A couple of months ago, withheld income and employment tax collections began to outpace our expectations, so we have modestly raised our estimates for the year as a whole. However, April non-withheld tax payments came in well below our estimate. On a DTS (Daily Treasury Statement) basis, April non-withheld taxes were down $25 billion (or 18%) versus a year ago. We had been expecting a small increase based on the anticipation that capital gains realizations would level out following the very steep drop-off seen in 2008. Thus, the message from the revenue side of the budget seems to be that the impact of the recent pick-up in economic activity is starting to flow through, but that backward-looking factors (such as 2009 capital gains realizations) are even weaker than anticipated. On the spending side, stimulus-related outlays appear to be tracking below official estimates. Moreover, the Treasury reported a $114 billion reduction in TARP outlays for the month of March tied to a re-estimate of the losses that will ultimately be borne by that program.
The deficit is expected to decline gradually over the next few years as economic recovery takes hold, tax rates rise and stimulus-related spending slows. In 2011, our deficit estimate is $1.125 trillion (7.3% of GDP), and by 2012 we see the deficit at $975 billion (6.0% of GDP). While the declining trajectory of these projections might seem somewhat encouraging, it should be noted that further progress beyond 2012 would be grudging at best under current policies.
But the long-run outlook looks bleak. To assess the longer-run outlook, we took the CBO's baseline budget estimate for F2020 and adjusted it for the impact of expiring tax provisions. This approach implies a $1.2 trillion budget deficit in F2020 - or 5.25% of GDP. It's worth noting that the CBO's economic projections show a 5.0% unemployment rate in 2020. So, even with the US economy at full employment ten years from now, the adjusted baseline budget deficit is still more than 5% of GDP. Moreover, these estimates do not incorporate three negative risks to the deficit outlook that appear to be identifiable - but not quantifiable - at present. First, there appears to be a significant likelihood that promised offsets to the forthcoming increase in government healthcare spending may not materialize. Second, there is a risk that states and municipalities may require significant financial assistance beyond that contained in the 2009 economic stimulus legislation. Third, these estimates include only a modest amount of additional support for the GSEs - and do not build in any losses associated with the Federal Housing Administration's mortgage insurance program, despite considerable exposure to still weak real estate markets.
The picture beyond 2020 is even bleaker. Pressures associated with an aging population and healthcare inflation point to rising entitlement spending and a further intensification of the budget imbalance. Specifically, long-run estimates published by the CBO show that combined spending on Social Security, Medicare and Medicaid is expected to jump by a little more than 4% of GDP between 2020 and 2035. Factoring in the impact of higher debt service, the structural budget deficit could well reach (a Greece-like) 10% of GDP over this timeframe. Clearly, the US continues to face severe budget pressures over both the short and long run even though the recent improvement in the economy has brightened things a bit.
Near-Term Outlook
We detailed our budget estimates for the next few years. The following policy assumptions are used to derive our budget estimates:
• An AMT patch is enacted every year.
• Additional defense spending is authorized relative to the current budget, consistent with the supplemental appropriations for wars in Iraq and Afghanistan that have been enacted in recent years.
• A sharp cutback in physician reimbursement payments under the Medicare program continues to be delayed (as has been the case every year since 2003).
• The 2001 tax rate cuts are extended but only for those earning less than $250,000 (consistent with President Obama's campaign pledge and F2011 budget proposals). The tax cuts on interest and dividends adopted in 2003 expire after 2010 as scheduled.
• The ‘Making Work Pay' tax credits are extended.
• Extended unemployment benefits (and COBRA subsidy) continue through the end of 2010.
• A freeze on non-defense discretionary spending is adopted in F2011 and F2012.
• We do not include the small-business tax breaks or the bank liability tax proposals that are receiving consideration in Congress. There is still a good deal of uncertainty regarding the final outcome of these proposals, and the items appear to be too small to have any meaningful impact on the budget outlook.
