At the Council meeting last week, European governments agreed to change the Treaty and create a permanent Crisis Resolution Mechanism (CRM) (see Appendix 1 in the full report for details). For financial markets, the conclusions reached at the Council seem to have raised more questions than provided answers. This is partly because, at this stage, there is little detail on what the new permanent Crisis Resolution Mechanism would look like. In this context, financial markets are trying to get to grips with what policymakers have in mind when they refer to "private sector involvement".
In this note, we outline our take on the state of the debate. Our main conclusion is that even if some sort of a Sovereign Debt Restructuring Mechanism (SDRM) were to replace the European Financial Stability Facility (EFSF) in July 2013, the risks of a debt restructuring in the euro area periphery still seem more than adequately priced into the government bond markets. In our view, the CRM proposal does not materially alter the costs and benefits of a country defaulting for EMU as a whole. At the end of the day, and political rhetoric aside, no one in euro area politics has an interest in any euro area country defaulting.
To prevent a future sovereign debt crisis, the European Council has decided to pursue a two-pronged strategy, with a political peer review under a reformed Stability and Growth Pact (SGP) on the one hand, and greater market discipline through private sector involvement in future financial rescue operations on the other. The existing European framework for policy coordination has clearly failed to prevent unsustainable macroeconomic developments. Not only were the rules of the SGP not applied as intended, they were also not encompassing enough (see also a recent speech by Commissioner Olli Rehn, Why EU Policy Co-Ordination Has Failed, and How to Fix It, October 26, 2010).
The first part - the reform of the SGP - is relatively advanced already as far as the details of the proposal are concerned (see Appendix 2 in the full report for details). Essentially, the proposal adopted by the European Council foresees earlier and easier sanctions against countries that are not fully complying with the 3% and 60% ceilings of the Treaty of the European Union (TEU).
• The sanctions would set in earlier than under the current regime.
• Sanctions could also be imposed on countries that are in violation of the debt criterion (so far it was only the violation of the deficit criterion that could trigger sanctions).
• Sanctions will be semi-automatic in the sense that it would take a qualified majority vote (QMV) to stop them rather than to pass them.
In addition, the Commission will be tasked with monitoring the potential build-up of macro economic imbalances within the euro area, notably when it comes to competitiveness issues. This last point recognises that countries such as Ireland or Spain did not violate any of the SGP requirements at any time in the run-up to the current crisis.
The second part - the introduction of a permanent Crisis Resolution Mechanism - is still relatively vague. It is clear that a permanent solution is needed when the EFSF expires in June 2013. We think that this permanent CRM will most likely be a combination of an emergency lending facility, like the EFSF, and a new legal framework for sovereign debt restructuring.
We understand that the notion behind involving the private sector in any future CRM is two-fold: From a political point of view, in general politicians feel that it is not fair that taxpayers (directly or indirectly) stemmed the last crisis on their own. From an economic point of view, there is the hope that the spectre of private sector involvement in future emergency financing will reinforce market discipline in euro area government bond markets. For it has become obvious that the risk of sovereign financial turbulences was not adequately priced for most of the first ten years of the euro. The under-pricing of these risks has likely contributed to excessive lending to the euro area periphery and thus to the building up of the imbalances we see in the euro area today.
Both the reformed SGP and the CRM have their idiosyncratic problems. At the outset, it is not clear whether they are substitutes or complements to each other. What is clear though is that in the political process they are part of one package of policy measures. The main flaws of the SGP are that the threat of sanctions suffers from a time inconsistency problem and that it is based on a peer review process.
The time inconsistency problem refers to the fact that it might not be practical to sanction a country in fiscal trouble because this would only aggravate the problem further. A case in point is Greece, which despite being in a clear violation of the SGP, was not sanctioned. By anticipating sanctions earlier than under the present SGP, this time inconsistency problem will probably be alleviated. However, it will still not be fully resolved.
Similarly, the reverse QMV voting will make it easier to pass a motion on sanctions under the peer review process. However, this remains dependent on a political decision, and we note the reluctance of elected politicians to accept the European Commission proposal or even the farther reaching ECB suggestion, which foresees a greater degree of automatism than proposed by the intergovernmental taskforce led by the President of the European Council, Herman van Rompuy. ECB Executive Board Member Lorenzo Bini-Smaghi describes this process as "current sinners being judged by potential future sinners" and concludes that this very process was causing "the tendency for forgiveness to prevail" (see The Challenges Facing the Euro Area, November 1, 2010).
