The euro area finance ministers have established the European Financial Stability Facility (EFSF) as a limited liability company under Luxembourg law. The EFSF will raise funds and provide loans in conjunction with the IMF to cover the financing needs of euro area member states in difficulty, subject to strict policy conditionality. Conditions would vary on a case-by-case basis, but would be similar in spirit to those in the case of Greece. Euro area member states would provide guarantees for EFSF issuance up to a total of €440 billion on a pro rata basis. The shareholding of each euro area member in the EFSF will correspond to its respective share in the paid-up capital of the ECB.
The euro area members will issue guarantees for the EFSF debt instruments. This would happen as soon as 90% of shareholding has completed the relevant national parliamentary procedures. In the mean time, the €60 billion Balance of Payment facility is already available to cover urgent funding requirements - if needed (see Fast-Track to Fiscal Union, May 10, 2010).
Once the programme is finally up and running, however, our understanding is that there will be no need to go through parliamentary approval to disburse the individual loans. According to the spokesman of the Eurogroup, JC Juncker, the EFSF should be operational before the end of the month.
In order to ensure the best possible credit rating for the debt instruments issued by EFSF, there would be an additional 20% over and above the guarantee of each euro area member's pro rata share for each individual bond issue, as well as the creation, when loans are made, of a cash reserve to provide an additional or cash buffer for the operation of the EFSF.
The European Investment Bank (EIB) would provide treasury management services and administrative support to the EFSF. The European Commission would ensure consistency between EFSF operations and other operations of assistance to euro area members and, together with the EIB, will support the setting up of the EFSF and contribute to its functioning.
The European Commission, together with the ECB, would negotiate the policy conditions attached to any loans provided by the EFSF and assess compliance with these conditions. This adjustment programme will likely be put together in a joint effort with the IMF. Such an adjustment programme would need to be approved in the country applying for financial help. This could constitute a hurdle in the euro area members with a razor-thin majority or a minority government, such as the Iberian countries for example.
What Could an Adjustment Programme Under the EFSF Look Like?
The Eurogroup mentioned that Spain's and Portugal's fiscal consolidation programmes would once again be looked at. The revised fiscal targets for 2010-11 are deemed to be appropriate (see The Mediterranean Diet: Too Harsh for EMU Health? June 7, 2010). However, both countries will need further fiscal consolidation beyond 2011, according to this evenings press briefing by JC Juncker and O Rehn. What's more, Spain and Portugal have to implement significant structural reforms, notably on the labour market and, also, pensions.
What would conditionality for Spain look like? This will depend on many factors and would be subject to negotiations. In the case of Spain, the IMF published its annual country review (the so-called Article IV) on May 24, which contains an impressive set of policy recommendations ranging from labour reform to fiscal consolidation and the restructuring of the financial system. Spanish conditionality might be influenced by this set of recommendations, though this will probably not be the only factor. Sometimes, past IMF support packages have deviated - to various degrees - from Article IV recommendations. But they are all we can go on for now.
In particular, we think that the labour market reform is an area that might feature in an eventual structural adjustment programme for Spain. On this front, there does not seem to be full agreement, though the government seems determined to announce the details on June 16. The scope of the reform is to end the two-tier system, which leaves many temporary contract holders with limited rights, while adjusting the labour force on permanent contract is considerably expensive. One suggestion seems to be that the reform will expand the use of a permanent contract that offers 33 days severance pay per year worked versus the typical 45 days severance pay. Should this happen, it will cut severance pay for workers holding permanent contracts. Streamlining the bureaucracy faced by companies adjusting their labour force, while discouraging the wide use of temporary contracts, seems on the cards too. What's more, it looks like there will be an increase in severance obligations for temporary contracts in an effort to discourage their excessive use.
Differences Between the EFSF and the Greek Bail-Out Package
The package to Greece was structured as a set of bilateral guarantees among countries belonging to the EU. Greece got a three-year loan amounting to €110 billion. EMU countries will provide €80 billion in total and €30 billion in the first year - contributing according to the respective central banks' contribution to the ECB's capital (see Our First Assessment of Greece's Loan and Austerity Package, May 2, 2010).
The EU-wide stabilisation mechanism would be an operation of the EU as a whole, rather than its member countries. It will have three components (see Fast-Track to Fiscal Union?): €60 billion from an existing financing facility drawn from the resources of the EU budget; €440 billion in loans and lines of credit drawn from a newly formed special purpose vehicle whose liabilities will be guaranteed by participating member states; up to €220 billion will be made available by the IMF.
While the €60 billion facility is backed by all 27 EU member states, the €440 billion SPV would only be backed by the 16 members of the EU who have adopted the monetary union. Another difference is that, in the case of the €60 billion facility, the European Community (EC) comes to the market to raise funds by issuing EC bonds backed by all EU member states - conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having a AAA 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.
