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from Breakingviews:

How Europe can get more bang for its bailout buck

By Peter Thal Larsen.

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Europe's bailout fund is no longer fit for purpose. As the euro zone's sovereign debt crisis has spread to Spain and Italy, the 440 billion euro fund looks increasingly puny. Expanding it is politically tricky. But using the EFSF's remaining firepower to guarantee new sovereign debt would give it more clout -- and buy some time.

The euro zone overhauled the EFSF at its July summit. But it has already been overtaken by events. After subtracting the sums it has agreed to lend to Ireland, Portugal and Greece, the EFSF probably has about 300 billion euros left. That might just pay for a Spanish bailout, but is nowhere near enough to help Italy. And if the EFSF bought government bonds in the market at the same rate as the European Central Bank is currently doing, it would run out of cash in five months.

Expanding the fund's capacity, or leveraging it up by turning it into a bank -- an idea touted by Tim Geithner, the U.S. Treasury Secretary -- would require another round of government approvals. That's a political non-starter.

A more feasible idea, which is being actively discussed by European policymakers, is for the EFSF to guarantee new issues of sovereign debt. For example, the fund could indemnify investors against losses on the first 20 cents of every euro of new debt. That would allow the EFSF to guarantee debt worth five times its current capacity -- or 1.5 trillion euros. Assuming the yield on the insured bonds was similar to the EFSF's current borrowing costs, the scheme would allow Spain and Italy to borrow at well below current market rates -- even after adding a chunky fee.

The scheme is not fool-proof. Investors might conclude the guarantee wasn't big enough to prevent losses, and that other governments might not be able to come up with the cash in the event of a default. Providing guarantees would make the EFSF's funds more risky, which might undermine its credit rating. However, of all the ideas that have been put forward to bolster the EFSF, the guarantee scheme is one of the few that could actually be implemented soon. For that reason alone, it is worth a try.

from The Great Debate UK:

Geithner’s fudge won’t kill the euro zone debt Ouroboros

U.S. Secretary of the Treasury Timothy Geithner (R) leaves after talks with Polish Finance Minister Jacek Rostowski in Wroclaw, September 16, 2011. Geithner urged euro zone ministers to leverage their 440 billion euro bailout fund and free more resources to tackle the debt crisis. REUTERS/Mieczyslaw Michalak/Agencja Gazeta

The frosty reception given to US Treasury Secretary Timothy Geithner at the ECOFIN meeting in Poland last week tells you all you need to know about what is wrong with the EU. The hostility was directed not at the feebleness of the advice he had to give, but at the right of an American passport-holder to offer any advice at all to the policymaking elite of Europe, who are so obviously capable of handling the crisis themselves without any outside assistance.

As far as I can tell, Geithner’s proposal amounts to leveraging the EFSF so that it can be inflated to a level sufficient to assure the markets that it has the resources to do the enormous job it has been given: bailing out Greece, Ireland, Portugal,  Spain, probably Italy and maybe even France at some point.

So, as ever, the American solution to the problem of excess leverage is… even more leverage. Financial wizardry is what Europe needs now – after all, it worked so well last time around… Risks? What risks? The additional borrowing will be guaranteed by the ECB, whose credit is cast-iron, so problem solved. Why did it take them so long to come up with an answer? If only it were so easy. Ask yourself: why is the ECB so creditworthy in the first place?

Not, in the final analysis, because its borrowing is backed by the governments of Greece or Portugal or Spain or Italy, nor even because it is backed by the Netherlands or Finland – however fiscally responsible they may be, they are simply too small to stand behind Europe’s central bank. In a crunch (and if we ever doubted that crunches happen, we know now that they do) even French support could be inadequate, given that it is currently running a sizeable budget deficit and faces a presidential election in a few months.

No: there are two meaningful levels of support that give the ECB its pristine credit status.

from Lawrence Summers:

The perils of European incrementalism

By Lawrence H. Summers The views expressed are his own.

