It looks as though the IMF will attempt to create a third line of defence against the European debt crisis by increasing its involvement and sending a clear signal that in a worst case scenario the IMF will be able to help cover the finance requirement of Italy and Spain. However, for this commitment to be credible the IMF will need to boost its resources substantially.
The IMF solution could be attractive because it can be used to circumvent some of the institutional weakness in the current eurozone set up. In addition, the major emerging markets appear to prefer channelling aid through the IMF compared to bilateral loans and/or investment in EFSF bonds or EFSF planned special purpose vehicles.
We expect a major boost in the IMF’s resources to be announced soon. Most likely resources will be boosted by bilateral loans from the national eurozone central banks and loans from the major emerging markets. A new SDR allocation in the IMF-system would be a strong response, but we think is less likely in the short run.
The US could prove the main impediment to boosting IMF resources because of resistance in Congress and concern that discussions about IMF funding could be intertwined with discussions about voting power and reform within the IMF-system.
IMF will need to boost resources to be a credible defence
It increasingly looks like the IMF will attempt to build a third line of defence against the European debt crisis. The first line of defence is EFSF, but as a stand-alone 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 is ECB bond purchases (SMP) and possibly a more proactive ECB if the eurozone countries commit to fiscal discipline. In our view, a third line of defence could be built by the IMF sending a clear signal that in a worst case scenario it will help to cover the finance requirement of Italy and Spain.
However, for such a commitment from the IMF to be credible the resources of IMF would have be boosted. Currently, the IMF’s free resources are USD390bn (EUR290bn) - far from enough to cover the finance requirement of Italy and Spain. Hence, focus currently is on boosting the IM resources and it looks increasingly likely that there could be a major announcement on boosting the IMF’s resources in the wake of the heads of state EU summit starting on 9 December. There could also even be some specific commitment of IMF resources to support the fire power of the EFSF.
IMF can circumvent institutional weakness in the euro zone
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 the EFSF and any increase in EFSF resources would have to be covered by guarantees from the individual eurozone countries possibly weighing on their rating. However, the ECB (through the national central banks) is allowed to lend directly to the IMF. 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 eurozone set up. As IMF aid is typically conditioned on an IMF-programme with commitments to fiscal consolidation and external monitoring of public finances, channelling aid through the IMF could be regarded as a suitable alternative solution until possible treaty changes have readied EU institutions to perform similar functions.
Secondly, the major emerging markets like China, India, Russia and Brazil have all clearly indicated that they prefer to channel any aid through the IMF to alternatively provide direct bilateral assistance to the euro area. The main argument is that funnelling loans through the IMF would be a collectivisation of credit risk in the sense that any losses would be shared by all IMF members. In addition, loans from the IMF have preferred creditor status. At the moment just convincing major emerging markets to buy bonds issued by the EFSF appears to be difficult. Convincing them to contribute to boosting the fire power of the EFSF by investing in the special purpose vehicles planned by the EFSF appears to be close to impossible.
Coordinated international intervention moving closer
The coordinated intervention in the USD 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 increasingly are prepared to get involved. The eurozone countries also appear to be ready for greater IMF involvement. In connection with the Euro group meeting on 27 November it was decided to “rapidly explore an increase in the resources of the IMF through bilateral loans.” While it has not been been clearly defined what is meant by “bilateral loans” press reports suggest it will include loans from national eurozone central banks to the IMF. According to press reports on 2 December, one of the options being considered is a EUR200bn loan from the national eurozone central banks to the IMF. The story has so far not been confirmed or rejected by either the ECB or the IMF.
A new allocation of special drawing rights (SDR) within the IMF system would be another option to boost the IMF’s resources and global FX reserves. A new SDR allocation was last made in April 2009 in the wake of the escalation of the global financial crisis in late 2008. Basically, when a new SDR allocation is made by all central banks, they extend a credit line to the IMF in exchange for increased access for to draw on the central bank’s credit facility at the IMF. As the SDR drawing right is included in FX reserves, a new SDR allocation increases global FX reserves and liquidity. Importantly, a decision to make new SDR allocation is mainly a political decision. This is most evident in the US, where a new SDR allocation will have to be approved by the US congress. Arguably, an SDR allocation could be regarded as a way of forcing central banks to ease monetary policy. This is the reason why Germany and the ECB have been fiercely resisting a new SDR allocation. However, Germany appears to be softening its resistance to an SDR allocation. On 30 November, German Finance Minister Schauble said 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”
Interestingly, the US could prove to be the main opponent against increasing the resources of the IMF. A US Treasury official on 2 December said that at this point there was no plan to ask the US Congress for more money to shore up the IMF’s coffers. This partly reflects that the US does not want to let the Europeans off the hook. However, the US defensive position also reflects the Obama administration acknowledgement that it could prove extremely hard to get approval for additional US resources in particularly the Republican dominated House of Representatives. Finally, the US also fears that discussions about boosting IMF’s resources could become intertwined with increasing emerging market voting power within the IMF. That said, we think that possibly increasing the IMF’s role in the European debt crisis will be high on the agenda when US Treasury Secretary Geithners tours the European capitals this week for discussions about solutions to the European debt crisis.