While the funding of any emergency loans would be different between the Greek packages and the EFSF, the principle of conditionality of the loans is the same. And the institutions involved are the same: the European Commission, the ECB and the IMF. This does not mean that the adjustment programmes would be the same too. But they would be constructed on the same principles. Of course, they would be tailor-made to the individual country.
Currently there are several cases pending at the German Constitutional Court against both the Greek bail-out package and the EU Stabilisation Fund.
On the former issue, the second senate of the Constitutional Court was very quick to throw out a request to issue an emergency injunction against the bilateral loan being disbursed to the Greek government. For details of the ruling, please see Appendix II in the full report. The Court still needs to look at the underlying case though. The loan agreement with Greece takes this into account with a clause stating that in the case of a negative ruling of the German Constitutional Court or the European Court of Justice, there is no obligation for the government to provide further funding. At the same time, there is also no obligation on the part of the Greek government to pay back the loans it has received so far ahead of their regular maturity.
On the latter issue, the EU Stabilisation Fund, the Constitutional Court has not ruled at all. The only action it has taken thus far is to ask several bodies, including the government of the federal republic, the regional state governments and the ECB for an assessment. Some commentators have argued that the case brought against the EU Stabilisation Fund might have a better chance of being considered because the Fund creates a semi-permanent structure for financial support as opposed to the Greek bail-out, which was a one-off. Another key difference between both cases is also that in Greek bail-out legislation no arguments were made that took recourse to the German constitution or the EU Treaty. This is also different for the EU Stabilisation Fund, which explicitly refers to Article 122 of the EU Treaty with respect to granting emergency assistance to other countries. Hence, it is maybe not surprising that thus far the German Constitutional Court has received four complaints on the EU Stabilisation Fund and there is one more on the way, according to press reports.
The most prominent complaint is the one brought by the Bavarian member of parliament and long-standing eurosceptic, Peter Gauweiler, who also has filed for an emergency injunction. For an emergency injunction to be granted (which would stop any disbursements until the Court has ruled), he needs to show that he personally is facing an immediate and direct danger from the German loan guarantees to be activated and that this danger is bigger than one emanating from the guarantees being activated for now. It would take a long stretch of imagination to see such an immediate danger being bigger for an individual than for the whole European financial system. Hence, it seems likely to us that the Court will throw out the request to grant an emergency injunction. There is no timeline for a decision like this though. Sometimes it takes days, sometimes weeks, sometimes months.
But even if the emergency injunction is not granted, the Court would still look at the full case. It does so in two steps. First, it assesses whether the case is admissible on the basis of an immediate and direct danger to the individual in question. Especially for a case brought by an individual, the hurdle of admissibility is a relative high one. The Court throws out more than 97% of the cases it receives of individual claimants. Second, if the case is admissible, the Court needs to assess whether it is justified on the grounds of the rule of law and notably the sovereign rights of the German people being infringed. Importantly, though, the Court cannot rule against the EU Stabilisation Fund because it violates EU law. In this case, it would probably need to pass the case onto the European Court of Justice.
On balance, we therefore don't think that there is a material risk for the German Constitutional Court throwing some spanners into the works of the EFSF. But there is an outside chance that the second senate of the Court will want to look at this issue in some detail and express a general view, notably in specifying some clear boundaries of what in the view of the Court is admissible for the government in this context and what is not. This is for instance what happened in the so-called Lisbon Treaty verdict of the Court (for details, see http://www.bundesverfassungsgericht.de/en/decisions/es20090630_2bve000208en.html).
Where does this leave the ECB and its securities markets programme? There are several interesting aspects in the communication on the EU Stabilisation Fund with respect to the ECB and in the ECB's own communication on the securities markets programme (SMP). We are likely to hear more about this on Thursday at the ECB press conference.
First, the ECB clearly stated that the SMP is intended to be temporary (see EuroTower Insights: On Buying Bonds, May 17, 2010). If you are looking for a milestone that could mark the end of the ECB's bond buying programme, the SPV being fully operational could be a potential candidate, we think. Even though we don't believe that the ECB will come out on Thursday and say that its SMP is approaching the end, we would have this as a risk on the radar. It is clear that the decision to buy government bonds is a controversial one on the Council, with Bundesbank President Axel Weber being an outspoken opponent of the bond buying programme.
Second, the EFSF being up and running could allow the ECB to reduce its bond purchases further. So far, week after week the ECB has spent less on peripheral government bonds than the market had expected and, also, less than the week before. From an initial flow of €16.5 billion in first week of the programme, we are now down to only €5.5 billion in the fourth week of the purchase programme as the ECB announced earlier today. At a total of €40.5 billion at the end of last week, the overall size of the programme still remains small, underscoring our view that the SMP is not intended to mark the start of another round of quantitative easing (QE) in the euro area.
