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The DZ Bank Roundtable: The European Rescue Package

01 Sep 2010

In early May, agreement was reached on the establishment of the European Financial Stability Facility (EFSF) in order to protect the euro and to "financially support euro-area member states in difficulties".

Formally set up in Luxembourg on July 1, the EFSF is backed by guarantees from euro member states of up to Eu440bn which can be activated at the request of a eurozone member state, with any support provided being conditional on the member state signing an MOU "in relation to budgetary discipline and economic policy guidelines".

The EFSF complements the Eu60bn European Financial Stability Mechanism (EFSM) under which the EU can provide support to member states with balance of payment difficulties. The two programmes can be supplemented by the IMF, bringing the total size of the rescue package for Europe to Eu750bn.

According to the Framework Agreement on the EFSF, the facility will finance the provision of loans via the issuance of "bonds, notes, commercial paper, debt securities or other financing arrangements" backed by unconditional and irrevocable guarantees from the 16 participating member states. These guarantees are provided on a pro-rata schedule based on the participants’ paid-up capital to the ECB. Germany is the largest of these, accounting for 27.13% of eurozone members’ contributions to the ECB’s capital. Malta, accounting for 0.09%, is the smallest.

If the facility is activated, Germany’s debt management office — the Frankfurt-based Finanzagentur — will manage the issuance programme on behalf of and in the name of the EFSF.

The origins of this package and the challenges and opportunities that lie ahead for the EFSF and the EFSM were discussed at the DZ BANK roundtable which took place in Frankfurt in late August. Participants were:

Herbert Barth, head of unit, borrowing, lending, accounting and bank office department, European
, LuxembourgStefan Bielmeier, managing director, head of research and chief economist, DZ BANK, FrankfurtCarl Heinz Daube, managing director, Deutsche
, FrankfurtLuc Everaert, chief of euro area and EU policies,
European Department, IMF, Washington (via video link)Klaus Regling, chief executive officer, European
Financial Stability Facility (EFSF)
, LuxembourgFrank Scheidig, global head of international clients,
DZ BANK, FrankfurtModerator: Phil Moore, contributing editor, EuroWeek

EUROWEEK: Briefly, what were the key events that led up to the establishment of the EFSF in May?Stefan Bielmeier, DZ BANK: The origins of the problem date to three years ago and to the stable currency levels and low interest rates which stabilised economies throughout Europe. Especially in southern Europe, however, many countries failed to use this environment to develop their industrial structure or their infrastructure. This led to rising current account deficits and structural imbalances.

Germany benefited strongly from this because the low wages it has had in recent years improved its productivity. But while Germany benefited others didn’t, which is why we ended up with this mess. So we have now needed to save the entire region with these various packages. The first was the rescue package for Greece, but that did not inject enough confidence into the market which meant we needed a larger package.

Klaus Regling, EFSF:On the subject of interest rates, we need to distinguish between two elements. Countries joining the euro area suddenly but not unexpectedly benefited from low interest rates. That was a nice benefit, which some countries used wisely and others did not. But on top of that we had a market failure. One reason for the global crisis was that interest rates were too low for too long, and that too much liquidity was in the system.

Consequently, risk spreads were too low on all asset classes. In Greece this was the case until as recently as October 2009. Last October the spread of Greek 10 year government bonds was only 40bp above the German bund in spite of the fact that a new government in Athens was implementing campaign promises which would push the budget deficit up even further. But markets did not react, which I consider to be a real market failure.

So we had a combination of low interest rates and the fact markets reacted too late. Interestingly, among finance ministers in the euro area there were several rounds of discussion years ago on how to address the very low risk spreads on government bonds in the euro area because they realised that this created wrong incentives, but nobody came up with a satisfactory solution.

EUROWEEK: Let’s wind the clock forward to today and ask how the EU and the IMF are responding to the crisis.Herbert Barth, EC:It’s important to note that the response has not only been in the form of the facilities that we see so prominently in the press today. A lot has also been achieved by the other measures taken under the package of the European Stabilisation actions. On the one hand there have been the financial packages put together under the EFSM and the EFSF, but on the other action has been taken with respect to the strengthening of fiscal co-ordination, budgetary consolidation, the enhancement of market surveillance, and to increase competitiveness of the weaker countries. All this is as important as the financial support mechanisms and should be emphasised within the overall evaluation of the EU response to the crisis.EUROWEEK: Is the co-operation we’ve seen between entities such as the European Commission and the IMF unprecedented?Luc Everaert, IMF: Clearly the IMF’s involvement is unprecedented. I think we were all a bit late in recognizing that the global crisis was going to happen. But from that moment the IMF stepped up its global surveillance role and began to warn strongly about the increasing risks, particularly in the financial system.

