It increasingly looks like the IMF will attempt to construct a third line of defence against the European debt crisis. As a standalone defence mechanism EFSF is no longer credible as financial markets have moved on and increasingly questions Italy’s and Spain’s ability to cover their finance requirement in the market. The second line of defence of course is the ECB’s bond purchases and possible a more proactive ECB if the eurozone countries commit to fiscal discipline. In our view, a third line of defence would now be constructed by the IMF sending a clearer signal to the market that in a worst case scenario it would be able to cover the finance requirement of Italy and Spain.
However, for such a commitment from the IMF to be credible the resources of the IMF would have to be boosted. Currently the IMF’s free resources are USD390bn (EUR290bn) – far from enough to cover the finance requirement of Italy and Spain. Hence, there is now considerable focus on boosting the IMF’s resources and it looks increasingly likely that there could be a major announcement on boosting IMF resources in the wake of the heads of state EU summit starting on 9 December. There could also even be some specific commitments of IMF resources to support the firepower of the EFSF.
At the moment it is much easier to increase the resources of the IMF compared with increasing the resources of the EFSF. With the current set up the ECB is not allowed to lend directly to EFSF and any increase in EFSF resources would have to be covered by guarantees from the individual eurozone countries, possible weighing on their rating. However, the ECB (through the national central banks) are allowed to lend directly to the IMF and if these funds are channelled back as loans from the IMF into the eurozone it opens a way to circumvent some of the restrictions in the current institutional euro zone set up. Second, the major emerging markets such as: China, India, Russia and Brazil have all clearly indicated that they prefer to channel any aid trough the IMF to alternatively provide direct bilateral assistance to the euro area. Just convincing these major emerging markets to buy bonds issued by the EFSF appears to be difficult. Convincing them to contribute to boosting the fire-power of EFSF – by investing in special purpose vehicles created by the EFSF – appears to be close to impossible.
The coordinated intervention in the US dollar swap market by the major central banks in the past week suggests that the European debt crisis has reached a critical stage where countries outside Europe are increasingly prepared to get involved in stemming the European debt crisis. The eurozone countries also appear to be ready for more IMF involvement. In connection with the euro group meeting on 27 November it was decided to “rapidly explore an increase of the resources of the IMF through bilateral loans”. While it has been not been clearly defined what is meant by “bilateral loans” press reports suggests it will include loans from national eurozone central banks to the IMF.
Germany has so far been fiercely against extending loans to the IMF, including a general increase in the Special Drawing Rights (SDR) within the IMF system. An increase in SDRs would one option for boosting global liquidity and IMF resources. A major SDR allocation was last made in early-2009 in the wake of the escalation of the global financial crisis. A general SDR allocation would effectively work, as an increase in global FX reserves for all central banks extending a credit line to the IMF, in exchange for increased access to draw on their credit facility at the IMF. Comments from German Finance Minister Schauble on 30 November suggest that Germany has softened its stance on extending loans to the IMF and a possible new SDR allocation. Specifically Schauble said: “we are prepared to increase the resources of the IMF through bilateral loans” and he added that “if the IMF wants to widen its freedom to take action by increasing the special drawing rights, then we are prepared to talk about it”.
In addition, the IMF managing director Lagarde is working hard to get commitments for additional IMF resources. Brazil, on 1 December, made a strong commitment to providing additional resources to the IMF and China and Russia have also signalled that they are willing to provide resources.
How the European debt crisis “solution” is eventually designed could be very important for how the impact would be on the FX market and financial markets in general.
An important final note about SDR allocations is that the decision on SDR allocations is mainly a political decision, although it of course has huge implications for monetary policy. That it is a political decision is most pronounced in the US where and SDR allocation would have to be approved by the Congress (this could be a major uncertainty). Basically SDR allocations could be regarded as a way to force central banks to expand monetary policy. This implicit loss of monetary independence in SDR allocations has been one of the main reasons for the ECB’s and Germany’s resistance to SDR allocations.