In his celebrated essay “The Stalemate Myth and the Quagmire Machine,” Daniel Ellsberg drew out the lesson regarding the Vietnam War that came out of the 8000 pages of the Pentagon Papers.  It was simply this:  Policymakers acted without illusion.  At every juncture they made the minimum commitments necessary to avoid imminent disaster—offering optimistic rhetoric but never taking steps that even they believed offered the prospect of decisive victory.  They were tragically caught in a kind of no man’s land—unable to reverse a course to which they had committed so much but also unable to generate the political will to take forward steps that gave any realistic prospect of success.  Ultimately, after years of needless suffering, their policy collapsed around them.

Much the same process has played out in Europe over the last two years.  At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the quagmire machine.  They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.

The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions.

A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  There are many differences between the environment today and the environment in the Fall of 2008 or any other historical moment.  But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.

To her very great credit, new IMF managing director Christine Lagarde has already pointed up the three principles any approach to Europe’s financial problems must respect.  First, Europe must work backwards from a vision of where its monetary system will be several years hence.  The reality is that politicians have for the last decade dismissed the widespread view among experienced monetary economists that multiple sovereigns budgeting and bank regulating independently will over time place unsustainable strains on a common currency.  The European Monetary Union has been a classic case of the late Rudiger Dornbusch’s dictum that “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”  So it has been with the buildup of pressures on the Euro system.

There can be no return to the pre-crisis status quo.  It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance, and equally apparent that when banks and sovereigns do not have access to lender of last resort financing the risk of self fulfilling confidence crises becomes substantial.  The respective responsibilities of the ECB, financial regulatory authorities and EU officials can be defined in different ways.  But there must simultaneously be an increase in the central financial commitment to the financial stability of member states and reduction in their financial autonomy if the common currency is to survive.

from Breakingviews:

China’s friendly blackmail of EU may do the trick

By John Foley The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s no surprise that China’s pledges of support for indebted trade partners come with strings. But Premier Wen Jiabao, addressing the World Economic Forum on Sept. 14, was unusually blunt about what he expects in return: to be named by Europe as a market economy. That would cost Europe little -- but that doesn't mean it should agree.

Chinese investment must look more appealing as stricken euro zone states like Italy, Greece and Spain face up to the possibility investors will refuse to finance their deficits. Italy’s gouging by bond markets on Sept. 13 gives a taster. Just a drop of China's $3.2 trillion in foreign exchange reserves would give troubled countries a reprieve, and help lower their bond yields.

Market economy status is, on the face of it, an easy thing to give in return. After all, it's just a label. But without it, countries can accuse China of dumping goods, and then use other countries’ prices -– say, India’s energy prices or Thailand’s land costs -– to prove their point. Under World Trade Organisation rules, China gets market status anyway in 2016, but as Wen says, bringing that forward a few years is the kind of thing one might expect "from one friend to another."

Perhaps. Only China isn’t a market economy -– it’s a “socialist market economy.” Some important hallmarks aren’t there. The exchange rate is guided more by policy than market forces. Capital is allocated by decree rather than just by price. True, China isn’t the command economy it was under Chairman Mao. But the suppressed rate on deposits, for example, or the inflated lending rates for small companies, show that not everything is pure supply and demand.

So while Europe could give China what it wants -– and it has flexed the “market” definition before for Russia -– it’s hardly a commendable course. Far better for Europe’s leaders to get their own house in order, including planning for a Greek default and pushing Italy to cut back its debts. That might sound like harder work. But it would have the added appeal of making China’s veiled ultimatums redundant.

from Breakingviews:

Italian mega-tax would be game-changer

By Hugo Dixon The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

An Italian mega-tax would be a game-changer. A one-off wealth tax of 400 billion euros, as proposed by the former UniCredit boss, Alessandro Profumo, would solve Italy’s debt problem, thus helping reverse the euro crisis in general. Italians are so wealthy, they could afford it. They certainly have no business asking for help from the Germans, who are actually poorer. But before such an idea has a hope of being implemented, Silvio Berlusconi would first need to be turfed out.

