- According to unconfirmed reports in the Italian press, the IMF is preparing a major loan for Italy in the event that Italy’s access to funding freezes. The IMF has this morning denied that it has any current discussion with Italy about an IMF aid package. Nonetheless, IMF-aid remains an option for Italy and possibly Spain.
- The advantage of involving the IMF is that it will make it possible to circumvent some of the institutional weaknesses in the current eurozone set up. An IMF agreement would commit Italy’s fiscal policy to an international agreement. In addition, while the ECB is not allowed to lend directly to sovereign states, it is allowed to lend directly to the IMF.
- However, the IMF’s resources are currently not sufficient for a major aid package to Italy and/or Spain – the IMF’s resources would have to be boosted. One possibility would be to increase SDR holdings in the IMF system. However, this would have to be improved by the US congress and could turn out to be a major uncertainty. Alternatively IMF resources could be boosted by bilateral contributions from major emerging markets, such as China. It appears major emerging markets prefer channelling aid through the IMF to purchasing EFSF bonds or euro bonds.
- At this stage an IMF solution only appears to be likely in a worst-case scenario. Particularly, the US fears that major IMF involvement would let Europe off the hook.
IMF could circumvent institutional weakness in the eurozone
At the weekend La Stampa reported that the IMF is preparing a EUR400-600bn loan for Italy in the event that the debt burden worsens. However, the report has not been confirmed and this morning the IMF has said that it is not currently involved in any discussions with Italy. Nonetheless, IMF aid remains an option for Italy and possibly Spain and below we outline the pros and cons for IMF involvement.
One of the most important arguments for an IMF solution is that it is a way to circumvent some of the institutional weaknesses in the eurozone arrangements. Particularly, there is at the moment no formal way to commit to fiscal discipline within the eurozone, although both Germany and France are now pushing for faster fiscal integration and eventually a fiscal union. This process would take time and probably require treaty changes and the ratification process would also remain a major uncertainty for financial markets. Hence, fiscal integration is unlikely to be a solution in the short run. The advantage of involving the IMF is that its lending is conditional and the IMF already has the resources and experience in monitoring fiscal policy. This is precisely the reason why the IMF has been involved in bailing out Greece, Ireland and Portugal. The problem with Italy and Spain is that they have so far not committed to fiscal consolidation in an international agreement.
Although Italy and Spain have unilaterally committed to improving public finances, there is at the moment no mechanism that ensures that promises are actually implemented and that the ECB’s bond purchases in the secondary market are eventually rewarded with fiscal consolidation and economic reforms in Italy and Spain.
In addition, the IMF could be used to circumvent some of the current restrictions on the ECB’s lending. While the ECB’s founding treaty does not allow for direct lending to sovereign states, it does allow for direct lending to the IMF, or possibly to a trust fund within the IMF. Hence, one possible construction could be to allow the ECB to lend money to the IMF and allow the IMF to lend this money to Italy and/or Spain, for example.
IMF resources would have to be boosted
If the IMF has to be involved there are currently two IMF credit facilities available for aiding Italy: A traditional stand-by agreement and the new precautionary and liquidity line (PLL).
The size of the stand-by agreement loan is decided on a case-by-case basis and in principle there is no upper limit on the size of the loan. The disbursement of the loan is made in tranches and is dependent on fulfilment of the conditions in the loan agreement.
The size of the PLL facility depends on the country’s IMF quota (which also decides a country’s voting share within the IMF). For Italy we estimate that it would be able to borrow EUR50-100bn through the PLL (500-1,000% of quota). This is far from the EUR400-600bn mentioned on Sunday in La Stampa. There is less conditionality and more flexibility in the PLL facility as it works as a drawing right that the country in question can draw on as it wishes.
Lending EUR400-600bn to Italy would be a huge amount for the IMF. Currently the IMF’s free resources are estimated at about USD390bn. Hence, if Italy and possibly Spain have to be bailed out by the IMF, the IMF would certainly require additional resources. One simple solution would be to create additional SDRs within the IMF system, as was done in early-2009 in the wake of the global financial crisis. Basically increasing SDRs would amount to all central banks extending credit/drawing rights to the IMF, according to their IMF quotas. In the US an SDR increase would have to be approved by US Congress. The US Congress had earlier been reluctant to approve SDR increases, so this could be a major uncertainty.
Alternatively, the IMF could boost its resources by bilateral loans – as has happened in recent years in respect of China and Japan – making major bilateral contributions. There is no doubt that major emerging markets, including China, would prefer channelling contributing aid through the IMF to direct bilateral aid to countries such as Italy and Spain, or purchasing bonds issued by the EFSF.
IMF appears to be only worst case solution
At this stage we do not believe that at major IMF package is on the cards. First the US appears to be reluctant to involve the IMF in a bailout, because it could to some extent be regarded as letting Europe off the hook. In addition, a major aid-package, possibly for Italy and/or Spain, would require additional funding by the IMF. However, in a worstcase scenario – in which eurozone initiatives prove insufficient to stabilise European bond markets and with significant negative spill over to the rest of the global economy – a major IMF package could prove to be part of a solution.