Going back to the previous discussion, one of the problems that led to the euro area crisis and to sovereign risk spiralling out of control was that the financial system was insufficiently repaired after the initial global shock. It took a long time for Europe to recognize that more decisive action was needed. It’s true that mechanisms such as the guarantee schemes were put in place but there wasn’t sufficient force from national authorities to decisively address the weaknesses in the banking system. Fortunately we have now seen initiatives such as the stress tests which have shown that a number of European countries are addressing some of these problems.

Some credibility with the markets was lost in the context of delays in dealing with the Greek crisis and it’s going to take some time to re-establish that credibility. So the first step was to make sure that no further damage was done, and that led to the establishment of the new facilities.

Co-ordination of policies has been exceptional. We were fortunate in that we already had some programmes in central and eastern Europe where we had already worked in co-operation with the European Commission and to some extent with the ECB. So we were ready to extend this co-operation which has of course been increased quite significantly under recent circumstances.

EUROWEEK: Picking up on Luc’s point about the financial system, how effective have initiatives such as the stress tests been in helping to analyse weaknesses in the financial system and assess what needs to be done to repair it?Frank Scheidig, DZ BANK:I’m sceptical that the stress tests have really helped us to come up with new insights into the system or individual banks. The symbolic effect may have been more important with regulators signalling to the banks that they are watching them closer than before and to the general public that they are prepared to take action when necessary.

Luc referred to credibility, and I think that the big, frequent investors want to have an environment in which they are assured of liquidity, especially in sovereign or agency risk, which disappeared entirely at the peak of the crisis.

The European Central Bank convincingly reassured investors on that score about a year ago when it announced its covered bond buying programme. I believe that this initiative has not only rebuilt market confidence. I also predict that it will even turn out to be a profitable one for the taxpayer. Up until early March this year there could have been a similar effect if the politicians had agreed among each other to set up an investment fund like the one that was set up by the ECB in the covered bond market. That would have sent a strong message to the market that, for example, the combined European Union would be able to buy up to 50% of each member country’s sovereign debt per issue. Then we wouldn’t need to talk about maximum amounts like Eu440bn here or Eu250bn in Washington. Instead it would have acted as a crystal clear message to investors and to the market that there is no place here for any speculators, hedge funds or any form of prop-driven activity because the community of the sovereign countries of the European Community are holding out against it. That would have calmed the market, and countries that have had problems financing themselves through the market would have been able to do so at a cheaper level than they are doing right now.

Regling, EFSF: I don’t fully agree. I do agree that earlier action could have calmed markets. However, there is one important point that you missed. As Mr Barth already mentioned, Europe did not only put a lot of money on the table. Several countries also implemented actions to adjust macro-economic imbalances within the euro area, and took measures to push through tough budgetary consolidation.

But this only happened late in the game because until May certain countries weren’t ready to take additional measures to reform their labour markets, to increase competitiveness and to intensify the consolidation process. More pressure was needed.

So you’re right as far as markets are concerned. But what counts in the end is the willingness of countries to adjust more, which they weren’t ready to do in February and March.

Barth, EC: I would add that politically it would have been very difficult to sell the idea that member states should be committed to buying bonds from weaker countries without some form of cap. First, there is Article 125 of the Lisbon Treaty, according to which the Union is not allowed to bail out member states. Second, you’ll remember how lively the discussions were that took place in national parliaments about the guarantees that have been ultimately given on the current scheme.Scheidig, DZ BANK: That’s why I gave the example of the ECB’s covered bond programme, which had a positive impact almost immediately.

If there is an expectation that markets will accept these investment programmes then spreads will obviously tighten. This is why I make the point that no taxpayer’s money, be it from Germany or anywhere else in the European Community, will end up being burned as a result of those rescue packages.