Impact on the Public Debt
Our deficit estimates imply a sharp rise in government indebtedness. We estimate that the ratio of debt held by the public to GDP will hit 67.6% by the end of 2012. A back-of-envelope calculation using the CBO's long-run estimates (adjusted for expiring tax provisions) suggests that the debt/GDP ratio will hit 87% in 2020 - a level not seen since the post WW II period (1947). In comparison, the public debt/GDP ratio was 36% when the financial crisis began in autumn 2007. Meanwhile, the gross public debt - a measure which includes the liabilities to the Social Security and Medicare trust funds - would be well over 100% by the end of the decade. A study by Reinhart and Rogoff presented at the 2009 AEA meetings found that countries with gross debt/GDP ratios in excess of 90% tend to grow about one percentage point more slowly than other countries. Interestingly, this finding holds for both developed and emerging economies (see Growth in a Time of Debt, December 31, 2009). Our analysis suggests that the US will easily exceed the Reinhart/Rogoff sovereign debt threshold by the end of this decade, absent policy action that addresses the deficit situation.
Impact on Treasury Financing
The adjustment to our budget forecast and the somewhat larger-than-expected cutback in the size of the May refunding auctions have led us to pare our expectations for coupon sizes going forward. For some time, it has been clear that the Treasury was overborrowing and cutbacks in coupon offerings were in the pipeline. For example, the current pace of coupon borrowing would imply a drastic shrinkage in the bill market over the next few years. While cutbacks in coupon sizes lie ahead, there are a wide range of possible changes.
We consider three alternative financing scenarios. Note that under each of the alternatives, gross coupon issuance amounts to $2.335 trillion in F2010. This implies modest cuts in most coupon issues over the next few months. The big question is where we go from there.
In the first scenario, the Treasury targets the bill share of the outstanding debt at 20%. This is close to the historical average (adjusted for the impact of the Supplementary Financing Program in recent years). Under this scenario, gross coupon issuance would need to be cut to a run rate of about $1.7 trillion and the average maturity of the outstanding debt would stand at 5.6 years by the end of 2012.
In the second scenario, the 20% bill target is the same, but the Treasury eliminates the 3-year note in order to try to achieve a somewhat longer average maturity. Obviously, the overall amount of coupon issuance under this scenario would be the same as in the first (i.e., $1.7 trillion), but the average maturity of the debt would be slightly higher.
In the final scenario, the target is changed to something we believe to be more relevant in the current environment. Instead of holding the size of the bill market at some proportion of the total Treasury market, we hold it near its historical size in relation to the overall economy. In other words, we target the ratio of bills to GDP. The long-run average ratio is a bit below 10%. So, we created a financing scenario that holds the size of the bill market near $1.5 trillion over the next few years, as opposed to having it continue to grow rapidly in line with the expansion of the outstanding debt. Such a shift helps to achieve a lengthening of the average maturity.
In autumn 2009, Treasury officials indicated that they were aiming to push the average maturity of the outstanding debt up to a range of 6-7 years (see remarks by Karthik Ramanathan, Acting Treasury Assistant Secretary for Financial Markets, at the CFA's 2009 Fixed Income Management Conference). The average maturity dipped to about 4 years during the recession versus a more normal range of 5-5.5 years. In our view, the intended extension of the maturity of the debt still represents a prudent strategy. However, it will be impossible to achieve such an objective if there are significant cutbacks in the 10s or 30s. Indeed, it is a bit of a stretch to even achieve the bottom end of the range within the next several years - especially under the first two scenarios which target a larger bill market. Another factor to consider is the potential impact of draining operations conducted by the Federal Reserve. As part of its exit strategy, the Fed will begin engaging in reverse RPs and term deposits at some point down the road. Ultimately, the operations will take hundreds of billions of dollars away from the front end of the curve, and this situation could persist for several years. Some shrinkage in the size of the bill market could help to alleviate the potential distortions across financing markets. Thus, for a variety of reasons, we prefer the third financing scenario, which targets a smaller bill market. We illustrate a rough assessment of the likely coupon sizes that will be achieved by early 2011 under this scenario.
