Sunday, January 22, 2012

The latest actions in the Eurozone's "war"

The Eurozone bureaucrats and the ECB are trying to use an economic equivalent of the Powell Doctrine in fighting the crisis. Finally they are starting to realize the need for employing all available resources that are politically viable in the current environment.  Here are some of the latest monetary and fiscal actions:
  • The ECB lowered bank reserve requirements from 2% to 1%.  That’s a release of EUR 100bn into the banking system, which we should see showing up in the ECB Deposit Facility.
  • Draghi is gearing up for LTRO-II.  The demand is expected to be high, though the amount is still capped by the availability of eligible collateral.  The ECB will have to make exceptions for some banks on the types of collateral the central bank can accept.  Many banks will simply shift some of what they currently have on the overnight basis with the ECB into the new LTRO.
  • The combination of the ESM and the EFSF will be set at EUR 500bn capacity for now.  Some member states such as Slovakia are uneasy about taking it higher at this stage.  However the Board of Governors of the ESM will have the ability to increase it if needed as part of the new Eurozone treaty. Depending on how the crisis progresses however, the EUR 500bn may not be enough. There has been some talk of the IMF increasing its lending capabilities to supplement the ESM. For now that’s off the table because the US, who has a veto power at the IMF, will not agree to an additional Eurozone exposure. And of course the issue of subordination will be on bond investors' minds as the ESM structure is finalized.
  • The latest draft of the Eurozone treaty will call for funds from member states in five annual installments of EUR 80mm in order to capitalize the ESM.  As soon as the ESM gets to 90% of the target size, it will be made operational.

  • Only the member states that have started modifying their constitutions to comply with the new treaty will be eligible for any ESM support.  The treaty effectively holds a gun to the heads of the periphery states, forcing them to begin the push toward balanced budgets. Countries who have not complied with the treaty budget modification requirements will not only be shut out of the ESM, but will also be brought before the European Court of Justice. The latest draft of the Eurozone treaty will make this process almost automatic. Repeat violators will have to pay a substantial penalty directly to the ESM. The idea is to diminish any ability of the periphery politicians to derail unpopular austerity measures.
The Eurozone treaty will become law once 12 out of 17 member states ratify it, ushering in a massive deleveraging process of the periphery states. It is gearing up to be an extended process with some potential casualties, made particularly treacherous by the onset of a Eurozone-wide recession.   
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