It is important to give voters a simple message that they can understand, first to indicate that the money hasn’t gone, and second that there is no question of rich economies like Germany subsidizing poorer ones like Greece, and that there will always be a return on their investment. If we could communicate the story behind these programmes more effectively, they would be much better supported. But so far we haven’t sold them properly.

EUROWEEK: So you’re saying that we need to emphasise that this is not simply a bailout for fiscally irresponsible countries?Scheidig, DZ BANK: Yes. I think the problem was that there was a perception that German taxpayers would simply be giving money to Greece, and that the money would be lost. It was a failure of communication. These were guarantees and the German taxpayer will end up making a profit, because the Greeks will have to pay three percentage points more for these loans than the funding costs of the member states.

There’s another area where we have profited, although Carl Heinz is better qualified to comment on this than me. I wonder what level Germany would have funded itself at if we had had an environment with no support for Greece. My guess would be at least 75bp-100bp higher than today’s level.

Those billions saved already are definitely a strong answer to those people who fear that we have made a simple money transfer and that those funds will never be paid back.

Carl Heinz Daube, Finanzagentur: It is certainly true that at the moment we have historically low rates for German government bonds. The yield on our last 10 year bund yield in August was 2.25% and even the 30 year bonds are below 3%. This is a function of the global uncertainty in the market about the outlook for the global economy and about the crisis in certain countries. That has underpinned the continued flight to quality which Germany has benefited from for more than two years now. As Frank mentioned, of course this is good news for the German taxpayer. In this year’s budget, although the overall borrowing requirement is extremely high, at something like Eu338bn, the bill to German taxpayers for servicing that debt could be lower than last year. Barth, EC: But I don’t think we can only argue from the German perspective. Your perspective is bound to be different depending on the member state you’re representing. The flight to quality benefitted some member states but burdened others as their spreads widened. In any case, all member states and probably most other euro borrowers would have had to face substantially higher funding costs had Greece not been financially supported.Bielmeier, DZ BANK: We’ve talked about the ECB’s covered bond programme. But a covered bond by definition has collateral backing it. What is the collateral for a sovereign? It’s the taxpayer. So in a situation where a country’s economic structure is poor and where the economy is shrinking, you need a political commitment. As Luc has said, in the past the commitment has not been there. Barth, EC: People say that it took too long to address the crisis in February, March and April. But let’s not forget that when European politicians got to grips with the crisis response and decided in early May to put together the Eu750bn package, this became operational within just eight weeks. The Greek facility was also put together very quickly. Scheidig, DZ BANK: And investors gave their response. We had a drop of more than 10 cents in the euro after the rescue package had been released. Not before. Even huge investors in Asia, which we all know can buy up to 30% or 50% of an issue, decided back in May that the only EU risks they were going to buy were Germany, France and supranationals. Thank God things have changed now. But if we hadn’t persuaded them to come back into the market I don’t know what sort of level the currency would be standing at today.Regling, EFSF: But we know that Asian investors are now buying Spanish bonds again. So we have been able to restore confidence through policy action by implementing key adjustment measures and setting up the EFSF as a fall-back in case something goes wrong and there is a liquidity need.Bielmeier, DZ BANK: We should certainly mention the huge restructuring measures that are underway in Spain, Greece and Portugal that are starting to become effective. True, these economies are still in recession but they are now in much better shape to grow over the longer term. EUROWEEK: To move on to the EFSF itself, can Klaus give us some more details of the nuts and bolts of its structure?Regling, EFSF: A key point is that the EFSF is a very small facility. The finance ministers of the euro area wanted it to be a very lean and efficient institution. But we also had to be operational almost immediately. To achieve that, I rely on the help of two big and well-established European institutions. One is the German Debt Office, the Deutsche Finanzagentur, which will act on behalf of the EFSF to raise money if necessary. The other is the European Investment Bank in Luxembourg which helps us with much of the back office work.

Because we are supported by such strong and credible institutions, the EFSF itself can be very small. We were able to announce a month ago that we are fully operational, and with the help of the Finanzagentur and the EIB it would have been possible to tap the market immediately.