Whether enlisting market discipline will work as an additional plank to safeguard sustainability depends on whether bond markets price default risks efficiently. The evidence from the emerging market sovereign debt crisis would suggest that this is not the case. According to a recent IMF staff note, the bond market sounds a false alarm much more often than a real one (see Defaults in Today's Advanced Economies: Unnecessary, Undesirable, and Unlikely, IMF SPN 10/12). Looking at all episodes in which sovereign spreads were rising above 1,000bp since the early 1990s, the authors find that out of a total of 36 cases in which the spreads repeatedly hit and broke consistently above 1,000bp, only seven led to a debt restructuring (equivalent to only about 20% of the cases). Of course, many of the countries hit hard by contagion in the course of the Mexican, Asian, Russian and Argentine crises needed emergency funding from the IMF. But they did not restructure their debt. The tendency of the bond market to ‘cry wolf' far too often is reminiscent of the "equity market pricing in nine of the last five recessions", as Nobel-Prize winner Paul A. Samuelson is famously quoted as saying.
As a result, we think, there is a danger that the discipline imposed by financial markets will be rather severe. And that is even before we start to discuss the pro-cyclical behaviour of financial markets and financial institutions, or the surge in market volatility in the face of uncertainty. As far as a permanent CRM is concerned, there are two different approaches that could be pursued to facilitate private sector involvement in a future sovereign debt crisis in the euro area.
The first approach is to create a Sovereign Debt Restructuring Mechanism (SDRM) for the euro area. This seems to be the option preferred by the German government, which is insisting on the private sector involvement clause in the change to Art 122 (2) to extend emergency lending to cases in which the stability of the euro area as a whole is threatened (see Appendix 3 of our full report for the key Articles for the TEU). Until we have an official proposal by the German government and the key points are worked out by the European Commission, the proposal made by the IMF in 2002 might provide some guidance, even though adaptation to the institutional set-up of the euro area and the constraints imposed by the TEU would probably be necessary (for details, see A New Approach to Sovereign Debt Restructuring, IMF 2002).
The main obstacle to an SDRM is whether it can be set up to still be compatible with an accelerated Treaty change under Art 48 (6) - the latter would not be possible anymore if there were to be a new European institution to which responsibilities from national entities were transferred. As in the EFSF framework agreement, it would probably be the euro group, maybe even Ecofin, who would take the decision on an activation of the CRM following the request being submitted by a country. Within the euro group, the EFSF set-up would suggest that the decision would likely be a unanimous one. Within Ecofin, European governments would probably stick to the established QMV.
The second approach would be to introduce standardised collective action clauses (CACs) into the local legislation governing the bond markets in all euro area countries. CACs facilitate an easier repayment rescheduling if a supermajority of investors (typically 75%) agree. Some European countries have these clauses already for foreign currency debt. But the euro area countries do not have them for their domestic currency bonds, which are issued under local law. The advantage of such a contractual solution is that it does not require a change in the Treaty, only a coordinated change in the local law. The disadvantage is that policymakers would no longer be alone in the driving seat in any future debt crisis. Instead, any future sovereign debt crisis potentially would be settled via court cases (i.e., CACs) and not entirely via a political decision-making process.
Both proposals could potentially unsettle peripheral markets because of the perceived prospect of haircuts. At this stage, we think that this would be premature. While we cannot completely rule out a euro area debt restructuring, we continue to believe that the risks are lower than the markets are pricing and that investor surveys show (see Investor Polling from our Global Macro Conference: Prefer Equities & EM, October 1, 2010). In itself, the proposal for a permanent crisis resolution mechanism does not increase the probability of default, we think. This is because the proposal does not materially alter the costs and benefits of defaulting for EMU as a whole. In addition, it is important to remember that the CRM would only come into force in 2013. In the CAC's approach, haircuts could probably only apply to government bonds post the change in the law. While this by itself could raise new issues, it underlines the forward-looking nature of the change in the EMU framework.
But investors could face other possible financial risks under a CRM, we think. These risks initially centre on measures such as a prolongation for bank loans or a maturity extension for bondholders, which are more adequately described as ‘bail-ins' rather than ‘bail-outs'. As for the bail-ins for bond investors discussed in other areas (e.g., Basel III), bail-ins here can potentially have adverse systemic implications (see European Credit Strategy: Trick or Treat: The Future of Bank Senior Debt, October 15, 2010). If they do, they become a source of contagion rather than a means of stabilisation. Given that both investor polls and market measures show that investors are already assigning a probability to a debt restructuring in the euro periphery, the risk of a market rout is hopefully limited.
