Euro area takes huge step towards comprehensive policy package

Euro area heads of state made far more progress than expected at last Friday’s summit. They reached an agreement on a number of elements of the comprehensive policy package which is due to be finalised on March 24/25.

Most important, in our view, was the decision that the cost of liquidity support can be reduced in order to help with debt sustainability. We have argued that the liquidity support that is being provided is too expensive to enable the peripheral sovereigns to achieve anything more than simply stabilise debt-to-GDP ratios at close to the peak levels. Even though the magnitude of the reduction in the borrowing cost envisaged at this stage (100 basis points) is not enough, it is a step in the right direction and it sends a signal that concessional lending could be used to enable the peripheral sovereigns to return to debt sustainability without disruptive debt restructurings.

But, it was also made clear that a lower borrowing cost of liquidity support is conditional on the behaviour of the recipient sovereign. In recognition of the commitments that Greece has made, the borrowing cost of the bilateral loans will be reduced by 100 basis points, and their maturity will be extended from 4 years to 7.5 years. In contrast, due to the reluctance of the new Irish government to discuss raising its 12.5% corporate tax rate, the borrowing cost of the EFSF and EFSM loans to Ireland have been left unchanged.

The comprehensive policy package which will be completed by March 24/25 is due to have five elements: an increase in the size and a broadening of the scope of the EFSF (which will provide liquidity support out to mid 2013); more details on the operation of the ESM (which will provide liquidity support beyond mid 2013); a reformed Stability and Growth Pact (which will guide fiscal policy across the region); a new macroeconomic surveillance framework (which will guide macro prudential and structural policies to limit intra regional imbalances); and a competitiveness pact (which will guide all policies towards lifting growth potential in the region).

Regarding the EFSF, Euro area leaders agreed that its lending capacity will be increased to 440 billion euros, although they did not specify how this would be achieved. In terms of additional functionality, only one thing was agreed: allowing the EFSF to intervene in the primary debt markets. This looks to be an alternative to providing liquidity loans, rather than taking over the role of secondary market support that the ECB has been doing. It looks like the ECB has failed in its attempt to have the EFSF take over this task.

Regarding the ESM, it was confirmed that it will have an effective lending capacity of 500 billion euros and that this will be ensured by a mix between paid in capital, callable capital, and guarantees. It will also have the power to purchase debt in the primary markets, but not the secondary markets.

On the reforms to the Stability and Growth Pact and the new macroeconomic surveillance framework, these will be finalised by the finance ministers before March 24/25.

On the competitiveness pact, Euro area leaders agreed on its broad contours (it is now called the pact for the euro). It is essentially about boosting growth potential in the region, motivated by the idea that ‘competitiveness is essential to help the EU grow faster and more sustainably in the medium and long term, to produce higher levels of income for citizens, and to preserve our social models’. It covers four areas: improving competitiveness (through inter alia a better alignment of wages and productivity, and through higher productivity); boosting employment (through increased flexibility and tax reforms); improving the medium term sustainability of public finances (through inter alia aligning retirement ages with demographics); and reinforcing financial stability (through legislation on banking resolution and regular bank stress tests).

Euro area leaders made some other announcements as well, including an agreement that the introduction of a financial transactions tax should be explored and there is a desire to develop a common corporate tax base.

Even though the final announcement on the comprehensive policy package is still almost two weeks away, the content seems pretty clear. No one should doubt that Euro area leaders are committed to ensuring the survival of the monetary union. On the question of whether sovereign debt restructuring is going to occur, the comprehensive policy package was never going to be able to fully resolve that issue. Whether or not any of the peripheral sovereigns end up restructuring their debt depends on both the extent of the fiscal effort they are willing to engage in and the extent to which the rest of the region is willing to subsidise the liquidity support. Both of these are still unclear, but the rest of the region has now sent a powerful signal that if the debtor sovereigns put in a good faith effort then debt restructurings could well be avoided.

David Mackie