Finally, it's important to recognize that borrowing needs remain extremely elevated by historical standards. Indeed, although expected gross coupon issuance of $1.96 trillion in 2011 is down more than 15% versus 2010, it is higher than in 2009, far more than double any previous year, and little changed from our prior estimates. As economic recovery takes hold in the US, credit demands will begin to emerge across the private sector. Thus, we still believe that a significant supply/demand imbalance across fixed income markets will work to push real yields higher at some point in the future.
The deepening crisis in Europe and worsening spillovers across markets drove a big flight-to-safety rally in Treasuries over the past week. Strong economic data were ignored as the severe widening in peripheral European debt spreads and sharp decline in the euro sent shockwaves across markets, with risk markets, especially corporate credit, plunging, volatility in rates and stocks soaring, commodity prices selling off sharply with an additional negative impact from rising investor concerns about the impact of China's increased efforts to slow its property markets. The major new development during the past week's run of European turmoil was the relative severity of the widening in the yield spreads over Germany by much bigger and thus systemically important Spain and Italy. There was some mild relief Friday, but for the week the 2-year Spanish and Italian debt spreads over German Bunds both more than doubled, to near 236bp and 185bp, respectively. Though not quite as severe in relative terms and not as systemically frightening, the absolute moves were still much bigger and Friday's closes were new wides for Portugal (+245bp to 551bp) and Ireland (+183bp to 403bp). Greek spreads also surged to new wides, but Greek yields are already at levels where the market - probably appropriately - is already priced for a reasonable likelihood of a debt restructuring. Probably the most worrisome spillover into US markets from the EMU crisis was the major pressure through the week on 3-month Libor and short-dated eurodollar futures, which contributed to a huge further widening in front-end swap spreads, as European banks led a rise in liquidity demand that put big upward pressure on Euribor and near-term Euribor futures that has spread globally, with the Bank of Japan seeking to ease pressure in Tokyo markets with a big liquidity injection. Inflation expectations in the TIPS market were crushed by the weakness in commodity prices and rising concerns about the global growth outlook, so there was a meaningful dovish repricing of Fed policy in futures markets at the same time eurodollar futures were seeing big losses, resulting in a further major widening in forward Libor/OIS spreads - a painful reminder of how the financial crisis first manifested itself in 2007 when soaring dollar demand led by European banks caused an, at the time, unprecedented blowout in Libor over expected fed funds. The key question of course now is whether this contagion intensifies as it did in 2007 and a seizing up of global liquidity and a major increase in risk-aversion leads to broad weakness in the global economy, or whether the situation ends up more like 1997-98 when there were at times major spillovers from the crisis in Asia and then Russia into US markets but ultimately not enough to derail growth. Indeed, the downward pressure on long-term rates, inflation expectations and commodity prices and the easier Fed policy in response to market turmoil ultimately resulted in the 1997-98 turmoil being stimulative for the US economy, which soared in late 1998 and 1999. We will certainly be closely monitoring the extent of ongoing spillovers of this episode, but our base case at this point is that the growth impact stays mostly confined to Europe and that upside risks to the US outlook are becoming increasingly apparent after the past week's strong employment and ISM reports indicated that the acceleration in the economy in March has extended into 2Q. Certainly the Treasury market is likely to remain well supported as long as the crisis in Europe continues - and we think it could for some time - and the collapse in inflation expectations that the European turmoil has caused should allow Fed tightening to be delayed longer than we were previously expecting even if growth upside continues to come through.
