Mario Blejer and Eduardo Levy Yeyati – Economy Watch

Europe’s Fate Rests In The Hands Of The ECB: Mario Blejer & Eduardo Levy Yeyati

Mario Blejer and Eduardo Levy Yeyati — Tue, 14 Feb 2012 08:01:43 +0000

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The ECB’s recent decision to lend unlimited funds to eurozone commercial banks at very low rates acknowledges the need to address a core drawback in the euro-architecture: the ECB itself. However the banks use the money, it is now clear that the eurozone’s future will be determined largely by the ECB.

BUENOS AIRES – Many observers have recently declared that the eurozone debt crisis is practically resolved, or at least on hold for a few years. The falling yields at the Italian government’s last bond auctions in 2011 suggested a significant reduction in the perceived sovereign-default risk. Since Italian bonds are regarded as the bellwether of the crisis, many interpret this is a sign that the European debt market is normalizing.

The “solution” to the crisis was putatively facilitated by the European Central Bank’s decision to lend unlimited funds to commercial banks for three-year terms at very low rates. But a central bank would normally do even more to fulfill its role as lender of last resort. So why all the renewed optimism?

The immediate answer is that national banks will now use the scheme to borrow cheaply from the ECB and invest in short-term sovereign bonds, using the interest-rate spread to create a profitable “sovereign carry trade.” Despite the inefficiencies and distortions arising from such monetary financing, the ECB may indeed provide some breathing space for governments.

[quote]But the real reason why this otherwise standard policy decision seems like such an important step is that, for the first time, the ECB has recognized the need to address a fundamental flaw in the eurozone’s architecture: the ECB itself.[/quote]

At the core of the problem is currency. In the 1990’s, emerging-market crises were first and foremost currency crises: sharp corrections of overvalued currencies that bankrupted public and private sector debtors.

By contrast, the currency issue in the European crisis is difficult to pinpoint. Is Italian euro debt denominated in local or foreign currency? Whose currency is the euro? And whose central bank is the ECB? These questions are key to the European predicament. Indeed, the possible answers suggest two very different versions of the eurozone.

One version of the eurozone conceives it as a unity, externally and fiscally balanced, and with a fully functioning monetary union. It is also heavily indebted, but in domestic currency. The alternative conception assumes that the eurozone is a group of individual countries within a common currency area. Most of the countries are unbalanced and are indebted in a currency (the euro) that they cannot print on demand. This is equivalent to foreign-currency debt.

In the first version (the euro crisis minus the currency problem), the scenario looks more like the United States than like Latin America in the 1990’s (with Italy resembling California rather than Argentina). In the second version, however, the eurozone saga is comparable to the emerging markets’ story. Like a dysfunctional family, the northern “advanced” countries ponder whether or not to bail out the southern “emerging” economies.

The prognoses for each case are starkly different. In the former version, interest rates converge and the default risk is nil, because, with the ECB backstopping its members’ liabilities, as the Federal Reserve does in the US, the euro becomes “local currency.” And how often do we hear about sovereign restructurings of local-currency debt?

In the latter version of the eurozone, there is differential credit risk and, ultimately, bank runs, de-euroization, and default: the common currency is at odds with the needs of the member states.

[quote]Which of these two alternatives should prevail is a question for eurozone members to decide. But two things are clear. First, the eurozone’s future will be determined largely by the ECB’s role. Second, there is little flexibility – European policymakers cannot overcome the crisis if they do not eliminate the currency problem and the resulting default risk.[/quote]

This helps to explain the misgivings about the International Monetary Fund’s massive aid to the region. Why would the IMF lend Europe special drawing rights (the Fund’s unit of account), rather than euros, thereby creating a currency imbalance? Such an imbalance is at the root of all emerging-market crises; the IMF’s actions therefore suggest that Europe is already giving up on the euro.

Today, the euro faces a fork in the road. One route, a currency area without sovereign backstopping, will lead to debt, currency crises, and the eurozone’s dissolution. The other, a monetary union with a proper central bank, internal fiscal transfers, and active, regionally-oriented monetary policy, will lead to a slow but steady recovery without default.

Clearly, to paraphrase Robert Frost, the road taken will make all the difference. For that reason, the euro’s fate lies not in Athens, or in Rome, but at the ECB’s headquarters in Frankfurt.

By Mario Blejer and Eduardo Levy Yeyati

Copyright: Project-Syndicate, 2012

Mario I. Blejer is a former governor of the Central Bank of Argentina and former Director of the Center for Central Banking Studies at the Bank of England. Eduardo Levy Yeyati is Professor of Economics at Universidad Torcuato Di Tella and Senior Fellow at The Brookings Institution.

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The post Europe’s Fate Rests In The Hands Of The ECB: Mario Blejer & Eduardo Levy Yeyati appeared first on Economy Watch.

