House of Lords - The euro area crisis - European Union Committee

The euro area crisis - European Union Committee Contents

CHAPTER 3: IMPLEMENTATION OF THE 26 october 2011 agreement

36. In the autumn of 2011 the key focus of a co-ordinated euro area response to the crisis was the European Council and euro area summit held in Brussels on 26 October. The summit statement described the agreement as a "comprehensive set of additional measures reflecting our strong determination to do whatever is required to overcome the present difficulties and take the necessary steps for the completion of our economic and monetary union."[30] The agreement included three main pillars: i) a writedown of Greek debt; ii) the recapitalisation of European banks; and iii) strengthening of the resources available through the EFSF. This chapter examines what exactly was set out in this "comprehensive" agreement; the extent to which its elements have actually been implemented; and their contribution to resolving the crisis.

i) A writedown of Greek debt

A) WHAT WAS AGREED

37. The euro area summit statement said:

"Together with an ambitious reform programme for the Greek economy, the PSI [Private Sector Involvement] should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors ... On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks. The new programme should be agreed by the end of 2011 and the exchange of bonds should be implemented at the beginning of 2012."[31]

B) IMPLEMENTATION AND ANALYSIS

38. The summit deadline was not met, and 2011 finished with no deal in sight. Despite initially positive signals that a deal with creditors was within reach, negotiations have dragged on. In late January it was stated that European finance ministers were pressing private bondholders to accept higher losses through receiving lower rates of interest for the new bonds to be issued (and therefore an effective loss of some 70 per cent, with a consequential reduction in the Greek debt), on account of the deteriorating economic environment. It was also reported that private sector creditors were calling on the ECB to receive a reduced return on its holdings of Greek bonds.[32] As this report was finalised on 7 February, agreement had not been reached on the writing down of Greek debt; nor on further Greek austerity and structural reform measures; nor on the finalisation of the €130 billion rescue package for Greece.

ii) Bank recapitalisation

A) WHAT WAS AGREED

39. Professor Buiter stated that many European banks were undercapitalised even before the crisis and that, in much of continental Europe, losses both before and in relation to the crisis "were simply buried in the books of the bank ... in the hope that a bit of growth and a steep yield curve would allow them to recapitalise themselves out of the flow of profits over a decade or so ... That hope was ambushed by the global slowdown and the sovereign debt crisis." He warned of "tail risks that ... could take down the European banking system and much of the world's banking system with it".[33]

40. The run-up to the October summit was punctuated by a disagreement between France and Germany about how best to recapitalise European banks. France favoured the use of the EFSF to recapitalise institutions, including its own banks. Germany disagreed because this would increase the burden on euro area taxpayers (and on German taxpayers more than any others).

41. The 26 October agreement by the European Council indicated that Germany had won this policy argument, stating that private sources of capital should be the first port of call for additional capital. The section on "Capitalisation of banks" stated that:

"There is broad agreement on requiring a significantly higher capital ratio of 9% of the highest quality capital ... to create a temporary buffer, which is justified by the exceptional circumstances. This quantitative capital target will have to be attained by 30 June 2012 ... National supervisory authorities, under the auspices of the EBA, must ensure that banks' plans to strengthen capital do not lead to excessive deleveraging, including maintaining the credit flow to the real economy ... Banks should first use private sources of capital, including through restructuring and conversion to equity instruments ... If necessary, national governments should provide support, and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries."[34]

42. The EBA calculated that, on the basis of the data then available, European banks would require a recapitalisation amounting in total to €106 billion.[35] On 8 December, the EBA revised its estimate of the capital shortfall amongst European banks to nearly €115 billion.[36]

B) IMPLEMENTATION AND ANALYSIS

43. There was widespread scepticism as to whether the agreement reached in Brussels was sufficient. In a November 2011 article for the Financial Times, Professor Buiter asserted that bank recapitalisation worth €106 billion was likely to provide between a third and a quarter of what was ultimately required to bring about a fully functional EU banking system.[37] And in spite of the words of the Council statement, there was concern that the agreement would lead banks to reduce their proportion of debt by deleveraging rather than boosting their capital, with deleterious consequences for the availability of credit and therefore for the economic health not only of the euro area but of the entire EU. Edward Carr, Foreign Editor of The Economist, was particularly critical of the length of time—9 months—that banks had been given under the October agreement, arguing that this gave the banks the opportunity to reduce their capital requirement by cutting back on their lending rather than boosting their capital.[38] Since the October summit, the ECB and other central banks have implemented major operations to provide liquidity support to the European and global financial systems. These operations are considered in chapter 4.

44. We are concerned about the extent of uncertainty that remains in the crucial area of bank recapitalisation. The 26 October agreement provided few details on exactly how recapitalisation will be achieved, and though the agreement was right to warn banks not to seek to reduce debt ratios by deleveraging, it is not clear whether and how they can be prevented from doing so—indeed, the long time period offered seems to facilitate rather than guard against this. A sustained restriction of credit, particularly in the current economic climate, would be highly damaging.

iii) Rescue funds

BOX 1

The European rescue funds

This report refers to three European rescue funds. The European Financial Stability Facility (EFSF) was created following the May 2010 European Council to provide financial assistance to euro area Member States in financial difficulties. The EFSF, along with the smaller European Financial Stability Mechanism (EFSM), are temporary solutions pending the establishment of the permanent European Stability Mechanism (ESM). The creation of the ESM was agreed at an October 2010 European Council. Before it can come into force the ESM requires an amendment to the Treaty on the Functioning of the European Union, and a separate treaty between euro area countries. It was initially envisaged that the ESM would come into force in 2013, but this has now been brought forward to July 2012.