Italian entrepreneurs, including the head of Confindustria, the business lobby, have reacted surprisingly well to Profumo’s idea. Part of the reason is that every week Italians are effectively suffering a wealth tax as a result of plunging domestic stock and bond markets. The latest austerity programme, which would balance budgets in 2013, hasn’t stopped the rot. Even media reports that Italy was cosying up to China in the hope of getting it to buy bonds hasn’t helped. Yields rose again on Sept. 13 after a poor bond auction.

So getting the agony over with has some appeal to Italy’s wealthy. The 400 billion euros that Profumo proposes would cut national debt from 120 percent of GDP to below 100 percent. That would change market psychology. Equity and bond prices might rebound -– meaning that investors might gain more on the market swings than they lost on the tax roundabout.

What’s more, Italians are frankly quite rich enough to bail out their own government. The latest Bank of Italy data shows that net wealth was 8.6 trillion euros or 566 percent of GDP in 2009 –- more than Germany’s 6.1 trillion euros (or 246 percent of GDP) in 2008. Even if a wealth tax was focused on the richest people, a one-off tax of 10 percent, collected over a few years, should do the trick.

Profumo hasn’t just pushed the tax idea; he’s offered to enter politics to implement it as part of a coalition government. Sadly, that can only happen if Berlusconi quits and, despite all the judicial scandals and economic mismanagement, he is still clinging onto power.

from Lawrence Summers:

Europe’s dangerous new phase

By Lawrence H. Summers The opinions expressed are his own.

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama surrounding bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change in direction but if not, the world can no longer afford the deference that the IMF and non-European G20 officials have shown towards European policy makers over the last 15 months.

Three realities must be recognized if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank (ECB) is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed because time had passed since the Bear Stearns bailout the market had learned lessons and so was prepared. In fact the main lessons learned had to do with how to best find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates become likely insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland and is in danger of happening in Italy and Spain. (See interactive graphic.)

Debtor countries can only reduce their debts by running surpluses vis-a-vis the rest of the world. If traditional debtor countries are going to start running surpluses, traditional surplus countries must be willing to reduce their surpluses or move towards deficits.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring taken alone will address a growing general confidence crisis.

from Breakingviews:

China makes an uneasy saviour for Europe

By John Foley The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

HONG KONG -- Expectations that China will help fix the euro zone are writ large as Wen Jiabao, the premier, visits Hungary, Britain and Germany. No wonder: the single currency aids Chinese exports, and buying periphery debt may help win friends on other issues. While China appears to have much to gain, the support isn't wholly likeable from Europe's perspective.

China has a keen interest in the health of the euro. For one thing it provides a counterbalance to the U.S. dollar. Second, it prevents member states from deliberately holding down the value of their currencies to promote exports, as China has done. The effect is marked: China's trade surplus with the EU swelled by a third in 2010.

China's interest in the sovereign debt of stricken euro zone countries is real enough, too. While the details of its holdings of foreign debt aren't made public, Wen Jiabao pledged to buy Greek bonds in October 2010, and unidentified Asian buyers have taken part in some sales of European "stability facility" bonds.

This isn't just charity: yields on European debt outstrip U.S. bonds and investors could make bundles if -- if -- defaults do not happen. Besides, China's largesse may win support on other issues. A long-standing bugbear is the EU's block on military supplies to China. The desire to lift the embargo may explain the release of imprisoned artist and activist Ai Weiwei the day before Wen Jiabao set out on his tour.

If China really wanted to help Europe out, it would look to its own currency rather than the euro. While the yuan has appreciated against the dollar over the last twelve months, it has slid 10 percent against the euro and 13 percent against the Hungarian forint. Talk of supporting the eurozone may have perversely strengthened the euro still further.