EUROWEEK: Carl Heinz, can you expand a little on the role of the Finanzagentur?Daube, Finanzagentur: If a country applies for loans from the EFSF, the Finanzagentur will be in charge of organising the funding for this programme. So we’ll use our experience of issuing bonds or short term funding.

We are more than happy to provide all tools to the EFSF in case of emergency. And as Klaus said, we have been ready to issue right from the beginning. Any funding that the Finanzagentur does will be on behalf of the EFSF.

Scheidig, DZ BANK: Based on my experience with the government-guaranteed issues that we started selling to investors post-Lehman, I strongly recommend that the major issues about the structure of the EFSF need to be explained to the main buyers of sovereign and agency bonds beforehand.

Although it might be very clear to us that this is a sovereign or agency asset class, investors will need to understand the legal and operational set-up in order to put in place credit lines or re-allocate existing country limits.

If and when it becomes likely that there will be a need to issue, then the EFSF, the EC and the IMF should use a roadshow at least to the hubs where the major investors in and particularly outside Europe are based – i.e. Asia and the US.

Regling, EFSF: There is no doubt that we will do that. I see communicating with markets and investors as one of my most important jobs. That is why I was in Asia three weeks ago talking to some of the major sovereign wealth funds there. They were grateful for the information because we’re new.EUROWEEK: Where is the impetus for that coming from? Are investors coming to you with questions or are you reaching out to them on a more proactive basis?Regling, EFSF: I receive plenty of invitations to go to Tokyo, Beijing and North America to explain what we’re all about.Barth, EC: We have been in the market for the EU for a long time and a number of investors were re-alerted to us in 2008 when we activated the balance of payments programme for the non-euro area member states. So we have regular meetings with all the investment banks and obviously prior to the existence of the EFSF they raised the question of how the various rescue packages would work. We also work closely with the EFSF as we’re part of the same family, and the network we have established over many years is automatically shared with Klaus Regling and his team. Regling, EFSF: And because we’re both based in Luxembourg, when the banks come to visit you they also visit me. EUROWEEK: What sort of questions are you getting from investors? What do you perceive investors’ principal concern or point of interest is?Scheidig, DZ BANK: In the initial stages they want to understand how the EFSF functions, which is very understandable and is one of the reasons we’re sitting here today. It’s new, and with 16 countries supporting it, it’s complicated. So a lot of legal and operational explanation is needed.

They also want to understand the political aspect. I think that people outside Europe have underestimated again and again how much political commitment there is to supporting the euro.

Everaert, IMF: I’d like to clarify a couple of things. It’s quite clear that the IMF is not formally involved on the funding side of facilities in Europe. We’re continuing to do business under our regular facilities and procedures and the way the operation would work would be very similar to what we did in Greece. On a case by case basis a member country would need to request assistance jointly to the European Commission and the IMF. We would then establish what the financing needs were and how the funds would be distributed.

So I know that there is this figure of Eu250bn out there but that is not a committed figure from the IMF. It is an amount that has been put out there representing more or less what has been the practice in recent programmes in Europe in terms of the combination of Fund financing and financing from EU official sources. But this is not a precise commitment. It will have to be assessed in every country on a specific case by case basis and then we’ll see how the funding will be done.

There will of course be conditionality attached to these facilities which is in line with the regular business of the IMF.

EUROWEEK: So the conditionality would be similar if not identical to previous IMF bilateral programmes?Everaert, IMF: Yes. From the IMF perspective it would be simply a bilateral operation just like in the case of Greece.

From time to time the IMF enters into what we call precautionary standby arrangements, where we have an agreement with a country on a conditional programme and we make the money available just in case the market access isn’t there. So my question to Klaus would be: is there a mechanism in the EFSF which would allow us to agree on a programme on a contingency basis ahead of the possibility that that country might need the money although it still has market access?

Regling, EFSF: No. The concept of the precautionary credit line does not fit in with our approach because ministers have said very clearly in our legal agreement that a country needs to lose market access, so we would no longer be in the precautionary phase. We would only be coming in when the country needs money. Everaert, IMF: One issue I’d like to raise is the broader policy context of the EFSF. It would be preferable for the European economy to evolve in such a way that we don’t actually need to tap into any of these facilities. But we think the global economy is likely to slow down in the second half of this year and maybe beyond, so there is still a risk that we will run into some economic difficulties.