Boost in IMF resources imminent
We expect that there will be an announcement of additional resources for the IMF in the coming weeks. Most likely it will be based on bilateral loans from the eurozone countries and the major emerging markets. The major markets like China, Russia and Brazil have all indicated that they are willing to contribute with new resources for the IMF. We think the boost in IMF resources could be EUR200bn – EUR400bn. At this stage, a new SDR allocation looks less likely primarily because of US reluctance. However, should the financial crisis escalate further, this is a forceful instrument that could eventually be used.
At this stage, focus will primarily be on boosting IMF resources and at this stage we do not expect an announcement of a specific aid-package for Italy or Spain. For a discussion of the different IMF aid options available for Italy and Spain IMF loans to EFSF will, in our view, be difficult within the current IMF charter that only allows loans to sovereign states.
Design of funding important for impact on financial markets
How a European debt crisis “solution” is designed and funded could have important implications for financial markets not least the FX market.
If the aid is funded solely by bilateral loans from the eurozone central banks to the IMF it will be effectively work as bilateral loans from the ECB to the eurozone countries that receive IMF-loans. This could effectively be regarded as quantitative easing (QE) as there is no direct sterilization requirement (compared to the other solutions this is the most negative for EUR).
If it is solely left to the ECB’s bond purchases, the ECB’s balance sheet will be expanded. Although the ECB will sterilize the liquidity impact from its bond purchases, it is arguably close to QE because the maturity of the ECB bond purchases is substantially higher than the maturities of the liabilities the ECB creates to sterilize the liquidity impact.
If the solution is aid funded solely by a new SDR allocation, it will effectively work as QE on a global scale (all central banks expand their balance sheets) with central banks indirectly purchasing eurozone government bonds through the IMF.
If the solution turns out to be IMF-aid funded solely by bilateral loans from the major emerging markets (no SDR increase), then it will most likely have no major impact on central bank balance sheets. The loans to the IMF will most likely be provided from major emerging markets FX reserves. If we assume the FX reserves are mostly invested in US dollar assets, this solution would effectively work as a reallocation of global FX reserves from US-dollar to euros (compared to the other solutions this is the most positive for EUR).
Of course the solution will probably turn out to be a combination of the four solutions described above.
The IMF solution could be attractive because it can be used to circumvent some of the institutional weakness in the current eurozone set up. In addition, the major emerging markets appear to prefer channelling aid through the IMF compared to bilateral loans and/or investment in EFSF bonds or EFSF planned special purpose vehicles.
We expect a major boost in the IMF’s resources to be announced soon. Most likely resources will be boosted by bilateral loans from the national eurozone central banks and loans from the major emerging markets. A new SDR allocation in the IMF-system would be a strong response, but we think is less likely in the short run.
The US could prove the main impediment to boosting IMF resources because of resistance in Congress and concern that discussions about IMF funding could be intertwined with discussions about voting power and reform within the IMF-system.
IMF will need to boost resources to be a credible defence
It increasingly looks like the IMF will attempt to build a third line of defence against the European debt crisis. The first line of defence is EFSF, but as a stand-alone 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 is ECB bond purchases (SMP) and possibly a more proactive ECB if the eurozone countries commit to fiscal discipline. In our view, a third line of defence could be built by the IMF sending a clear signal that in a worst case scenario it will help to cover the finance requirement of Italy and Spain.
However, for such a commitment from the IMF to be credible the resources of IMF would have be boosted. Currently, the IMF’s free resources are USD390bn (EUR290bn) - far from enough to cover the finance requirement of Italy and Spain. Hence, focus currently is on boosting the IM resources and it looks increasingly likely that there could be a major announcement on boosting the IMF’s resources in the wake of the heads of state EU summit starting on 9 December. There could also even be some specific commitment of IMF resources to support the fire power of the EFSF.
IMF can circumvent institutional weakness in the euro zone
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 the EFSF and any increase in EFSF resources would have to be covered by guarantees from the individual eurozone countries possibly weighing on their rating. However, the ECB (through the national central banks) is allowed to lend directly to the IMF. 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 eurozone set up. As IMF aid is typically conditioned on an IMF-programme with commitments to fiscal consolidation and external monitoring of public finances, channelling aid through the IMF could be regarded as a suitable alternative solution until possible treaty changes have readied EU institutions to perform similar functions.