Third, our sense is that so far the ECB has heavily concentrated its purchases in the Greek bond market. This would make sense because this was likely the most dysfunctional market at the start of the programme. But it is also the country whose EU/IMF adjustment programme the ECB has worked on in detail and approved. This involvement was the main reason why the ECB Council felt comfortable to decide that it would still accept Greek government bonds as collateral if even these were rated sub-investment grade by credit rating agencies. Along the same lines, one could argue that the Eurosystem was probably happy to take exposure to Greek government bonds after it had assessed the situation thoroughly. In this context, it is therefore reassuring for governments to see that the ECB will again be closely involved in the adjustment programmes that are a precondition for emergency loans from the EFSF.
For full details and appendices, see Europe Economics: Enter the EFSF, June 7, 2010.
As turbulence first originated in Euroland takes a toll on financial markets around the globe, what are the implications for Brazil? While our Latin America economics team has taken a first glance at the regional impact from the new global turmoil (see "Latin America: The New Turmoil", This Week in Latin America, May 24, 2010), here we take a deeper look at the transmission channels and implications for monetary policy in Brazil. Besides trade and capital flows, we believe that commodity prices - and hence China, more so than Europe - is the key factor to watch.
Starting points matter - Brazil's red-hot economy means the central bank still has monetary tightening work to do in the near term. Amid breakneck domestic demand expansion, shrinking slack in the economy and upward inflation pressures, the monetary policy committee (Copom) looks bound to hike rates again on June 9 - just a day after the release of what is likely to be a very strong real GDP growth figure for 1Q.
But a key debate ahead is whether global headwinds would eventually do part of the cooling job for the Copom. If our global view remains relatively constructive, then the impact from external developments on Brazil should prove limited. However, if we start to see significant growth downgrades across the world, along with darkening prospects for China and commodity prices, then odds increase that the Copom would eventually slow its hiking pace, with interest rates peaking sooner and lower than we have assumed.
Transmission Channels
One transmission channel from turmoil in Euroland is exports. About 17% of Brazil's total exports go to Europe: one of the largest shares in Latin America. But Brazilian exports to Euroland are mainly commodities, including soybeans; for instance, almost 60% of Brazil's exports to that region are commodity-related. And Brazil is a relatively closed economy by Latin American standards, in terms of weight of exports as a share of total GDP. The resulting role of exports to Europe as a share of GDP is relatively modest, at about 2% of GDP. Europe has gradually lost market share as a destination for Brazil's exports over the years - by contrast, China has gained market share steadily. In fact, China has already outpaced the US as a key trade partner for Brazil.
Outflows of profits and dividends are another potential transmission channel. Brazil's current account deficit is already widening, as domestic demand quickly outpaces global growth. In particular, the deficit in current account services (including items like international interest payments and net tourism outflows) has taken a turn for the worse. Outward remittances of profits and dividends could show significant deterioration, against a backdrop of strong domestic profitability in Brazil amid acute conditions at the home country of foreign companies operating in Brazil. Net outflows of profits and dividends in the 12 months through April 2010 stood at US$24.1 billion. As a reference, they had reached their worst point of US$37.0 billion in the 12 months through December 2008.
Foreign direct investment (FDI) inflows could weaken. More than half of FDI into Brazil comes from Europe. Countries like Greece, Italy, Ireland, Portugal and Spain together account for about 13% of FDI into Brazil, and Spain alone represents about 11%. In the 12 months through April 2010, total FDI into Brazil stood at US$25 billion. Here too, China might play a rising role over time - China historically does not show as a meaningful source of flows into Brazil, but local press stories talk about announced FDI plans from China into Brazil already adding up to about US$10 billion.
Other capital flows might suffer as well. While FDI tends to be relatively more stable over the business cycle, portfolio flows can prove highly volatile. During the 2008-09 global downturn, equity flows into Brazil plunged from a pre-crisis peak of US$24 billion in the 12 months through May 2008 to net outflows of US$11 billion about a year later, in 2009. Similarly, fixed income flows fell from a pre-crisis peak of US$28 billion positive inflows to net outflows of US$6 billion at the worst point in 2009.
The credit channel proved crucial in the 2008-09 global market turmoil, but we suspect it will be less critical this time round, absent a global financial meltdown. One key ingredient in the local credit market turmoil in 2008 was the unexpectedly large and widely spread exposure of Brazilian firms to currency derivatives, which turned lethally damaging as the currency went the wrong way, sparking credit risk and counterparty concerns. Fortunately, such sort of local exposure looks much reduced nowadays.
Above all, commodity prices remain a critical link, in our view. While Brazil's economy is relatively closed, and commodities represent only about half of Brazil's total exports, the empirical historical correlation between international commodity prices and Brazil's real GDP growth is simply too strong to be ignored.