But private sector involvement is only credible if the financial sector is strong enough to withstand it. Otherwise, it will face the same fate as the no bailout clause of the TEU. In this context, the relatively slow recapitalisation of euro area banks remains an issue of concern (see Eurotower Insights: The Lure of Liquidity, June 17, 2010). A substantial haircut imposed on owners of peripheral government bonds would create additional capital needs across the euro area banking sector up to and including the ECB itself. (The ECB owns about €65 billion of peripheral government bonds and like many commercial banks does not mark them to market as it intends to hold them to maturity.)
A key difference between the euro area and any emerging market crisis is that the countries in question now are part of a political union. Hence, they will need to take into account the impact of their decisions on other euro area countries (for a playbook of how an emerging market debt crisis typically evolves, see EM Profile: Ten Takeways from EM Sovereign Debt Restructuring, May 13, 2010). In this respect, the guiding principle that would be introduced to Art 122 (2) - the stability of the euro area as a whole - could be interpreted as making restructuring less likely because the hurdle is a lot higher than it is for a stand-alone country.
The Commission will work out the cornerstones of the private sector involvement by mid-December. This is important because in the reform of the SGP, the fact that the European governments did work on the basis of the intergovernmental taskforce rather the Commission proposal caused some consternation not just at the Berlaymont building, but also at the European Parliament. This is material because in this revision of the SGP, the European Parliament has co-legislation rights. And this legislative process would normally start with a Commission proposal, not the agreement of an intergovernmental task force.
The intergovernmental van Rompuy taskforce will assess whether an accelerated treaty change under Art 48 (6) is possible. Such a fast-track change is only possible if no additional tasks are transferred from national parliaments to European institutions. It is key for the German government to amend the Treaty to minimise any risk of getting a negative verdict on the German participation in any rescue mechanism. There is also broad agreement on using the simplified revision fast track to avoid referenda in a number of countries, including the UK and Ireland. Still, even under the fast-track procedure, these small changes to the TEU would need to be ratified in every EU member state.
Press reports and recent speeches suggest that the ECB is concerned about the European Council conclusions. According to various press reports over the weekend (e.g., Financial Times, October 30, 2010), ECB President Trichet voiced his concerns that the agreement reached at the European Council meeting could have adverse effects on funding costs in the periphery. Subsequently, Executive Board Member Bini-Smaghi expressed his doubts publicly in a speech (see The Challenges Facing the Euro Area, November 1, 2010). Professor Bini-Smaghi is worried that the reformed Stability and Growth Pact will not make a difference in the decisions taken by the Eurogroup on sanctions against their peers. In addition, he is warning about entering the uncharted territory of a sovereign debt restructuring in an advanced economy. In his view, a debt restructuring in the euro area is not comparable to an EM debt restructuring because of the much higher level of assets/liabilities at risk (notably those held by domestic and foreign banks). He also stressed that any mechanism that automatically combines emergency loans with debt restructuring would invite speculative attacks.
This suggests to us that the ECB continues to be worried about financial stability in the euro area. This has several implications.
• First, the ECB is likely to be concerned about the banks - probably based on what it sees happening in its regular refi operations and in the case-by-case emergency liquidity assistance (ELA) given by national central banks.
• Second, any debt restructuring would likely have a marked impact on the ECB's own balance sheet. Any significant write-down could potentially cause a case where the ECB itself needs a capital injection from its shareholders (in this case the euro area governments). While there is a loss-sharing agreement for the ECB's monetary policy operations, a recap is clearly a situation that the ECB will want to avoid - for reputational reasons as well as for any (perceived) infringement of its independence.
• Third, the concern voiced by the ECB president also underlines our view that the start of monetary policy tightening in the euro area might still be quite a while away. But we will be all alert this Thursday at the ECB press conference for any comments on behalf of the Governing Council on the proposed changes to the TEU from ‘the horse's mouth' itself.
What's next on the path towards a permanent CRM? First, Germany will have to finalise its proposal for a SDRM by mid-November. Second, the van Rompuy taskforce and European Commission will look at the prospects for a change in the Treaty and work out the cornerstones of a permanent CRM by mid-December. Third, the change to the Treaty is intended to be detailed, drafted and approved by mid-2011. Finally, the change is planned to become effective in mid-2013 when the EFSF expires.
