Huge debts will put ECB resolve to the test

European equity and bond markets performed well in the second half of 2012. The rally reflected a growing belief that the Euro-Zone and the European Central Bank (ECB) was, at last, taking the correct policy actions. But the financial resources remaining to deal with the crisis may be insufficient.

The major bailout facility -- the European Stability Mechanism (ESM) has total lending capacity of around Ǩ 500 billion. After promised financial assistance for Greece, Ireland and Portugal as well as 100 commitments for the recapitalization of the Spanish banking sector, the ESM has an available lending capacity of around Ǩ 208 billion.

Greece, Ireland and Portugal may need further assistance. As their economies remain weak and market funding is unavailable or expensive, they may need additional funding to meet maturing debt and also finance budget deficits. Spain and Italy may need assistance programs. Spain has debt of Ǩ 800 billion (74 per cent of GDP). Italy has debt of Ǩ 1.9 trillion (121 per cent of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of Ǩ 160 billion in 2013 and Ǩ 120 billion in 2014. Italy has principal and interest repayment obligations of Ǩ 350 billion in 2013 and Ǩ 220 billion in 2014. An effective deposit scheme to deal with capital flight from peripheral countries would need to cover around Ǩ 1-1.5 trillion of deposits, placing a large claim on available funds.

Potential requirements far exceed available resources.

The only other potential source of financial support is the ECB. It has already provided more than Ǩ 1 trillion in term financing to banks through the long-term refinancing operation (LTRO) alone. The ECB has purchased around Ǩ 210 billion in sovereign bonds under the SMP. In July 2012, the ECB announced the outright monetary transaction (OMT) program allowing purchase of unlimited quantities of sovereign bonds. ECB president Mario Draghi announced that: "within our mandate, the ECB is ready to do whatever it takes to preserve the euro."

But the OMT program is conditional. ECB action is contingent on the relevant government formally requesting assistance and agreeing to comply with the conditions applicable to assistance from the ESM/ European Financial Stabilization Facility (EFSF). Instead of avoiding market pressures, the triggering mechanism requires that financing problems of "at-risk" countries get worse before the ECB will act.

ECB purchases will be confined to short or intermediate maturities. This condition is designed to make intervention similar to traditional monetary policy. It is also designed to reduce the cost of bank loans, which are driven by shorter-term interest rates.

The ECB can also nominate a cap on yield or the size of its purchases in advance of any intervention. There is uncertainty as to whether the ECB will relinquish its status as a preferred creditor on such purchases in the event of default or restructuring.

The OMT program revealed significant divisions within the ECB. Jens Weidmann, the head of the German Bundesbank and a former adviser to the chancellor, opposed the measure. Other Euro-Zone members are also known to be uncomfortable.

The ECB president's statements have been dominated by two words: "may" and "adequate." Market analyst Carl Weinberg neatly summarized this as: "A promise to do something unspecified at some yet-to-be-determined time involving yet-to-be-invented programs and institutions, in a yet-to-be-decided way."

The OMT has not been activated to date. The ECB has gambled that the announcement it is prepared to intervene will restore market access of peripheral borrowers and reduce the interest rate demanded by the market. The borrowing cost of weaker countries remains above sustainable levels. But the true access to market remains unclear because of the activity of banks purchasing sovereign debt, which can be financed with the ECB at a profit.

Markets will undoubtedly test the ECB's resolve. As Yogi Berra knew: "In theory there is no difference between theory and practice. In practice there is."

Satyajit Das is a former banker, author of Extreme Money and Traders Guns & Money and a consultant to Jory Capital.

Republished from the Winnipeg Free Press print edition February 19, 2013 B6