Following the unprecedented downgrade of the European Financial Stability Facility and nine eurozone sovereigns by Standard & Poor’s, there is a renewed impetus for the International Monetary Fund to step up its involvement in the deepening euro area crisis. In an executive board meeting earlier this week, managing director Christine Lagarde requested that the membership step up the fund’s own war chest in an effort to better equip the institution to adequately confront the growing global threat. The move follows an earlier reshuffle at the helm of the European department of the IMF, signalling that the fund has been quietly preparing itself for the gloomiest scenario in which the situation in Europe develops into a full-blown systemic crisis.
Currently, the IMF is unable to ring-fence the euro area and contain any spillovers to the global financial system unless its global membership agrees to provide a significant boost to its resources. As it stands, the organisation has some $385bn in its forward commitment capacity, including the activation of the contingent facility — the new arrangements to borrow — that can be used “to cope with an impairment of the international monetary system or to deal with an exceptional situation that poses a threat to the stability of that system.”
This is grossly inadequate. To put things in perspective, in the current year alone, the Italian treasury will issue some €440bn on a gross basis, including short-term bonds. If one were to include corresponding amounts for Spain and—possibly—France, that figure would rapidly balloon. In contrast, the EFSF has at its disposal a bit more than $300bn net of its commitments to Greece, Ireland, and Portugal. Moreover, its recent downgrade by S&P will make it increasingly difficult to issue bonds to sustain its interventions. The prospect of leveraging that amount is less likely now that two among its top guarantors — France and Austria — have lost their AAA-ratings.
Against this backdrop, we propose an option to expand the international community’s firepower against a worsening crisis in the eurozone. The mechanics of the proposal are relatively simple, but it is also conditional upon Europe credibly strengthening its policy framework so as to reassure the IMF membership that its policies are worth funding. Our proposal is as follows: the IMF membership should decide on a general allocation of Special Drawing Rights (SDRs) as a way to provide confidence and generate additional financing that could be partially mobilised toward the euro-area crisis.
SDRs are international reserve assets and can be thought of as a potential claim on the freely usable currencies of IMF member countries. Their issuance would relax the constraints currently complicating the financing of the EFSF. Since the EFSF relies on guarantees provided by the euro-area member states through their respective treasuries, any step up in the guarantees to the EFSF triggers a corresponding increase in the contingent liabilities to be borne out by that member’s public sector budget. For many sovereigns, this could entail a further deterioration in their rating status.
If approved by at least 85 per cent of the fund’s total voting power, the SDRs allocated to member countries through their fiscal agents — typically, national central banks — could be mobilised for this purpose thus relaxing the constraint on public sector budgets. General allocations of SDRs are distributed based on the quotas that members hold in the fund’s capital subscription — the euro-area countries together hold 23 per cent of the capital base. Once allocated, euro-area countries could use their SDRs to provide a guarantee to a “vehicle,” which could in turn leverage on such guarantees to further expand its financial capability.
Such an arrangement, where euro-area members use their SDR allocations to guarantee a vehicle, would bear zero cost for the guarantors as long as the SDRs were not called upon. If the guarantee was triggered, then the SDRs would need to be exchanged with assets denominated in any freely usable currency, including the euro. The transaction would trigger an “open” position in SDRs for which euro-area members would bear a cost equal to the SDR interest rate, which is indexed to money market rates. Currently, the SDR annual interest rate stands at approximately at 0.10 per cent, while, for instance, yields on Italian one-year bonds stand at over 3 per cent. So long as the SDR guarantees were not called upon, there would be zero cost for the guarantors. And if the guarantee was triggered, then the interest rate charged to the euro members would be equal to the more advantageous SDR interest rate relative to current eurozone sovereign borrowing costs.
A general SDR allocation would also allow some smaller, developing economies to increase their liquidity buffers as a protection against global liquidity shocks that might arise if market turmoil continued. Other IMF members, in particular those with large reserve assets, could join a “pool of the willing” by exchanging their SDR allocations to buy euro-denominated bonds issued by the vehicle described above. These euro bonds would yield some percentage on an annual basis, which would be a multiple of the SDR rate charged on the “open” SDR position. To give an idea, currently EFSF bonds yield more than 3 per cent against the 0.10 SDR rate that an IMF member would be charged in “opening” its SDR position. Moreover, assuming that such members would have diversified in euros anyway, they would not need to hedge against exchange rate exposure. The proposal above will not solve the deep-seated problems of the euro area crisis but will help to galvanise the international community’s resolve and partially alleviate the financing constraints once the Europeans finalise a credible and reassuring policy framework.
The proposal above will not solve the deep-seated problems of the euro area crisis but will help to galvanise the international community’s resolve and partially alleviate the financing constraints once the Europeans finalise a credible and reassuring policy framework.