The second aspect of the same issue is that we shouldn’t think that facilities of this kind can substitute for real policy action. Europe seems to be moving in the right direction and some appropriate policies are being implemented. But we still need to continue with the implementation of policy in three areas where more progress could be made.

One is the issue of establishing fiscal sustainability in all the euro area member states. We’ve made some progress but there are still areas that need to be addressed in the long run. If we can put in place policies to do this then I think it will help to build more credibility for markets and for market participants in the euro area.

The second is to follow up on the recent stress tests and really deal with the problem of weak banks. That too is essential.

The third element is the issue of how to restore medium and long term growth in the euro area and how that growth can be balanced. It’s fine for the German economy to grow at 9% in the second quarter. But if that growth is based mainly on exports, when other parts of the euro area still have competitiveness problems in the tradable sector, it’s not going to make the euro area very homogenous over time. Nor is it going to persuade investors to look at the euro area as a cohesive unit.

So my call would be that all countries, including Germany, need to push on with structural reforms so we get a better balance in the mix of demand in the euro area.

Regling, EFSF: That is already happening more in Europe than in many other parts of the world, especially on the fiscal side. I don’t see any fiscal consolidation programme in the US, while in the euro area every country is following one, each with a different time frame agreed by the Ecofin council. I think other industrialised countries should follow that strategy.

On the subject of structural reforms, we have reached an agreement on Agenda 2020 at the EU level for all 27 member states, and the European Commission has identified what are the obstacles to growth in each. All countries are working on this, but Agenda 2020 will not produce results overnight.

I also reject the notion that Europe is lagging in growth. If you look at GDP growth per capita over the last 10 or 15 years the euro area has grown as much as the US, although this is unfortunately not mentioned enough in IMF documents. But it’s a fact.

Bielmeier, DZ BANK: In terms of structural reforms, Germany has also introduced the debt brake into its Constitution which could serve as a blueprint for other countries and was clearly very well received by the market. So in Germany we have achieved a lot in terms of budget consolidation, which is very important.EUROWEEK: Luc, were you hinting that there is a danger that the European rescue packages may act as safety nets that might delay or discourage the reform programmes that some European governments still need to undertake?Everaert, IMF: I think that risk was certainly there in the past but in the European countries that are affected by market pressures we’ve seen strong action. So this risk does not seem to be materialising for the time being. But we still need to keep an eye on it. I don’t think we can let any of the countries that have faced market pressures allow any slippage in their programmes of fiscal consolidation or structural reforms.

In response to what Klaus says, it is true that until the crisis Europe was growing at the same rate as the US on a per capita basis. But since the start of the crisis Europe has fallen behind quite a bit and we shouldn’t forget that in absolute levels Europe is still some 25% behind the US. So my concern isn’t so much that Europe is lagging in terms of growth but that it has great potential and the sooner it takes action to realize that potential the better, and the sooner we’ll come out of this global crisis.

Regling, EFSF: I’m all in favour of that and I agree that policy action is what really counts. We know that this difference in GDP per capita level of 25% that Luc mentioned is the result of less labour input in Europe. We’re working on that to some extent but nobody wants to give up six weeks vacation. The rest, on the productivity side, comes from the retail sector and financial services. Once they get to grips with this crisis, I would not be surprised if we see an erosion in the difference in financial services where the US seems to be so far ahead today.Bielmeier, DZ BANK: One thing that seems to be clear is that the current driver of GDP growth worldwide has been low interest rates and governments’ stimulus programmes. These positive effects will run out in the next few months or quarters and we are therefore heading into an era of somewhat lower GDP growth. We think that in 2011 and 2012 we will see lower GDP growth and lower inflation which is when the real tests to the system will come. That is when the challenges will also come for the weaker countries in Europe, which will have to handle very severe austerity programmes at the same time.EUROWEEK: A critical issue for the EFSF is what its credit rating will be. Is the EFSF asked by investors about the impact of the cross-guarantees on the rating, given that many of the guarantors are not triple-A rated? The question that many people have legitimately raised is how can the EFSF be rated triple-A. At least one commentator has even compared the structure with that of a CDO. Regling, EFSF: I think the comparison with a CDO is absurd. The EFSF is not a structured vehicle but a living institution with political masters, with capital and with staff.

