Bank Sarasin calls for European Stability Mechanism access to the European Central Bank and supports the concept of a European redemption fund18.06.2012
In its latest Macro Focus, "What policy makers must do!", Bank Sarasin calls for the permanent rescue fund, the European Stability Mechanism (ESM), to be given access to the European Central Bank (ECB). According to Bank Sarasin, transforming the fund into a bank would dramatically increase its firepower, helping to calm markets. The Bank also supports the German Council of Economic Experts' concept of a European redemption fund because it would give the markets what they want - a comprehensive financing guarantee from the euro core to the peripheries combined with strong conditions that would ensure budget consolidation.
Bank Sarasin calls for Euroland politicians to act given that core Europe is now in crisis, as demonstrated in the chart below. Economic sentiment in Italy has now almost sunk to the level reached during the Lehman crisis. Sentiment in Spain is in deep decline. Germany and France are following the downward trend. Without measures to counter plunging sentiment, Euroland will fall into deep recession.
Weakening economic sentiment
Source: Thomson Reuters Datastream
Jan Poser, Chief Economist, Head of Research and Chief Economist at Bank Sarasin
"Euroland is in economic freefall. Without measures to counter this situation, it will slide into a deep recession. Both ESM access to the ECB and a European redemption fund would avert this crisis and calm financial markets. Instead of passing the buck, European politicians need to make productive decisions. We do expect that a compromise will be reached and that Euroland will be pulled out of this recession."
What will work
Bank Sarasin is calling for the ESM to be given access to the ECB. The current rescue umbrella is too small to provide Italy and Spain with a credible defense. Transforming the fund into a bank would increase its firepower, which would help to calm markets.
The European redemption fund proposed by the German Council of Economic Experts is also a promising initiative. As a temporary, partial mutualisation of debt, it would give the financial markets what they want - a comprehensive financing guarantee from the euro core to the periphery, combined with strong conditions that ensure budget consolidation. Risk premiums for the remaining national debt would therefore decrease rapidly. Interest rates for the redemption fund would be low because the newly established market would have sufficient liquidity at about EUR 2.3 trillion.
The European redemption fund would allow euro countries to refinance the portion of their debt that exceeds the Maastricht limit of 60% of GDP, with the community liable for new debts placed with the fund. The fund would eventually dissolve itself since all countries would commit to a strict financial consolidation programme to reduce their debt to 60% of GDP over 25 years. Each debtor would guarantee their debt with a 20% deposit paid in gold reserves. Surplus revenues generated by national taxes to pay this debt would be paid to the fund and not flow to national budgets.
What won't work
First, interest rate cuts, while symbolic, would not be sufficient. The ECB can only lower rates by another 100 basis points and the actual financing rate is already close to zero. Second, the Securities Market Programme (SMP - government bond purchases to dampen rates on Spanish and Italian bonds) is a double-edge sword. Because the ECB did not participate, private-sector creditors were forced to take a big haircut, reinforcing the market's impression that bond purchases by the ECB were senior to privately-held bonds.
Third, the proposal for a pan-European deposit guarantee not only misses the point but is actually dangerous. If savers' panic is not based on concerns about the banks but a euro exit, such a fund will not stop the run on deposits because, in this case, the deposit guarantee would be converted into the new local currency. If a euro guarantee was extended to southern Europe, it would give the electorate an incentive to vote for a euro exit.
Fourth, while another long-term liquidity injection (Long-term refinancing operation or LTRO) would provide the banking system with sufficient long-term liquidity, the two LTROS in December and February only had short-term impacts and did not address the underlying issues. While this sticking plaster can be used to prevent the worst, it is not a cure.