Through the fog of details surrounding the latest plan to deploy European Financial Stability Facility funds, there is one simple truth: Now, more than ever, the EFSF needs to hold onto its triple-A credit rating.http://feeds.wsjonline.com/~r/wsj/marketbeat/feed/~3/cJXnvxBgDJw/
The problem is there’s no guarantee that will happen.
Without that top-notch rating for the EFSF, the power of the bailout fund’s support to hold down runaway bond yields on, say, Spanish or Italian bonds is severely depleted. And for the EFSF to maintain its rating, it needs its two biggest contributors–France and Germany–to hold onto their top-notch ratings as well. In the case of France that’s a big risk.
Sound confusing and circular? Well that’s because a new plan revealed by European Union sources is both. Here’s how it works:
The proposal being kicked around by European officials essentially calls for the EFSF, the region’s bailout fund, to issue bonds to individual, heavily indebted countries such as Spain and Italy. Those countries would then post the EFSF bonds as collateral covering what is likely to be a portion of the face value of any new bonds they issue to roll over existing debt. In this way it should help enhance the sovereign bonds’ appeal to private investors.
In theory, this would meet the bailout program’s goal of lowering borrowing costs for heavily indebted countries. And since Italy and Spain, the third and fourth largest economies in the euro zone, are the main source of anxiety about the risk of a euro-zone-wide financial contagion stemming from a widely expected default on Greek debt, this in turn could calm nerves and allow the two countries to focus on strengthening their economies.
In recent months, waning confidence among bond investors has forced both Spain and Italy to implement austerity measures at the expense of near-term economic growth, all so as to shore up their books and avert more ratings downgrades. Investors have demanded higher returns because they perceive Italian or Spanish debt as riskier than, say, German bonds.
The EFSF collateral would, theoretically, provide those same nervous investors with a reassurance that they will be “insured” if Italy or Spain cannot fully repay any future bonds. However, the reassurance is seriously diminished if the collateral itself starts to decline in quality–especially if it is only worth, say, 20% of the sovereign bond’s face value. The EFSF will thus need to keep its triple-A rating and maintain it as long as EFSF bonds are being held as collateral for them to be an effective tool for attracting investors to the new sovereign bonds.
Investors need to know that if Italy or Spain falter, they have something solid to fall back on. But if they don’t believe the EFSF can maintain its triple-A rating, they will be unlikely to accept a lower yield for those countries’ bonds.
Herein lies the problem: the EFSF’s triple-A rating hinges entirely on Germany and France, the two biggest backers of the euro-zone bailout facility, being able to maintain theirs. If either were to be downgraded, all bets would be off.
And on that score, Germany’s rating doesn’t appear to be in any grave danger. But France’s is another story.
On Monday, Moody’s Investors Service started making noises that France’s rating could be in danger in the future due to a deteriorating credit profile and potential losses in the country’s banking sector. The agency called France’s credit profile the weakest among its triple-A peers and said the government has less room to maneuver because of its stretched balance sheet, banking sector risks and projected slow growth.
This puts a lot of pressure on France, whose president Nicolas Sarkozy is among the leaders trying to hammer out a plan by this Sunday to deploy the EFSF funds. While he does so, he must also make sure his own country is implementing austerity measures and cleaning up its own fiscal balance, lest it weaken the whole EFSF edifice–all while he faces a presidential election next year.
France’s banking problems are based largely on its banks’ holding risky sovereign debt from other European countries–and mostly from Greece, whose fate as a debtor will also be considered at a critical meeting of European Union finance ministers this weekend. The larger the “haircut” that banks are ultimately forced to take from Greece, the quicker that country can get out from its spiral of economic austerity, falling confidence, and rising borrowing costs, but the bigger the risk to French banks.
Perhaps this is why EU bank regulators also flagged the idea Wednesday that the EFSF might guarantee bank debts, perhaps with a similar collateral scheme. In short, the plan is shaping up as a highly delicate and complicated balancing act, with many moving parts and ongoing risks. Keep your seatbelt on.