For the week, benchmark Treasury yields plunged 15-25bp, with the front end lagging. The 2-year yield fell 15bp to 0.82%, 3-year 19bp to 1.30%, 5-year 25bp to 2.17%, 7-year 24bp to 2.87%, 10-year 24bp to 3.43% and 30-year 24bp to 4.28%. T-bills barely budged at first but finally joined the flight-to-quality bid on Thursday, with the 4-week bill's yield down 6bp on the week to 0.07% and 3-month 3bp to 0.13%. With the dollar index surging over 3% and pressuring commodity prices on top of general global growth worries that were also added to by concerns about the impact of China's latest tightening moves, TIPS far underperformed, and inflation breakevens plunged. Even with disruptions from the disaster in the Gulf of Mexico, June oil plunged 13% on the week, while industrial metals prices were down about 6%. While the dollar surged to $1.271 from $1.329 against the euro and saw big rises against other European currencies, the Canadian and Australian dollars, and major emerging market currencies, it substantially lagged the yen, falling to 91.2 from 93.9, which added to global liquidity concerns, given the yen's perceived role as a funding currency. The 5-year TIPS yield dipped 1bp to 0.39%, the 10-year was unchanged at 1.27% and the 30-year yield fell 6bp to 1.81%. As a result, the benchmark 10-year inflation breakeven plunged 24bp to 2.16%, 5-year 24bp to 1.78%, and 5-year/5-year forward 24bp to 2.53%, after having pushed up to the high end of the historical range at 2.83% as recently as April 29.
There was major upward pressure through the week in Libor and short-dated eurodollar rates and spreads over expected fed funds as a jump in liquidity demand that seemed to have been led by European banks ended up having a bigger impact on dollar than euro funding markets. This dynamic brought back bad memories of the initial outbreak of the global financial crisis in August 2007, when European funding pressures also led to a severe widening in Libor/OIS spreads. 3-month Libor surged 8bp on the week to 0.428%, sharply accelerating what had been a gradual rise since the end of February after the SFP bills program began to be ramped back up and excess reserves to come down somewhat. This boosted the spot 3-month Libor/OIS spread a bit less, to 18bp from 11bp, as some much milder upward pressure on overnight rates caused the expected average fed funds rate over the next three months to rise to 0.245% from 0.2325%. This spread is priced to blow out much further in coming weeks and months. The June 2010 eurodollar futures contract plunged 18bp to 0.65%, Sep 10 14bp to 0.75%, and Dec 10 7bp to 0.895% - against a decent scaling back of Fed tightening expectations this year as the Jan 11 fed funds contract gained 6.5bp to 0.435%. As a result, the forward Libor/OIS spread to June surged to 38bp, September to 40bp and December to 42bp. There was also significant pressure during the week on 3-month Euribor spot and near-term futures and spreads over the expected European overnight rate but less so than in US rates, which was puzzling. In 2007, when the problem assets were dollar-denominated, there was a major rise in European banks' demand for dollars. But it is unclear why the spillover from the weakness in euro-denominated government bonds is showing up more severely in dollar than euro interbank rates. There is a rising expectation in the market that the ECB will follow the Bank of Japan and move to try to address the euro funding strains in the coming days with stepped up repo operations, which may provide some explanation. We don't expect any domestically focused moves by the Fed, given the greatly improved economic backdrop, the still enormous amount of excess reserves in the US banking system, and the, to this point, muted moves in Libor rates and spreads relative to 2007-08. It is possible at some point that the Fed could revive the FX swap lines with the ECB so that the ECB could provide dollar liquidity to European banks, but we're probably some way from that at this point. The weakness in short-dated eurodollar futures and the big widening in forward Libor/OIS spreads helped drive a major widening in short-dated swap spreads and further flattening of the swaps curve. Even after a decent pullback Friday, the benchmark 2-year swap spread widened 12.25bp on the week to 35.75bp, while the 10-year spread rose 4.75bp to 4.75bp, and the 30-year spread rose 3bp to -20.75bp. So, the swaps rate curve flattened significantly more on top of the already big Treasury yield curve flattening.
A notable positive market trend during the week was how solidly the agency MBS market performed during a big rise in interest rate volatility, which could help provide a material positive offset going forward for the US economic outlook to the negative economic fallout from Europe. Normalized 3-month X 10-year swaption volatility rose to 120bp from 99bp, up from the low since late 2007 of 90bp hit in mid-March. Mortgages lagged Treasuries and swaps with this volatility increase but not much, only about a third of a point versus Treasuries and a few ticks versus the widening in swap spreads for Fannie 4.5% MBS, as there was a decent tightening in mortgage Libor OAS spreads. Current coupon mortgage yields fell below 4.25%, near their lows for the year, which should lower average 30-year mortgage rates down towards 4.875% after holding near 5% for most of this year.