Bottom line: In our view, the probability of a debt restructuring in the periphery involving a very sizeable haircut is still lower than the market believes. But a number of peripheral countries are facing troubled waters, notably Greece, Portugal and Ireland. The sovereign crisis is far from over. It now seems that the market could eventually get a solid legal framework for any future sovereign debt crisis. To get clarity on the key features of this CRM is vital for investors. Investors appear to be nervous, as illustrated by the market reaction to the EU Council agreement. But, we believe that in itself the agreement reached at the European Council has not changed the cost-benefit calibration of imposing a haircut on bond holders. A restructuring in the periphery would still be very costly for the core. Hence, European policymakers are unlikely to hand the crisis management over to local courts across the euro area and the markets. A SDRM under the EFSF umbrella therefore seems more likely to us than the contractual approach of the CACs. So for now, we are off to study those IMF proposals...
For full details, see Euroland Economics: The Next Crisis Resolution Mechanism, November 2, 2010.
Key Policy Rates Hiked and Other Prudential Norms Announced
In today's 2Q monetary policy review, the Reserve Bank of India (RBI) hiked the repo rate by 25bp to 6.25% and the reverse repo rate by 25bp to 5.25%. This was in line with our and consensus expectations of a 25bp hike in both rates. The repo rate is the rate at which the RBI provides liquidity to the commercial banks; the reverse repo is the rate earned by banks on excess liquidity parked with the RBI. The RBI left the cash reserve ratio (CRR) unchanged. In addition, the RBI announced prudential norms to address the concerns on asset prices, particularly the housing sector. These include: a) capping the loan to value (LTV) ratio in respect of housing loans at 80%, b) increasing the risk weight for residential housing loans of Rs7.5 million and above to 125% from 100% earlier, and c) increasing the standard asset provisioning by commercial banks for sanctioning housing loans at ‘teaser rates' to 2% from 0.4% earlier.
RBI Maintained Strong Growth Outlook, Concerned about Inflation
The policy statement highlighted that the domestic economy is on a strong footing. The 8.8% GDP growth for 1Q of F2011 (12-months ended March 2011) suggests that the economy is steadily regaining the pre-crisis growth trajectory. The statement indicated that although uncertainty persists with regard to global recovery, India's domestic growth drivers are robust, which should help to absorb to a large extent the negative impact of a slowdown in global recovery. We maintain our view that GDP growth will accelerate to 8.5% in F2011 (Morgan Stanley estimates) from 7.4% in F2010. We see upside risks to our growth forecasts.
On the inflation front, the statement mentioned that inflation remains high. Both demand- and supply-side factors are at play and inflationary expectations also remain at an elevated level. The statement highlighted that, given the spread and persistence of inflation, demand-side inflationary pressures need to be contained and inflationary expectations anchored. It also mentioned that the risks to inflation are largely on the upside. The policy statement indicated that inflation (WPI) is likely to moderate to 5.5% by March 2011 from the current level of 8.6% (as of September 2010). We expect headline inflation to be slightly higher at 6% by March 2011. We estimate non-food inflation of 6.4% by March 2011 compared with the current 7.5% (September 2010).
Strong Growth Driven by Domestic Demand
We believe that India's domestic demand-oriented model remains the best in the region. India's seasonally adjusted industrial output is now 14.2% above the pre-crisis peak, compared with 4.6% for AXJ ex-China ex India. Both urban and rural consumption has been strong. Passenger car and two-wheeler sales growth accelerated to an average of 24.6%Y and 26.1%Y, respectively, during the three months ended September 2010 (versus 26.1%Y and 15.9%Y during the same period last year). Similarly, consumer durables production growth accelerated to 26%Y during the three months ended August 2010 compared with 21%Y in the year-ago period. As evident from these data, it is not just the base effect that is behind this growth acceleration. In addition, the capex cycle is also picking up in full swing, particularly infrastructure, as capacity utilization is rising quickly. The drag on exports is reducing, with export growth accelerating to 23.2%Y in September 2010 compared with -7.4%Y during the same period last year.
RBI Hints at a Pause in Rate Hike in Immediate Future
The policy statement mentions, "Based purely on current growth and inflation trends, the Reserve Bank believes that the likelihood of further rate actions in the immediate future is relatively low. However, in an uncertain world, we need to be prepared to respond appropriately to shocks that may emanate from either the global or domestic environment." This statement implied that the RBI may not hike rates in the near future. Moreover, we see a very low probability of any measures from the government to change the fiscal spending plan immediately. The next fiscal spending plan will now be announced only towards the end of February 2011.
Macro Stability Risks to Reduce but RBI Still Walking a Narrow Path
Apart from the strong structural growth dynamics, the government's loose fiscal and monetary policy had pushed growth above its near-term potential, increasing the macro stability risks of inflation, current account deficit, low deposit growth and rise in asset prices, in our view. We believe that going forward the macro stability risks should reduce. The hike of 150bp in the repo rate and 200bp in the reverse repo rate has pushed short-term policy rates up by about 250bp since February 2010. We believe that a steady increase in fixed investments should help to increase capacity. At the same time, the rise in short-term interest rates as well as slight tightening in fiscal policy should help to reduce the macro stability risks over the next six months to some extent.