In all, China is key for Brazil's outlook, more than Europe is, in our view. As long as the broader global picture remains benign, China enjoys a Goldilocks outlook and commodity prices find a bottom, implications from Euroland turmoil to Brazil should be relatively contained. However, if global prospects take a significant downturn, Brazil would hardly prove immune, in our view.
The good news: domestic policy response should provide some cushion to a global shock. Brazil's downturn in late 2008 was sharp but relatively short-lived, especially in industrial production. That was thanks to a swift rebound in China and Brazil's new-found ability - for the first time in recent memory - to run expansionary fiscal and monetary policies in response to a negative external shock. In the end, Brazil's downturn proved less dramatic than OECD leading indicators alone would suggest.
Starting Points Matter
What would a global slowdown mean for monetary policy in Brazil? The starting point for Brazil is a domestic economy which is firing on all cylinders. Brazil's economy is red-hot. Real GDP growth in 1Q10, to come out on June 8, looks bound to prove at least as strong as in the last quarter of 2009, when the economy expanded at a sequential, annualized pace above 8%, while domestic demand ran at a double-digit pace.
Recent data suggest some growth moderation in 2Q, but still strong. Several indicators are posting a sequential decline in April. For instance, industrial production was -0.7%M in April, interrupting a steady string of strong monthly gains. Still, industrial production was up 17.4%Y. On average during the three months through April, industrial production expanded at a breakneck sequential annualized pace of 18.6%.
Domestic demand drivers remain strong. Ranging from solid job creation and rising real wages, all the way to upbeat confidence and expansionary domestic credit conditions, usual drivers of domestic demand remain supportive. And measures of slack in the economy show there is little spare capacity left - the unemployment rate has fallen to record lows, and capacity utilization in industry climbs towards pre-crisis peak levels.
The central bank remains in tightening mode for now. With the economy growing faster than any reasonable estimate of ‘potential', real interest rates below most estimates of ‘neutral', and inflation expectations running above target, the central bank's monetary tightening job is hardly finished. Growth remains too strong, despite recent signs of moderation. Sequential headline inflation may slow in the coming months on slower food and transport cost pressures, but underlying inflation trends remain a concern.
However, the local monetary policy debate is shifting. Not long ago, the debate was whether strong domestic growth would force the central bank to accelerate its hiking pace to 100bp, after the initial hike of 75bp in April. The debate now is whether the new global turmoil will lead the Copom to slow down its hiking pace to 50bp. We continue to look for a 75bp rate hike on June 9, to 10.25%. The voting score looks set to be unanimous once again.
For the central bank, global developments deserve close watching, but a major external shock is not yet its base case scenario. While external factors are surely gaining share in the Copom's thinking, domestic factors still seem the predominant driver for monetary policy decisions, at least for now. In other words, at the moment, the central bank does not appear to count on a global slowdown alone to do the job of cooling down Brazil's booming economy.
In that sense, some global deceleration might actually prove welcome, if it helps the central bank's task to moderate Brazil's expansion. Of course, be careful what you wish for, as too much of a good thing might become a bad thing. The authorities surely would not want to see a repeat of the 2008 global market turmoil.
In all, global headwinds could add downside risks to the policy rate outlook. Our forecast has assumed a full monetary hiking cycle of 400bp, to 12.75% - 300bp in 2010 and another 100bp in 2011. While the central bank still looks likely to keep hiking in the near term, next year's projected hikes now start to look questionable, if lingering global turmoil persists for long.
A slower hiking pace ahead? After an initial hike of 75bp in April, our 2010 forecast has assumed three more back-to-back hikes of 75bp each - in June, July and September this year. A 75bp hike in June looks almost certain in our minds. But the risk is that the Copom could eventually opt to slow its hiking pace, later on, if global headwinds prove sufficiently powerful. In a sense, risks around the rate outlook appear asymmetric - while the central bank now looks unlikely to accelerate the hiking pace to 100bp in light of external uncertainties, it might choose to slow the pace to 50bp if global conditions worsen. The end result - if global headwinds intensify, policy rates might peak sooner and lower than we have assumed.
Watch upcoming policy statements as guidance for likely future monetary action. The usually short accompanying policy statement, along with the actual Copom decision on June 9, seems unlikely to provide much guidance this time round. However, central bank watchers should closely read the Copom minutes to come out on June 17 for updated central bank views on global developments and implications for Brazil.
Bottom Line
What does the new global turmoil mean for Brazil? We suspect China and commodity prices - more than Europe alone - are key factors to watch. Starting points matter - Brazil's red-hot economy means the central bank still has tightening work to do. But if the global outlook turns decisively sour, Brazil's economy will not be immune - in that case, Brazil's policy rates might peak sooner and lower than otherwise.
Read Full Article »