The European Monetary Fund - born under bad signs

One of the concepts of proceeding to deeper European financial integration faces many obstacles. Its main flaw, however, is its timing.

CRISIS-HIT Europe is experiencing the first shock of its financial stability since it introduced the euro. The IMF’s appearance in Hungary, Latvia, Ukraine, Romania and probably in Greece, while disquieting for the EU as an ambitious political bloc, is not (and will not) be able nor authorized to solve the deep-seated structural and financial problems of ailing euro-zone economies.

Having this in mind, this February, two economists, Stephen Mayer (Deutsche Bank) and Daniel Gros (CEPS) published an article calling for the establishment of a European Monetary Fund (EMF). A rescue facility to provide EU member states with external funding when the markets don’t, or only at steep premiums. The authors argued that a higher level of monetary coordination was only possible if the EU challenged one of the contemporary axioms of global financial governance: that a country should never go under. They proposed a mechanism shielding member states from financial difficulties while enforcing stability criteria by punishment.

The idea of the EMF got a high profile when German finance minister Wolfgang Schauble announced in March he would initiate the creation of such an institution at the European level. France and Germany gave their backing to the concept but none of them enthusiastically. Since then, many others have considered the idea of the fund: some endorsed it (e.g. the current patient Greece), while others expressed pessimism (like the UK and Belgium). The European Commission and the European Parliament rushing to sign up to the idea, the ECB remained cautious saying they didn’t see the possible role of such a body, yet adding that the ECB would line up behind the mechanism if EU leaders deemed it necessary.

EU leaders seemed so when mandating European Council President Herman Van Rompuy to form a working group investigating the feasibility of such a facility in the end of March. But in the end, the very same problem (the Greek crisis) that opened Pandora’s box ended up derailing the debate about the initial concept. As a result, the idea has morphed into the image of a cash cow eating up the Germans’ and the City’s reserves.

However, the initial concept outlined a mechanism which largely dwells on the existing European monetary credo, aiming to reinforce and truly implement it. The EMF would have a twofold competence. The first ought to be the consolidation of member state’s financing by funds and surveillance.

The main contributors to the Fund’s reserves would not be the member states with healthy economic indicators, but the countries in breach of the benchmarks of the Stability and Growth Pact (SGP). Each of the renitent countries was to pay an annual 1 per cent of the amount of its current deficit above the 3 pct ceiling set in the SGP. Accumulated reserves would then be invested into A-rated (maybe German or French) bonds.

This would partly eliminate the moral hazard problem, namely that risky countries may further loosen fiscal policies with EMF aid in prospect.

The problem of moral hazard is rather a feature of the pre-EMF landscape, though. Indebted countries like Greece, Latvia or Hungary still hold a major asset their creditors don’t: statehood. Countries are never let go under, as long as the IMF exists, and the EMF doesn’t. An eventual bail-out is always likely to come on debtors’ rescue.

In contrast, in a system ruled by the EMF a country may go on default indeed. Beyond that point, the EMF could take over the management of state debt stock. This would manifest in a massive buy–up of the troubled country’s bonds by the EMF, at a significant discount. SGP rules would be strengthened by this discount (‘haircut’), a slash of toxic bonds’ value to the point where it doesn’t exceed 60% pct of the country’s GDP. This would allow investors to regain up to 20-25 pct of the total (face) value they would otherwise lose on the country’s bonds in case of its non-orderly default. The risk of contagion would be minimised, and the country in plight would be back from the brink. Upon such a bail-out, the renitent country would face rigorous fiscal diet geared at its financial recovery - just like during an IMF operation which may only entail short-term assistance or a one-off credit. In case of ultimate failure to comply with the EMF’s instructions, the country may be expelled from the Eurozone.

Apart from this last, appalling option, the concept offers long-term relief for all the three parties: to the saved country, to the surviving investors, and to the Eurozone as a whole.

The concept’s key appeal is, however, the automatic nature of the mechanism: no votes in the EU’s ECOFIN Council would be needed to enforce renitent members to pay, nor could such a vote break this obligation.

Yet what looks sleek on the drawboard may not always fly. That also holds for the EMF- project facing serious political obstacles right upon its birth.

If every country breaching the criteria of the SGP had to pay fines, the Fund’s assets would swell rather fast. To date 20 members states (including the UK, Germany, France and Italy) are subject to an excessive deficit procedure. Thus many of the member states would qualify for paying high amounts to the EMF every year. ConsensusEconomics, a macro economy watchdog estimates that Italy (a notorious Pact-breaker) should have paid more than €8 bn in 2009, would such a punishment mechanism operate. France, on the same account, would transfer roughly €4 bn to the European finance angel while Greece (trapped between a monstrous public payroll and a debt of around €300 bn) should pay a fine of round 0,55-0,60 pct of its GDP. Such a generous contribution on the score of budget deficit would spark anger in any country of post-crisis Europe. Instead of finding solace in Eurozone membership and gradual (albeit sluggish) economic revival, citizens of Pact-breaching countries would find dismay in punitive fines. Fury is predictable.

Nonetheless, fiscal freedom is a fundamental piece of state sovereignty, thus it is almost impossible to devolve to international, politically detached entitles. Even if there is a will to do this, the EU Treaty’s ’no bail-out’ clause (saying that none of the member states should be forced to bail out another one) remains to overcome. Speaking to Reuters recently, European Central Bank vice-president Vitor Constancio reminded: as long as member states patch up Greece’s financial holes with credits, the danger of violating the ’no bail-out’ clause can not emerge. To contrast, managing debt by buying up a country’s bonds would be a real bail-out, something the EU Treaty excludes.

But be necessary as it may, a treaty change seems unlikely to come any time soon, for Europeans have no appetite for another referendum-nightmare. Lawyers say, if not as an EU-wide institution, the EMF could still evolve as the first example of what the Treaty calls ’coopération renforcée’, an enhanced cooperation involving a smaller group of member states might be joined by others any time. The creation of such a community is possible without uneasy treaty reviews. But such an entity would not be worth creating without Germany and France (let alone the UK), countries giving the most to Europe’s economic weight.

However complicated this issue may be, countries enmeshed into a currency area like the Eurozone can’t tolerate any member’s fiscal meltdown. To date French and German banks hold nearly 70 pct of the Greek bonds the current price of which falls short of par value by some 20 pct on the markets. In case of a Greek default those assets become worthless or extremely illiquid, having serious consequences on the fragile economic recovery in Europe.The looming Greek insolvency affects weaker EU members as well. As predicted by analyst, 10-year Greek bonds’ yields (hitting historical heights of 8.4 pct this week) make other troubled countries’ interest rates climb. Portugal (another potentially weak Eurozone member) now borrows at an unprecedented 4.84 pct interest, as a result of market sentiment fearing contagion. Italy may follow, along with Ireland.

Under such an ominous outlook, creating a common European financial shield and assuring decent fiscal planning sound wiser then ever. It’s probably time for another big consensus in Europe, another rough ride.