On the subject of ratings agencies, discussions are ongoing. The process is not an easy one because in the euro area only 60% is AAA rated. It’s a small number of countries but with a large weighting. Everybody is aware of that, which is why credit enhancements have been written into the agreement, such as the over-guarantee of 120% and the cash buffer which will accumulate from the beginning and help to enhance our creditworthiness.

But ultimately it is up to the credit ratings agencies to reach their own judgements. They all have different methodologies and different approaches, and it will be a few weeks before we know where they stand.

EUROWEEK: But presumably there is no chance of the EFSF being anything other than a triple-A issuer? Regling, EFSF: There is no guarantee of that.EUROWEEK: But it would be impossible for the EFSF to begin life as a non triple-A borrower, surely?Bielmeier, DZ BANK: Yes. For it not to have a triple-A rating is out of the question, in my view. If the rating were anything lower the investor base would become very nervous.Scheidig, DZ BANK: I think it was a smart move to have the Finanzagentur manage the issuance process. There is no doubt that it is the benchmark in the sovereign sector outside the US. So just from that point of view nobody in the investor community would expect it to be anything other than triple-A.

It’s a valid point that 40% of the guarantee countries aren’t rated triple-A, but does this mean that the triple-A countries such as Germany and France have to guarantee the remaining 40%?

Regling, EFSF: They guarantee more than their share, up to 120%. You can run many scenarios and in most cases that would be sufficient. But the ratings agencies run hundreds of scenarios and we don’t yet know what the outcome will be. Scheidig, DZ BANK: But if the facility does go live and we can expect a high volume of issuance, it will be a challenge to attract the big investors who are capable of buying billions if it is not rated triple-A from the very beginning. So I would agree 100% with Stefan that from a market perspective the EFSF has to start with a triple-A and retain the optimum rating. EUROWEEK: What would happen to spreads if the facility were used? Wouldn’t they widen out sharply? Regling, EFSF: I don’t think you can generalise. You’re talking about contagion risk, which is a possibility, but it would really depend on the circumstances.Daube, Finanzagentur: The situation you describe will be totally new for all market participants. At this stage it makes no sense to speculate as to what would happen to spreads because we don’t know what the circumstances leading up to a country calling for help will be. Regling, EFSF: It’s important to understand that if the EFSF were to come to the market, Europe’s net funding needs would not go up. Less creditworthy borrowers would step out and be replaced by more creditworthy ones. EUROWEEK: So the credit quality of the EFSF, paradoxically, would go up the more the system was used?Regling, EFSF: I wouldn’t call it paradoxical. That is a key part of the system.Scheidig, DZ BANK: And of course the all-in costs of going to the EFSF would have to be lower than those that a borrower could achieve independently in the market. If not, why wouldn’t they fund themselves in the market? Barth, EC: I don’t think you can make a direct link between what a country’s funding costs are and what they would be if they used the support mechanism. The support programme would only be triggered if a country had severe refinancing problems and lost its own market access. In that case it would need to agree a support package with the other member states which would involve paying a certain credit spread over the funding cost which in the case of Greece equated to 3% over Euribor for the first three years and 4% thereafter.

The decision by a country to call for and by the other member states to provide support is not at all driven by comparing relative funding costs.

EUROWEEK: For investors looking for a benchmark, could pricing of the EFSF’s bonds be expected to be very similar to the EU’s?Barth, EC: The bankers could probably answer that question better than I can, although of course this is a question we ask the banks all the time when they visit us.

If a country were to activate a programme we would certainly be in a phase of very high volatility in the market, so it is hard to say what the pricing would look like in those circumstances. But from what banks tell us and based on current markets there would probably be a difference of no more than 10bp.

The EU is a well-established credit and it is reasonable to assume that a new market entrant like the EFSF would have to pay a small premium.

Scheidig, DZ BANK: I agree that as a new kid on the block, there would probably be a couple of basis points to pay. But from the perspective of a buy and hold investor I think that could be positive because the prospects for a strong performance would be good. The EFSF will be an issuer with a large funding volume, where secondary market liquidity is guaranteed.