A) WHAT WAS AGREED

45. The 26 October summit statement outlined agreement on "two basic options to leverage the resources of the EFSF:

providing credit enhancement to new debt issued by Member States, thus reducing the funding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market;
maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets."[39]

46. It was proposed that the EFSF would have the flexibility to use these two options simultaneously, depending on the specific objective and market conditions, and that "the leverage effect of each option will vary ... but could be up to four or five" times the €250 billion remaining in the pot.[40] The Statement called on the Eurogroup[41] to finalise terms and conditions in November. It also stated that further enhancement of the EFSF resources could be achieved through co-operation with the IMF.[42]

B) IMPLEMENTATION AND ANALYSIS

47. None of the three pillars of the Brussels agreement of 26 October is particularly secure, but the agreement on the EFSF was arguably the weakest. The impression was given that European leaders were reliant on other countries, and in particular China, to invest in the EFSF if its leveraging proposals were to be successful, an impression strengthened by the visit of the EFSF Chief Executive Klaus Regling to Beijing to make the case for investment. Yet China's attitude has been cautious. And though it was agreed that the EFSF would protect only a proportion (20-30 per cent) of new sovereign bonds, Eurogroup President Jean-Claude Juncker conceded that the EFSF was unlikely to meet the €1 trillion leveraging target.[43] The shortfall prompted Mr Juncker to state that euro area ministers and officials were seeking to "rapidly explore an increase of the resources of the IMF so it can more adequately match the firepower of the EFSF."[44]

48. The 9 December Statement by the Euro Area Heads of State or Government acknowledged that there was a need for "immediate action to forcefully address current market tensions." The agreed steps included rapid deployment of the leveraged EFSF; keeping the EFSF active until mid-2013, while at the same time bringing forward the coming into force of the ESM to July 2012; the removal of the requirement under the provisions of the ESM that private creditors would be forced to share the losses in future debt restructurings; and a reassessment of the overall ceiling of the EFSF/ESM of €500 billion to take place in March 2012. (At the end of January it was rumoured that European leaders were starting to consider the combining of the EFSF and the ESM (rather than the replacement of the EFSF by the ESM).) Finally, euro area and other Member States were to consider, and confirm within 10 days, the provision of additional resources for the IMF of up to €200 billion, in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. The statement also noted that euro area leaders were "looking forward to parallel contributions from the international community."[45]

49. The additional funding to the IMF was not confirmed within 10 days, in part because of the reluctance of the United Kingdom, and other countries outside the euro, to contribute. Indeed, in late January it had still not been agreed. European Commissioner Olli Rehn told the World Economic Forum in Davos in January that "we also need support from our American and British friends in the sense that we need to increase the resources of the IMF."[46] The view of the United Kingdom government on the provision of additional funding to the IMF was set out by the Minister for Europe in his evidence to us on 17 January. He explained that the Government is "ready to increase IMF resources, alongside other countries around the world, so that the IMF can play its systemic role in supporting its global membership, but we have always been clear, and this remains our position, that we will not participate in an increase in IMF resources that only comes from EU countries without the participation of other members of the G20."[47] On 19 January, the IMF launched an appeal for $500 billion in new lending capacity (including what was pledged by the euro area Member States in December), to help it cope with the effects of the EU debt crisis.

50. Given the cost to the global economy of the prolonged recession which could follow sovereign defaults and further bank collapses, and therefore the cost to all countries of a failure to ease the euro area crisis, there remains an urgent need to establish a credible and well-financed system of rescue funding. Primary responsibility lies with the euro area countries. However, given the global implications it is necessary for the international community, including the UK, to contribute through the IMF. We welcome the Government's willingness to contemplate this.

iv) Assessment of the 26 October agreement

51. In November 2011, the Minister for Europe described the 26 October summit agreement as "welcome progress ... But it is also fair to say that on all three of those counts there was quite a bit of detail that remained to be filled in at the conclusion of those meetings."[48] The weakness of each of the three pillars has been revealed in the months since the summit took place.

52. Two particular weaknesses have manifested themselves. First, the summit agreement was short on detail. This provoked scepticism as to whether the proposed measures would be rigorous enough to tackle the crisis. Second, the crisis escalated at an alarming rate after the summits took place (including Prime Minister Papandreou's quickly-abandoned call for a referendum; the fall of his government and the appointment of a new government under Mr Papademos; spikes in bond yields; the resignation of Italian Prime Minister Mr Berlusconi and the appointment of a government under Mr Monti).

53. It is imperative that rapid progress is now made in putting flesh on the bones, and drawing to a conclusion the outline agreements reached in October 2011 on Greek debt write-down; bank recapitalisation; and the financing of the European rescue funds. Even this package, though necessary, is likely on its own to prove insufficient. The following chapter examines other key policy responses currently under consideration.

30 Euro Summit Statement, 26 October 2011, para 2. Back

31 Euro Summit Statement, 26 October 2011, para 12. Back

32 "Lagarde presses ECB over Greek debt deal", Financial Times, 24 January 2012. Back

33 QQ 30, 34 (Sub-Committee). Back

34 Statement of EU Heads of State or Government, 26 October 2011, Annex, paras 4-5. Back

35 http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx. Back

36 http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf. Back

37 ''Eurozone bail-out needs a much bigger bazooka'', Willem Buiter, Financial Times, 1 November 2011. Back

38 Q 25 (Select). Back

39 Euro Summit Statement, 26 October 2011, para 19. Back

40 Euro Summit Statement, 26 October 2011, para 20. Back

41 The Eurogroup is a body composed of the finance ministers of the Member States of the euro area. Back