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If at first you don’t succeed…

20 June 2012 By Neil Unmack

Italy and France are proposing to use the euro bailout funds to buy sovereign debt in the market, in a bid to restore confidence. More likely, it would be used by creditors to dump their holdings.

Italian Prime Minister Mario Monti wants the euro zone’s rescue funds, the European Financial Stability Facility (EFSF) and its successor, the more permanent European Stability Mechanism (ESM), to buy sovereign debt. And French President Francois Hollande says the idea is worth exploring.

This is not a novel idea. The funds can already, theoretically, buy bonds in the secondary market. But countries would need to ask for it, and accept some form of conditions in exchange for the intervention. Monti’s proposal looks more radical. He seems to favour an automatic arrangement whereby the funds would buy sovereign bonds whenever yields rise above certain levels. That could persuade investors they won’t lose money on sovereign debt, and help restore confidence in the near-broken Spanish and Italian bond markets.

The proposal would need to overcome the obstacles that already hamper the funds. First, their capacity is finite; the EFSF can lend a further 248 billion euros, and the combined new lending once the ESM comes on line will be 500 billion euros. That’s before taking into account the 100 billion euros promised to Spain for the recapitalisation of its banks. If the funds can’t be increased or leveraged effectively, investors will worry that the bond-buying is temporary, and dump their holdings. The funds would be swamped, and Italy no better off.

Moreover, half-hearted bond-buying can make things worse. The risk is that the bonds bought by the bailout funds will be protected in a debt restructuring. The European Central Bank showed how this could be done in the Greek debt swap. And if bond-buying doesn’t work, Europe would quickly move to plan B, a proper bailout for Spain and Italy which would likely involve debt restructuring for private creditors. That’s a powerful reason for investors to run for the hills. If that type of bond buying is the only idea EU leaders can agree on at their summit next week, it could fall way short of what investors will want if they are to be convinced that the monetary union isn’t heading for a break-up.


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