I doubt that investors would see sovereign borrowers as the only benchmark and reference point for pricing. I think instead that they would regard agencies such as KfW, EIB, World Bank and the EU as their benchmark. It might be similar to SFEF, where both the sovereign and the agency sectors were used as reference points.

Barth, EC: The EU certainly has a very straightforward credit story to tell when issuing for the EFSM. The EFSF could potentially offer higher liquidity and may use some distribution techniques such as auctions through primary dealers that we can’t use because the EU funding requirement is more limited. The bottom line is that pricing of EFSF and EU bonds will be very close to each other.Daube, Finanzagentur: In general I would agree that all the ingredients are there for good secondary market performance in terms of volumes, liquidity, ECB eligibility and so on.EUROWEEK: So we would be talking about a very liquid borrower?Daube, Finanzagentur: Of course we don’t know what the numbers will be. But if the EFSF does issue, it is reasonable to assume that it will do so in sufficiently liquid volumes. Scheidig, DZ BANK: It will be necessary for the EFSF to explain the operational aspects of its funding strategy and programme. Does the EFSF plan to issue across the entire curve and provide liquidity in two, five, seven and 10 years or above? What sort of instruments will it be allowed to issue? Will it be allowed to use derivatives? Will it make sure it has a fully functioning repo market? These are all questions need to be answered on day one. Bielmeier, DZ BANK: The facility has been set up for three years. Does this mean the guarantees are also for three years? Regling, EFSF: No. The facility is set up for three years. If there is no financial operation by June 2013, we will close down. But if countries need to borrow and ministers agree, then the EFSF can exist for as long as is necessary to repay the last debt. EUROWEEK: So does this mean the EFSF could in theory issue up to 30 years?Daube, Finanzagentur: From my point of view that would depend on the circumstances of the country requiring help. It would depend on the specific demands of the borrower as well as on prevailing market conditions. Barth, EC: And as I understand it, bonds could be issued beyond the initial three years if a country programme is activated by the end of the three year period. Scheidig, DZ BANK: So country programmes could be activated right up until the last month of the three year period?Regling, EFSF: Yes.EUROWEEK: Can the EFSF pre-fund to take advantage of favourable funding windows?Daube, Finanzagentur: No. We have no such intention. EUROWEEK: So you would only be able to issue in response to a direct request from one of the member countries?Regling, EFSF: That is correct. In theory we could pre-fund but there has been a political decision not to do so because if we issued Eu10bn we would have that money sitting around in Frankfurt or Luxembourg which we would need to invest. There would be some negative carry which would have to be financed by drawing down the EFSF’s capital, which is not what ministers want – for good reason. EUROWEEK: On the relationship between the EFSF and the capital market, does its creation act as a self-fulfilling prophecy? Does its very existence serve to calm markets and therefore to ensure that it will not be used? Is the figure of Eu440bn purely a symbolic amount, which can never possibly be issued, not least because of the crowding-out effect it would have on the capital market?Regling, EFSF: I already explained that it wouldn’t lead to crowding-out because the EFSF would substitute other funding needs. So on a net basis the existence of the EFSF does not mean that there would be a larger funding need. For the euro area as a whole it would remain unchanged. And as I said earlier the quality of the credit would improve.

Otherwise I think you’re right. The existence of the EFSF together with the support of the IMF and the Eu60bn EFSM commitment has undoubtedly calmed markets. Markets know that if there are liquidity requirements there is a way to address them.

The moral hazard issue that you implied in your question is being addressed through conditionality. No government wants to do voluntarily what Greece is going through at the moment, and will only do so if there’s no alternative. Governments will not knock on EFSF’s door because they think it might be a little bit cheaper. It’s the opposite. There is a penalty charge which was intentionally put in by ministers to make it unattractive to use the EFSF. So clear attempts have been made to deal with the moral hazard threat which is very important.