However, for such a commitment from the IMF to be credible the resources of the IMF would have to be boosted. Currently the IMF’s free resources are USD390bn (EUR290bn) – far from enough to cover the finance requirement of Italy and Spain. Hence, there is now considerable focus on boosting the IMF’s resources and it looks increasingly likely that there could be a major announcement on boosting IMF resources in the wake of the heads of state EU summit starting on 9 December. There could also even be some specific commitments of IMF resources to support the firepower of the EFSF.
At the moment it is much easier to increase the resources of the IMF compared with increasing the resources of the EFSF. With the current set up the ECB is not allowed to lend directly to EFSF and any increase in EFSF resources would have to be covered by guarantees from the individual eurozone countries, possible weighing on their rating. However, the ECB (through the national central banks) are allowed to lend directly to the IMF and if these funds are channelled back as loans from the IMF into the eurozone it opens a way to circumvent some of the restrictions in the current institutional euro zone set up. Second, the major emerging markets such as: China, India, Russia and Brazil have all clearly indicated that they prefer to channel any aid trough the IMF to alternatively provide direct bilateral assistance to the euro area. Just convincing these major emerging markets to buy bonds issued by the EFSF appears to be difficult. Convincing them to contribute to boosting the fire-power of EFSF – by investing in special purpose vehicles created by the EFSF – appears to be close to impossible.
The coordinated intervention in the US dollar swap market by the major central banks in the past week suggests that the European debt crisis has reached a critical stage where countries outside Europe are increasingly prepared to get involved in stemming the European debt crisis. The eurozone countries also appear to be ready for more IMF involvement. In connection with the euro group meeting on 27 November it was decided to “rapidly explore an increase of the resources of the IMF through bilateral loans”. While it has been not been clearly defined what is meant by “bilateral loans” press reports suggests it will include loans from national eurozone central banks to the IMF.
Germany has so far been fiercely against extending loans to the IMF, including a general increase in the Special Drawing Rights (SDR) within the IMF system. An increase in SDRs would one option for boosting global liquidity and IMF resources. A major SDR allocation was last made in early-2009 in the wake of the escalation of the global financial crisis. A general SDR allocation would effectively work, as an increase in global FX reserves for all central banks extending a credit line to the IMF, in exchange for increased access to draw on their credit facility at the IMF. Comments from German Finance Minister Schauble on 30 November suggest that Germany has softened its stance on extending loans to the IMF and a possible new SDR allocation. Specifically Schauble said: “we are prepared to increase the resources of the IMF through bilateral loans” and he added that “if the IMF wants to widen its freedom to take action by increasing the special drawing rights, then we are prepared to talk about it”.
In addition, the IMF managing director Lagarde is working hard to get commitments for additional IMF resources. Brazil, on 1 December, made a strong commitment to providing additional resources to the IMF and China and Russia have also signalled that they are willing to provide resources.
How the European debt crisis “solution” is eventually designed could be very important for how the impact would be on the FX market and financial markets in general.
- If it is left solely to the ECB’s bond purchases the ECB’s balance sheet would be expanded. Although the ECB says it will sterilise the liquidity impact from its bond purchases, it would be viewed effectively as QE by the ECB.
- If the solution turns out to be primarily IMF aid-funded, solely by a new SDR allocation it would effectively work as global QE (all central banks expand their balance sheets) with central banks through the IMF indirectly purchasing eurozone government bonds.
- If the solution turns out to be primarily IMF aid-funded solely by bilateral loans from some of the major emerging markets (no SDR increase), then it would have no impact on central banks balance sheets. The loans to the IMF will in this case would likely be provided from the major emerging markets FX reserves. If we assume that the FX reserves are mostly invested in US dollar assets, this solution would effectively work as a reallocation of global FX reserves from US dollars to euros.
An important final note about SDR allocations is that the decision on SDR allocations is mainly a political decision, although it of course has huge implications for monetary policy. That it is a political decision is most pronounced in the US where and SDR allocation would have to be approved by the Congress (this could be a major uncertainty). Basically SDR allocations could be regarded as a way to force central banks to expand monetary policy. This implicit loss of monetary independence in SDR allocations has been one of the main reasons for the ECB’s and Germany’s resistance to SDR allocations.