Risk markets were crushed broadly and volatility also soared. The S&P 500 fell 6.4% to move slightly into the red for the year. Big losses were seen across all major stock market sectors but with energy, materials, industrials and consumer discretionary stocks doing worst with losses near 8%. The rise in equity market volatility was a lot larger than in rates, with the VIX spiking up to 41.5% from 22%, a high since the market lows in March 2009 after having been at lows since mid-2007 under 16% on April 20 before the latest wave of European turmoil began. Investment grade credit performed horribly on Thursday, the worst day of the past week, but managed a partial rebound Friday as stocks kept sinking. On the week there was still a severe 30bp widening in the IG CDX index to 122bp, 40bp wider than the recent April 20 tight and 37bp wider for the year. Early in the week high yield credit was holding up very well along with subprime and lower-rated CMBS, as these areas were briefly seeing a lot more relative support from the positive US economic outlook, but these areas turned down very hard later in the week to join the broad weakness. The high yield CDX index ultimately fell about in line with stocks for the week with a 6-point (or 6% since it closed near par on April 30) drop, which was about a 145bp widening in spread terms to near 640bp. This brief resilience followed by a crash later in the week was also seen in the ABX and sub-AAA CMBX markets, with the AAA ABX index ending down 7% for the week, junior AAA CMBX 10% and AA CMBX 7%. For a while the muni bond MCDX market was holding in much better than it did during the February Euroland weakness, but spillover intensified greatly mid-week before a bit of Friday improvement. In late trading Friday, the 5-year MCDX index was about 35bp wider on the week near 165bp, back not too far from the worst close of the year of 180bp during the worst of the early February Greece spread widening.
Non-farm payrolls surged 290,000 in April even though temporary hiring for the census remained sluggish at +66,000, and there were significant upward revisions to March (+230,000 versus +162,000) and February (+39,000 versus -14,000). Job gains were broad-based, with good upside in business services (+80,000), construction (+14,000), manufacturing (+44,000), retail (+12,000), healthcare (+26,000) and leisure (+45,000). Other details of the report were also strong. The unemployment rate rose to 9.9% from 9.7%, but only because of a surge in the labor force (+805,000) that exceeded a big gain in the household survey's jobs measure (+550,000). The average workweek rose a tick to 34.1, a high in over a year, which combined with the upside in payrolls boosted total hours worked by 0.4%. Manufacturing hours jumped 0.8%, pointing to another very strong industrial production report. Even with average earnings flat (the one disappointment of note in the report), the 0.4% aggregate hours gain boosted aggregate wages 0.5%. Inflation should be soft in April because gasoline prices didn't see the seasonally typical increase, so should lead to particularly strong income growth in real terms.
In addition to the surprisingly strong jobs report, both ISM surveys posted robust results in April, though the manufacturing sector continues to lead the recovery. The composite manufacturing ISM index rose to a lofty 60.4 in April from 59.6 in March, a high since 2004. Underlying details were even stronger, with the key orders (65.7 versus 61.5), production (66.9 versus 61.1) and employment (58.5 versus 55.1) posting good gains to unusually high levels, with a partial offset from a drop in the inventories gauge (49.4 versus 55.3). The customers' inventories index also plunged to a near-record low of 33.0, and restocking going forward should provide support to further manufacturing growth. The factory expansion continued to be very broadly based, with 17 of 18 sectors reporting expansion in both April and March. Meanwhile, the composite non-manufacturing ISM index held steady at a four-year high of 55.4 in April after the 5-point surge seen in March and February. Growth outside of manufacturing also remained broadly based, with 14 of 18 sectors expanding in April, the same as in March. The business activity index rose to 60.3 from 60.0, a high since 2006, while orders pulled back 4 points but to a still-strong level of 58.3. The employment index remained weaker, dipping marginally to 49.5. The industry breakdown for employment was more favorable, however, with nine sectors reporting increased hiring and six further job cuts.