Europe would have had more leverage when China depended on it for investment capital. Now the shoe is on the other foot; China's much needed assistance makes it harder for the Western trading bloc to push for the things that would really help -- like balanced trade. Wen's support may be genuine, but that doesn't mean it's entirely welcome.

from Summit Notebook:

When debt monetisation makes sense

If push comes to shove and Japan runs into difficulties finding buyers for its low-yielding government bonds, a little debt monetisation -- a dirty word for central banks -- would not be a bad thing.

Tomoya Masanao, managing director and head of Japan portfolio management at PIMCO, told the Reuters Rebuilding Japan Summit that if private investors are not willing to buy JGBs, then the central bank should fill the breach.

"If the Japanese private sector does not have enough ability to fund the government, it's natural that the central bank should step in," Masanao said.

Such a move would weaken the currency, and that would be a positive for an economy that is now grappling with a strong yen on top of the many other economic challenges it is facing.

For now, Japan faces no such threat of private investors being unable to lend the government a hand. As Masanao noted, Japanese corporations and households tend to save even more money when the fiscal deficit rises -- as is almost certain as government reconstruction spending kicks in after the massive March 11 earthquake, tsnuami and nuclear scare. Indeed, a chart below shows the remarkably strong relationship between government borrowing and household savings over the years.

Benchmark Japanese government bond yields are hovering near 1 percent and have only breached the 2 percent threshold twice since falling below that level in 1997. As the population ages, household savings rates have fallen. But with household financial assets at $18.5 trillion -- and a little more than half of that kept in cash and low-yielding bank deposits -- the supply of funds heading into JGBs remains ample, even with debt set to surpass 200 percent of Japan's $6 trillion GDP this year.

With the euro zone debt crisis raging more than a year later, the question of whether Japan faces its own debt crisis has been hotly debated. Still, the trigger for any Japan debt crisis remains far off and will be of a much different nature than Europe's troubles. Beyond its savings, Japan enjoys steady trade surpluses (despite the record deficit coming out of the disaster), and for that reason does not rely on foreign investors . Of course, the Bank of Japan already buys a hefty chunk of government bonds, even while arguing this does not equate to monetisation and fighting against any pressure to monetise.

from Breakingviews:

Euro zone crisis may be close to resolution

By Hugo Dixon The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

DAVOS, Switzerland -- The euro zone crisis may be close to resolution. There is certainly optimism among policymakers at the World Economic Forum in Davos that a comprehensive deal -- involving more discipline by peripheral nations and more help from rich nations -- could be put together in coming weeks. If so, the hot phase of the crisis could be over and even Greece would have a fighting chance of getting out of the woods.

There is still no deal. But the stars seem to be coming into alignment. Germany, the zone's paymaster, clearly realises that it has a strong interest in the single currency holding together -- and will do what is needed to make that happen. Peripheral nations also seem to be willing to go an extra mile to give Berlin enough air cover to sell further help to the German people.

The basic bargain would involve more generous terms for loans to indebted countries, especially Greece, balanced by hard-and-fast promises not to run up debts in the future. The countries are discussing some form of "debt brake", a provision embedded in the German constitution which forces it to balance its budget in the medium term. Such self-denial could, indeed, be a healthy mechanism for all countries to adopt.

Meanwhile, two changes could be made to make even Greece's debt burden -- which is officially forecast to peak at just under 160 percent of GDP -- more bearable. The first would be to buy back chunks of its debt in the secondary market at a discount and pass the benefit onto Athens. If, say, a quarter of its debt could be acquired at a 20 percent discount, the peak ratio would fall by 8 percentage points. Not huge, but helpful. More importantly is the idea of cutting the interest rate on the debt. If the country was able to fund itself at below 5 percent, the annual interest payment would be below 8 percent of GDP.