However, we do believe that the strength of domestic demand, continued rise in global commodity prices, rise in asset prices and consequent impact on inflation expectations for non-tradeable items mean that overall inflation risks remain high. Similarly, the risk of a potential further rise in oil and other commodities could increase the pressure on the current account deficit. Hence, we believe that policy-makers need to stay on course to manage the aggregate demand pressures. We expect the RBI to be back on the rate hike path after three months. The hint in the policy statement that the probability of a rate hike in the near term is low means that we now expect the RBI to hike the policy rate by 25bp by March 2011 compared with 50bp expected earlier.
Taking stock of macro stability risks:
a) Inflation likely to moderate but watch for global commodity prices: The headline WPI accelerated to 8.6%Y as of September 2010, after touching a low of -0.7%Y in June 2009. While food inflation has started moderating, non-food inflation remains high at 7.5%. We believe that a combination of a food price shock due to crop failure and the government's aggressive stimulus has pushed domestic demand higher than capacity, resulting in high inflation. We expect headline WPI inflation to moderate to 6% by end-March 2011. Non-food inflation, on the other hand, should remain around the 6.4% level by end-March 2011 (above the RBI's comfort zone). If commodity prices rise further, it would increase inflations risks.
b) Gap between credit and deposit growth: While bank loan growth was at 20.1%Y as of the fortnight ended October 8, 2010, the deposit growth was low at 15%Y during the same period. The gap between credit growth and deposit growth has been widening until recently. Currently, the banking system loan-deposit ratio is already high at 72.4% as of October 8, 2010. Similarly, the 12-month trailing banking system loan-deposit ratio is already tracking close to 93%. Considering that the statutory liquidity ratio is 25% (this has been reduced by 1% until November 7 as a temporary liquidity measure) and the cash reserve ratio is 6%, we have been highlighting that there is a need to significantly accelerate deposit growth so that the system has adequate liquidity to support this rising credit demand. In that context, we believe that the policy rate hikes are beginning to push banks to hike deposit rates - a step in the right direction, in our view. The risk is that inflation expectations remaining high affects deposit growth.
c) High level of current account deficit: The three-month trailing trade deficit widened to 9.7% of GDP, annualized as of September 2010, from the trough of 4% of GDP, annualized as of March 2009. In the past three quarters (ending June 2010), the current account deficit also shot up to 3.8-4% of GDP. The trade deficit data for the quarter ended September 2010 suggest that the current account deficit would have remained high in the quarter ending September 2010. We believe that this high level of trade and current account deficit reflects the government's aggressive push for higher domestic demand. In other words, the credit crisis-led income shock and current policy approach have pushed the savings rate down and increased the savings-investment gap. However, we think that over the next 9-12 months, as new production capacity is commissioned and the savings rate recovers with a rise in interest rates, the current account deficit will start narrowing. In the near term, however, we believe that risk would remain if capital inflows were to slow down or oil prices were to rise suddenly towards US$100/bbl.
d) Asset prices: The policy statement highlights that"asset prices in India, as in many other EMEs, have risen sharply. The equity market is close to its previous all-time peak level. Residential property prices in metropolitan cities have gone beyond the pre-crisis peak level. Gold prices are ruling at an all-time high level. Although the income levels of households and earnings of corporates in India have continued to rise, a sharp rise in asset prices in such a short time causes concern".
QE 2 May Reduce the Effectiveness of Monetary Policy
Although inflation has been moderating, it remains high. So far, the burden of managing inflation risks has been on monetary policy. After cutting the repo rate by 425bp from the peak of 9% between September 2008 and April 2009, the RBI has lifted it up by 150bp. Short-term market rates have risen by 250bp. However, real interest rates still remain negative and will likely remain very low even as short-term rates rise further and inflation moderates over the next six months. Although, so far, debt-related capital inflows have been manageable, there is an increased risk that these inflows may start rising if the RBI were to tighten monetary policy aggressively. Moreover, as the corporate sector is able to fund itself more easily from the capital market, the ability of monetary policy to influence aggregate demand will be limited. Hence, while we expect the RBI to start hiking policy rates again after a three-month pause, as we mentioned earlier, in the context of US Fed announcing QE2, the effectiveness of monetary policy will be weak in this environment and the burden of managing aggregate demand pressures will be on fiscal policy.
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