finance ministers did agree on options to enlarge the EFSF’s firepower by allowing it to provide insurance for up to 30 percent of new bond issues and to link up with private investors in co-investment funds to buy government bonds

However, with markets forcing Italy to pay record interest rates on its borrowing – close to 8 percent on its 10 year bonds last week – the search was on for alternatives to the EFSF. “This is a last attempt to put new life in the leveraging story,” Casten Brzeski, senior economist at the Dutch banking group ING, said of the Nov. 29 ministers’ meeting. “It’s a waste of energy, we all know it’s not going to fly … all eyes are on the European Central Bank.”

Increasingly economists have been arguing that intervention by the European Central Bank to act as a lender of last resort to nations in trouble is a key step to keep the euro alive rather than clinging to the EFSF. However, Germany has resisted, fearing an enhanced ECB role could trigger inflation. Germany also ruled out euro bonds that would mutualize debt across the euro zone.

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There are hopes, that Germany could relax its view on ECB intervention, if EU leaders back the plan Merkel agreed Monday with Sarkozy calling for tough new obligations for euro zone nations to adhere to fiscal discipline to enshrined in a revised EU treaty and national constitutions. ECB Governor Mario Draghi has already suggested that a “fiscal compact” among the nations could persuade his institution to take a more aggressive role in the bond markets.

Economists are urging Draghi to take such a role. “The ECB should be lender of last resort. Full stop. As for German arguments about inflation, at this point, there is just no danger of that,” said Jacques Pelkmans, professor of European economics at the College of Europe in Bruges, Belgium.

There is an emerging consensus ahead of this week’s crucial European Union summit on the need to get the International Monetary Fund to play a bigger role – notably by channeling funds supplied by European central banks.

The Paris deal also included a call for the launch of a new 500 billion euro European Stability Mechanism — designed as a permanent safety net for euro zone countries under bond market pressure — to be brought forward a year to mid-2011. “This is a further commitment and that’s good, it shows the market’s the right sort of attitude,” said Pelkmans.

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The ESM will have its own permanent reserves and more flexibility to act than the EFSF, however limitations may yet survive. Latest reports ahead of this week’s EU summit suggest leaders may want to keep both bailout funds running alongside each other to combine their lending capacities.