Even with such a package, Greece would still face a massive uphill struggle to boost its competitiveness. It would still need to push through aggressive moves to tackle rampant tax evasion. And it would still need to punish those who have looted the public purse in recent years -- otherwise, the general population will not be willing to endure the years of hardship ahead. But there is a narrow path the country could tread back to long-term health.

It will also be important to stop further dominoes falling, especially Spain. Madrid had a golden opportunity earlier this week to draw a line in the sand by coming up with its own comprehensive solution for its troubled savings banks, the cajas. It flunked it by saying that a maximum of 20 billion euros would be needed -- significantly less than the market consensus. But it is not too late to remedy the error. Spain's euro zone partners should pressurise it to make crystal clear that there is more money if needed. If a proper clean-up of the region's troubled banks is also part of a comprehensive solution, the euro zone will indeed be able to look forward to better times.

from Eric Burroughs:

The curiosities of euro zone CDS and pricing insolvency

One of the most striking aspects of the whole euro zone crisis has been the slow process by which credit and interest rate pricing converged. Say what? In short, in the early 2010 days of the crisis the CDS market began pricing government bonds as credit risk in a way the individual government bond markets were slow to recognize and appreciate. The real flare-up in the crisis happened when those two risks -- credit and interest rate -- converged. Since the May bailout for Greece, CDS and peripheral yield spreads have mostly tracked each other, especially since Germany's unilateral short selling ban on sovereign CDS/bonds caused a mini freak-out. Now, it's getting messy and curious.

Exhibit 1 is the difference between Spanish sovereign CDS and Spanish/German five-year yield spreads, otherwise known as the credit basis. There shouldn't be a big difference in these spreads because they ultimately gauge credit risk, just in different markets. Until the euro zone crisis really flared up last year, CDS spreads were leading. But all of a sudden, yield spreads are the ones leaping higher even as the most liquid five-year CDS spread stays below record peaks. Does that mean cash bonds are taking the driver's seat in this move?

Not necessarily. Just look at the latest crisis target, Belgium. It's not exactly news that Belgium is on the verge of splintering and no longer existing, potentially turning the heart of the European super-sovereign -- Brussels --  into a city-state. But that seemed to be enough to prompt a full attack by hedge funds knowing the blood in the water and seeking to exploit the coutry's and region's problems. But the 65 basis point spread difference between the CDS spread and the government bond yield spread seems a bit excessive. If anything, it shows the CDS hedgers/specualtors are being more aggressive with Belgium than they are with Spain -- a bigger target who has secured some backing from China. And it just goes to show that both cash bond spread moves should be taken with a certain grain of salt, as should the CDS moves.

Then there is Ireland. In the past week the CDS curve has inverted anew, suggesting that investors see a greater risk of default in the next one to three years despite the bailout that last November (the chart below shows the Irish one-year CDS spread in blue, five-year spread in maroon and net notional volume written on Irish sovereign CDS in orange). Europe is clearly struggling to contain these latest troubles. The market pricing suggests, as one macro hedge fund manager recently said, that liquidity is at a premium no matter the market. Plus with the European Central Bank spreading its intervention, it's getting even tougher to price euro zone credit risk as the bond buying spreads from country to country. One reason why Spain and Belgium are seen as more pure proxies at the moment is because the ECB has not yet spread its intervention into those bonds. Yet even with the ECB intervention, both Greek and Irish one-year CDS spreads have edged above benchmark five-year spreads, though the widest spread on the curve remains the three-year. So the market is pricing in a greater risk of default on a one-year horizon than a five-year horizon (inverted credit curve), with the greatest risk at the three-year horizon, roughly matching the 2013 EFSM EFSF expiry. That just goes to show the rising expectations that a debt restructuring of some kind may be in store for banks and debt investors, and if not that a default is becoming more probable in the short-term. Keep in mind the European Commission pretty much exonerated the sovereign CDS market of being the main drivers of the crisis.