Special Report-EU/IMF and G-7 to the rescue |
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Written by Michael J. Malpede
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Monday, 10 May 2010 18:38 GMT
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To try and calm investor fears and help stabilize the global markets the EU/IMF announced a near $1trln rescue plan. The plan includes guarantees and loans, European central bank purchases of bonds and a pledge from G-7 central banks to reopen swap lines in Europe to help alleviate USD funding strains. According to a Reuters report the package consists of €440bln in guarantees from Euro states plus €60bln in a European emergency stabilization fund. The IMF will contribute up to €250bln. European central banks began the purchase of bonds Monday. The bond purchases helped to half the cost of debt financing in peripheral European nations and boost demand for the EUR. Global equity and commodity markets surged in reaction to the announcement of the rescue plan. The EUR initially rallied above 130 in reaction to the announcement of the rescue plan and backed off into the mid 128 level in the US session. The Fed and other G-7 central banks pledged to provide liquidity to offset USD shortages in Europe. This is the biggest coordinated G-20 rescue plan since Lehman Brothers crisis in 2008.
The big question is whether today's announcement of a rescue plan for Europe will have lasting impact on the EUR and goes far enough to help resolve the EU sovereign debt crisis? The EU fiscal troubles cannot be easily fixed. For EU nations to qualify for the guarantees and loans they must pledge to adopt significant austerity measures. This means that the solution for the EU to crisis could be to significant drag on the EU recovery. Other peripheral European nations may be reluctant to seek aid because of the austerity requirements. A second concern is the impact of the massive infusion of liquidity on the price stability and ECB credibility. In reaction to this concern ECB President Trichet reaffirmed ECB independence and said that the ECB did not act because of pressure from EU leaders. It remains to be seen whether investors accept Trichet's explanation. The bond purchases increase the risk of inflation if the ECB does not act to mop up liquidity in a timely fashion. Slower EU growth and inflation risk are potential long term negatives for the EUR.
The fact that the rescue plan was coordinated with the G-7 and includes bond purchases should help the EU buy some time to allow indebted nations to take action to reduce the deficits and restructure debt without continuous speculative assault on the bond markets and EUR. The head of the IMF Strauss Kahn says the aid should work and he believes that the EU stabilization mechanism can provide resources to EU nations in need of funding relief. If the cost of funding continues to fall in reaction to the European central bank purchase of bonds weaker European nations like Portugal, Ireland and Spain may not need to draw upon the stability mechanism. The Fed's purchase of long-term debt and MBS securities after the Lehman crisis helped to drive funding costs lower, boost the economy and help stabilize the housing market. The EU/IMF rescue plan may have similar impact on EU financial markets. Investors will be watching to see whether countries like Portugal, Ireland and Spain find it necessary to seek support from the EU. If not, the EU/IMF may succeed in containing systemic risk from the Greek debt crisis. This however does not mean that the road to deficit reduction in Europe in the years ahead will be easy. It is far from certain that Greece can deliver on its austerity pledge. If Greek austerity measures fail a Greek debt default may emerge in the months ahead. We do not see the today's rescue plan as bullish for the EUR but it may be enough to stop some of the short-term selling pressure of the currency. In the near term the ECB is likely to try and defend EUR above 1.27.
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