Secondly, the major emerging markets like China, India, Russia and Brazil have all clearly indicated that they prefer to channel any aid through the IMF to alternatively provide direct bilateral assistance to the euro area. The main argument is that funnelling loans through the IMF would be a collectivisation of credit risk in the sense that any losses would be shared by all IMF members. In addition, loans from the IMF have preferred creditor status. At the moment just convincing major emerging markets to buy bonds issued by the EFSF appears to be difficult. Convincing them to contribute to boosting the fire power of the EFSF by investing in the special purpose vehicles planned by the EFSF appears to be close to impossible.
Coordinated international intervention moving closer
The coordinated intervention in the USD 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 increasingly are prepared to get involved. The eurozone countries also appear to be ready for greater IMF involvement. In connection with the Euro group meeting on 27 November it was decided to “rapidly explore an increase in the resources of the IMF through bilateral loans.” While it has not been been clearly defined what is meant by “bilateral loans” press reports suggest it will include loans from national eurozone central banks to the IMF. According to press reports on 2 December, one of the options being considered is a EUR200bn loan from the national eurozone central banks to the IMF. The story has so far not been confirmed or rejected by either the ECB or the IMF.
A new allocation of special drawing rights (SDR) within the IMF system would be another option to boost the IMF’s resources and global FX reserves. A new SDR allocation was last made in April 2009 in the wake of the escalation of the global financial crisis in late 2008. Basically, when a new SDR allocation is made by all central banks, they extend a credit line to the IMF in exchange for increased access for to draw on the central bank’s credit facility at the IMF. As the SDR drawing right is included in FX reserves, a new SDR allocation increases global FX reserves and liquidity. Importantly, a decision to make new SDR allocation is mainly a political decision. This is most evident in the US, where a new SDR allocation will have to be approved by the US congress. Arguably, an SDR allocation could be regarded as a way of forcing central banks to ease monetary policy. This is the reason why Germany and the ECB have been fiercely resisting a new SDR allocation. However, Germany appears to be softening its resistance to an SDR allocation. On 30 November, German Finance Minister Schauble said 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”
Interestingly, the US could prove to be the main opponent against increasing the resources of the IMF. A US Treasury official on 2 December said that at this point there was no plan to ask the US Congress for more money to shore up the IMF’s coffers. This partly reflects that the US does not want to let the Europeans off the hook. However, the US defensive position also reflects the Obama administration acknowledgement that it could prove extremely hard to get approval for additional US resources in particularly the Republican dominated House of Representatives. Finally, the US also fears that discussions about boosting IMF’s resources could become intertwined with increasing emerging market voting power within the IMF. That said, we think that possibly increasing the IMF’s role in the European debt crisis will be high on the agenda when US Treasury Secretary Geithners tours the European capitals this week for discussions about solutions to the European debt crisis.
Boost in IMF resources imminent
We expect that there will be an announcement of additional resources for the IMF in the coming weeks. Most likely it will be based on bilateral loans from the eurozone countries and the major emerging markets. The major markets like China, Russia and Brazil have all indicated that they are willing to contribute with new resources for the IMF. We think the boost in IMF resources could be EUR200bn – EUR400bn. At this stage, a new SDR allocation looks less likely primarily because of US reluctance. However, should the financial crisis escalate further, this is a forceful instrument that could eventually be used.
At this stage, focus will primarily be on boosting IMF resources and at this stage we do not expect an announcement of a specific aid-package for Italy or Spain. For a discussion of the different IMF aid options available for Italy and Spain IMF loans to EFSF will, in our view, be difficult within the current IMF charter that only allows loans to sovereign states.
Design of funding important for impact on financial markets
How a European debt crisis “solution” is designed and funded could have important implications for financial markets not least the FX market.
If the aid is funded solely by bilateral loans from the eurozone central banks to the IMF it will be effectively work as bilateral loans from the ECB to the eurozone countries that receive IMF-loans. This could effectively be regarded as quantitative easing (QE) as there is no direct sterilization requirement (compared to the other solutions this is the most negative for EUR).
If it is solely left to the ECB’s bond purchases, the ECB’s balance sheet will be expanded. Although the ECB will sterilize the liquidity impact from its bond purchases, it is arguably close to QE because the maturity of the ECB bond purchases is substantially higher than the maturities of the liabilities the ECB creates to sterilize the liquidity impact.
If the solution is aid funded solely by a new SDR allocation, it will effectively work as QE on a global scale (all central banks expand their balance sheets) with central banks indirectly purchasing eurozone government bonds through the IMF.
If the solution turns out to be IMF-aid funded solely by bilateral loans from the major emerging markets (no SDR increase), then it will most likely have no major impact on central bank balance sheets. The loans to the IMF will most likely be provided from major emerging markets FX reserves. If we assume the FX reserves are mostly invested in US dollar assets, this solution would effectively work as a reallocation of global FX reserves from US-dollar to euros (compared to the other solutions this is the most positive for EUR).
Of course the solution will probably turn out to be a combination of the four solutions described above.