EUROWEEK: On the topic of potentially crowding out other issuers I was thinking more of borrowers like KfW and other agencies than the sovereigns. Barth, EC: It could be that investors will ask for some relative re-pricing because there will be more volume in the broader SSA sector. So investors may ask for a basis point or two more from other triple-A issuers. Bielmeier, DZ BANK: So the question is whether the EFSF is seen as a sovereign or as an agency. If it’s regarded as a sovereign there will be no crowding out. If it’s seen as an agency we may see some of that. EUROWEEK: Would the EFSF issue purely in euros, or would it use other currencies on an opportunistic basis?Regling, EFSF: We don’t yet know. We would probably issue predominantly in euros but that would depend on market circumstances. All options are open. Daube, Finanzagentur: On the issue of pricing, another very positive point about the EFSF is that the market knows it won’t last for ever. EUROWEEK: Like Cades or SFEF?Daube, Finanzgentur: Exactly. Scheidig, DZ BANK: But we have to look at this from a very practical point of view. If we assume that EFSF will be seen as belonging to the same asset class as EIB or KfW, then investors will certainly run into problems if they want to invest the same amount again as they have in those credits, simply because their credit lines for those names are probably already 90% or more full.

Creating a new credit line will mean that the new borrower probably has to pay a bit of a premium at the beginning. In turn, borrowers like EIB or KfW will also have to pay a little more to complete funding programmes of Eu70bn or more. But over a three year horizon to 2013, a certain spread performance across the asset class will bring their funding costs down again, meaning that the net effect for agencies like EIB or KfW will be marginal.

EUROWEEK: The question has been asked if the EFSF will be seen as a sovereign or an agency. That raises the question of whether it will issue via auctions or syndications.Daube, Finanzagentur: The experience of the Finanzagentur has been if we are issuing something new, such as our US dollar benchmark, we would use syndication, which has worked very well.

The EFSF will use exactly the same technique. So when it launches inaugural issues across various points on the curve I would strongly recommend the use of syndication. Those bonds could then be tapped.

The advantage of using a syndication is that it would also allow us to make use of the banks’ marketing, networking and research strengths around the world.

Barth, EC: We and the EFSF will need to target banks and investors with our credit and funding story through roadshows, because if the EFSF were to be activated then the EU would also probably have to issue in much larger size within its Eu60bn programme.

So we would need to explain jointly to investors that two different credits within the EU family would be coming to the market. We would obviously co-ordinate our funding and marketing strategies to ensure a coherent and efficient market approach.

EUROWEEK: Would you go so far as roadshowing together?Barth, EC: That has not yet been decided.Scheidig, DZ BANK: Another interesting aspect is the short end of the curve. The Finanzagentur is a huge issuer of Bubills [money market instruments]. As long as we have these low interest rates using these instruments would lower the EFSF’s funding costs tremendously. So wouldn’t it make sense to offer short term instruments in order to give an alternative to investors who need to invest short term liquidity, like money market funds?Daube, Finanzagentur: Everything is possible. How many alternatives we use will depend on the amounts that it is necessary for us to raise. Scheidig, DZ BANK: With all due respect for pot deals I would also recommend that for the first few deals the EFSF chooses a syndicate structure with a firm underwriting commitment. It also makes sense to have banks with very strong local distribution power within the syndicate because any new asset class needs to maximize investor diversification. While the big players will be important drivers of any EFSF issuance, they are no longer the only investor group that underpins successful SSA transactions. We talked about liquidity earlier which has been trickier to assess post-Lehman and which has led the big guys to act a bit more cautiously. A much more diversified and granular investor base is therefore needed, which many of the national champions, amongst the banks in the 16 EU countries would be able to provide.EUROWEEK: Frank mentioned granularity. Would this extend to issuing retail or regional targeted bonds as the EIB has done?Scheidig, DZ BANK: No. The EFSF should definitely not be issuing retail-targeted bonds. It should definitely be targeting its issuance at institutions.

But issuance in the three to seven year maturity range is perfectly suited to bank treasurers when overall risk appetite is low. Leading savings banks and co-operative banks like ours with huge savings networks and extensive private banking contacts are well equipped to play a key role in placing such bonds.

Barth, EC: We need to distinguish here a little between primary and secondary market demand. In the six benchmark issues that we have done for the EU Balance of Payments facility to support Hungary, Latvia and Romania, private banks combined with retail accounted for about 8% of demand. But retail came in quite strongly in the secondary market. The more the sales forces understand the credit, the more they will be able to sell into retail. The flow of tickets to retail that we saw in the secondary market supported liquidity and therefore indirectly supported our future upcoming primary issuance. So it does make sense to incentivise the banks to sell into the retail market.
01 Sep 2010