On the softer side of the early April data run were initial indications for consumer spending. Motor vehicle sales pulled back to an 11.2 million unit annual rate after surging to 11.8 million in March from 10.3 million in April. And chain store sales results for April were somewhat softer than expected. The full March/April period was quite strong, but it appears more spending was pulled into March by the early Easter and weather impacts. Incorporating these results, we now see real consumer spending holding flat in April. The starting point for 2Q was so strong thanks to +0.5% gains in real PCE in March and February, that even with an April pause, 2Q consumption would remain on pace for a gain near +3.25% on top of the 3.6% rise in 1Q.
The economic calendar is pretty light in the coming week, with retail sales on Friday the most notable release, which is just as well since clearly investors are not focusing on US economic developments at this point. While markets deal with the ongoing turmoil in Europe and try to gauge the spillover into other regions, the Treasury market will need to take down the quarterly refunding auctions. This will be a bit less challenging, as the accelerating economy has translated to a big positive reversal in underlying tax revenue growth since March (though April non-withheld payments were soft) and allowed the Treasury to make a somewhat faster start to coupon size reductions than we were expecting. The 3-year auction on Tuesday was lowered by $2 billion to $38 billion and 10-year on Wednesday $1 billion to $24 billion, but the 30-year on Thursday was held at $16 billion. Economic data releases out in the coming week include the trade balance and Treasury budget Wednesday and retail sales and industrial production Friday:
* We look for a modest narrowing in the trade gap in March to $39.0 billion on a 1.3% gain in exports and 0.7% rise in imports. Imports should be restrained by a pullback in services, which were boosted in February by Olympics broadcast royalty payments. Port data also point to a flat reading for non-energy good imports, but higher prices should significantly boost petroleum products. On the export side, higher prices should also provide a boost to industrial materials and food, and the shipments figures point to further upside in capital goods. Note that our forecast is several billion dollars narrower than the BEA assumed in the advance 1Q GDP report.
* We expect the Treasury to report a $56 billion April budget deficit, $35 billion wider than in the same month a year ago due mainly to a surprising fall-off in April 15 tax payments. Based on the Daily Treasury Statement, April non-withheld taxes were down $25 billion (or 18%) versus a year ago. In contrast, we had been expecting a small increase based on the anticipation that capital gains realizations would level out following the very steep drop-off seen in 2008. The swing in non-withheld taxes along with continued upside in payments for unemployment benefits and other social insurance programs should more than offset some further acceleration in withheld taxes. So the message from the revenue side of the budget is that the impact of the recent pick-up in economic activity is starting to flow through but that backward-looking factors (such as 2009 capital gains realizations) are even weaker than anticipated. We recently updated our budget outlook and now look for a deficit of $1.25 trillion (or 8.5% of GDP) in F2010 - a bit narrower than our prior forecast.
* We look for a flat reading for April retail sales overall and ex autos based on the softer results for auto and chain store sales and a modest price-related drop at gas stations.
* The employment report pointed to a very sharp jump in factory output during the month of April. Indeed, even after factoring in another weather-related dip in the utility component, it looks like overall IP will be up nearly 1%. And the key manufacturing category is expected to post a 1.2% gain, which would represent the sharpest jump since the cash-for-clunkers-related surge in activity seen last summer. Manufacturing ex motor vehicles is also expected to be up 1.2% - one of the sharpest jumps seen during the past decade. By industry, the strongest performers in April are expected to include: metals, machinery, textiles, paper, printing and petroleum. Finally, the utilization rate is expected to jump to its highest reading since November 2008.
A Stabilisation Fund for the Euro Area
We are waking up to good news for the markets this morning. Overnight, euro zone leaders have decided to put together an emergency stabilisation fund for EMU countries. The stabilisation fund will be finalised before the market opens on Monday. The heads of state or government have asked their finance ministers to get together for an extra Ecofin meeting on Sunday afternoon to hammer out the details. A press conference has been scheduled for around 5:00pm London time on Sunday, but the timing of this briefing could obviously still change.