Why The IMF Must Stay Out Of Europe’s Crisis: Mario Blejer & Eduardo Levy Yeyati

Mario Blejer and Eduardo Levy Yeyati — Mon, 05 Dec 2011 08:43:18 +0000

Please note that we are not authorised to provide any investment advice. The content on this page is for information purposes only.

Europe, it seems, is determined to resolve its problems using other people’s money. But there are at least three reasons why the IMF should resist this pressure, and abstain from increasing its (already extremely high) exposure to Europe.

BUENOS AIRES – A short-lived rumour recently suggested that the International Monetary Fund was putting together a €600 billion ($803 billion) package for Italy to buy its new government about 18 months to implement the necessary adjustment program. Except for the magnitude of the package, this sounds no different from a standard IMF adjustment program – the kind that we are accustomed to seeing (and criticizing) in the developing world. But there is one crucial difference: Italy is part of a select club that does not need outside rescue funds.

[quote]So far, programs for the eurozone periphery have been spearheaded and largely financed by European governments, with the IMF contributing financially, but mainly acting as an external consultant – the third party that tells the client the nasty bits while everyone else in the room stares at their shoes.[/quote]

By contrast, the attempt to crowd multilateral resources into Europe was made explicit by eurozone finance ministers’ call in November for IMF resources to be boosted – preferably through debt-generating bilateral loans,– so that it could “cooperate more closely” with the European Financial Stability Facility. That means that the short-lived story of Italy’s jumbo IMF package, which was to be funded largely by non-European money, can be regarded as a game changer: while Italy may never receive such a package, Europe, it seems, is determined to resolve its problems using other people’s money.

There are at least three reasons why the IMF should resist this pressure, and abstain from increasing its (already extremely high) exposure to Europe.

First, and most obviously, Europe already has its own in-house lender of last resort. The European Central Bank can make available all the euros needed to backstop Italy’s debt. And printing them would only offset, through mild inflation, the effects of the otherwise Draconian relative price adjustment that is taking place under the corset of the common currency.

[quote]So it is puzzling that some observers have saluted the IMF’s involvement as a virtuous effort by the international community to bring the listing European ship to port. Why should the IMF (or, for that matter, the international community) do for Europe what Europe can but does not want to do for Italy? Why should international money be mobilized to pay for European governance failures? [/quote]

And if, as appears to be the case, Germany is playing a dangerous game of chicken with some of its eurozone partners, why should the cost be shifted to the IMF for the benefit of Europe’s largest and most successful economy? Letting the ECB off the hook in this manner would simply validate for Europe as a whole the same moral hazard feared by German and other leaders who oppose ECB intervention.

The second reason to avoid IMF intervention in Europe is that lending to a potentially insolvent country has serious implications for the Fund. For starters, taking the IMF’s preferred-creditor status at face value, an IMF loan would entail substituting its “non-defaultable” debt for “defaultable” debt with private bondholders, because the Fund’s money is used primarily to service outstanding bonds. As a result, a group of lucky bondholders would be bailed out at the expense of those that became junior to IMF debt and remained highly exposed to a likely restructuring. Since a “haircut” can be imposed only on whatever is left of the defaultable private debt, the larger the IMF share, the deeper the haircut needed to restore sustainability.

For the same reason, IMF loans can be a burdensome legacy from a market perspective. Because they represent a massive senior claim, they may discourage new private lending for many years to come.

This brings us to the third reason why the IMF should stay out of Europe’s crisis: what if Fund seniority fails? The implicit preferred-creditor status is based on central-bank practices that establish that the lender of last resort is the “last in and first out.” It is this seniority that enables the IMF to limit the risk of default so that it can lend to countries at reasonable interest rates when nobody else will. This works when the IMF’s share of a country’s debt is small, and the country has sufficient resources to service it.

[quote]But seniority is not written in stone: poor economies that are unable to repay even the IMF are eligible for debt reduction under the Heavily Indebted Poor Countries program, and 35 have received it since the program was established in 1996. What would happen if, in five years, Italy were heavily indebted to the IMF? What if private debt represented a share so small that no haircut would restore sustainability, forcing multilateral lenders to pitch in with some debt relief?[/quote]

The IMF’s seniority is an unwritten principle, sustained in a delicate equilibrium, and high-volume lending is testing the limit. From this perspective, the proposal to use the IMF as a conduit for ECB resources (thereby circumventing restrictions imposed by European Union’s treaties), while providing the ECB with preferred-creditor status, would exacerbate the Fund’s exposure to risky borrowers. This arrangement could be seen as an unwarranted abuse of Fund seniority that, in addition, unfairly frees the ECB from the need to impose its own conditionality on one of its members.

It makes little sense for the international community to assume that unnecessary risk. Let us hope that the IMF’s non-European stakeholders will be able to contain the pressure. The solution for Europe is not IMF money, but its own.

By Mario Blejer and Eduardo Levy Yeyati

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