Ecofin Council to Finalise Fund Details on Sunday
At this stage, we don't know much about the details of the stabilisation fund. But, in general, we believe that this is an important move that could help stabilise the euro area periphery as well as the banking sector and the money markets, which all started to show signs of stress towards the end of the week. Risky assets would likely also respond positively. We are less convinced, however, that it will be seen as positive for the euro or for Bunds. Here we would not rule out a negative market response. Much of the market reaction, of course, will depend on the details of the announcement on Sunday and whether these will convince market participants. The size of the fund will likely be one important headline to look out for.
All Eyes on Any ECB Policy Action Backing the Fund
In addition, any accompanying action by the ECB will likely be key for calming financial markets. There was unconfirmed market chatter on Friday that the ECB was about to launch a €600 billion facility over the weekend. The market chatter about this facility was contradictory, in the sense that some were talking a one-year lending facility (i.e., a new LTRO which could replace the €442 billion rolling off on July 1), while others were claiming that the ECB was about to embark on an outright purchase programme for government bonds. The latter version was also reported this morning by a German TV station, ARD. Alas, we will have to wait until Sunday evening or even Monday morning to see what the deal really is.
Could Be Modelled on Hungarian/Latvian Rescue Fund
As stated earlier, there are no more official details on the stabilisation fund yet - apart from the statement below. Press reports suggest though that the stabilisation fund would have a similar structure to the rescue packages for Hungary and Latvia. In these cases, the European Community (EC) came to the market to raise funds by issuing EC bonds that are backed by all EU member states and then lend the money on to the countries in question under a joint funding programme with the IMF. These lending programmes were managed under the EU's balance-of-payments facility, which so far has been explicitly dedicated to help countries that aren't in the euro. Changing this provision would require a Council decision and the support of non-EMU members. This BoP facility was doubled to a total €50 billion during the financial crisis and about €15 billion has been allocated to Hungary, Romania and Latvia (with €10.2 billion actually disbursed already).
How Did the Hungarian/Latvian Programmes Work?
Under the BoP facility, the EC raises money in the capital market to fund the lending programme. Typically, the lending is conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having an AAA borrowing rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, the IMF and the government concerned agree on measures designed to overcome the country's difficulties. This would probably be similar to what has just happened with Greece. The key difference would be that the fund would be readily available without having to go through the same lengthy approval mechanism again for another country. In addition, it seems that thus far there are no talks on possible IMF involvement in the euro area stabilisation fund.
Based on a Commission proposal, Ecofin approved the loans to Latvia, Hungary and Romania, usually at a five-year maturity. Subsequently, a Memorandum of Understanding is signed between the EU and the member state, setting out the conditions of the loan. Following signature of the Memorandum and the Loan Agreement, the first payment tranche is released. So far, Hungary (€6.5 billion), Latvia (€3.1 billion) and Romania (€5 billion) were granted assistance. Payments are usually made in installments. Ahead of the disbursements of further tranches there is typically an assessment of the progress made with respect to the policy measures taken. In the case of the CEE countries, this assessment was made by both the IMF and the European Commission. In the case of the euro area, it probably would just be the European Commission providing an assessment and the Ecofin Council taking the decision.
Some Important Differences
We had discussed the option of replicating these programmes for Greece in our first report on Greece (see Whither Greece? January 25, 2010, page 14). There is no indication of the amount that the EC could be mandated to raise yet, but if it really was modelled on the CEE cases, it would mean that also countries outside the euro area would guarantee the bonds issued by the European Community. We would deem such broad support from EMU-outs unlikely - especially in the UK, after the election. So it probably will just be the euro area countries who will back the fund and who seem to be moving towards more of a fiscal union in response to the crisis. In exchange, the fiscal discipline enshrined in the peer-review process under the Stability and Growth Pact will likely be tightened too. These changes and their compatibility with the European Treaty could potentially be challenged in the German Constitutional Court. That said, just this morning the Court threw out the case brought yesterday against the Greek rescue package.
More of the Same ECB Liquidity or Something New?
Read Full Article »