Monday, March 02, 2009


Give us your money, or we will send over our unemployed millions is the clear message from the Prime Minister of Hungary, Gyurcsany to Western Europe.

The letter which he sent to the other heads of State yesterday reads like a contribution to an economic seminar, and in those rarified climes makes perfect sense. But the EU is not a seminar and the vaguely veiled threat is all too real.

Of course the problem for the UK is that it and Ireland are the only countries that have fully opened their doors to Eastern Europe, and thus are the only ones who would have to shoulder the burden of the millions who are being left behind.

It is, however hard to criticise Gyurcsany. After all when Hungary joined the EU they were promised 'solidarity'. It was this promise that encouraged Eastern European politicians to join the EU in the fitrst place. Now, when the chips are down it becomes brutally apparent that the richer countries didn't mean a word of it. And how could they. There own economies are going into a downward spiral with staglflation round the corner and unemployment jumping skywards. Because there is no European Demos, there will be no European solution. German taxpayers will be preparede to bail out Essen, but not Budapest.

For a while last week it looked like the Germans were going to help the Irish, with both Merkle and her finance Minister making positive noises, but now that the Eastern bloc has fired this warning shot across the bows that looks like an impossibility. They cannot help Ireland, without helping Hungary, and the German economy just doesn't have the spare loot to do that.

Below is the letter

Non-paperProposal for setting-up a Multilateral European Stabilization and Integration Program (ESIP) to support CEE economies

MULTILATERAL action required to prevent a second systemic shock CAUSED BY eastern europe

Despite cautious economic policies, Eastern Europe is being affected disproportionately by the global financial and economic crisis:

With only a few exceptions, economic policies in CEE have been conservative, e.g.: large national bank reserves; high compulsory bank solvency ratios; large-scale privatizations, including in the banking sector; relatively low public debt; low budget deficits

Open capital accounts, integration with the EU, and excessive global liquidity have led to an exceptionally large flow of funds to the region:1 EUR ~700 bn in international loans outstanding, and even larger amounts of cumulative foreign direct investment. This veritable tidal wave of money has been the main reason for the region’s low savings rates, large current account deficits (especially in South-East Europe, the Baltic states, and Ukraine), asset price bubbles, and substantial balance sheet risks in case of devaluation. These conservative economic policies in most CEE countries have led to a longer-than-usual maturity structure for these flows (e.g., intra-group and long-term debt)
Long-term investments and funding in Eastern Europe have led to significant acceleration of economic integration with the EU. However, the resulting high export quota2 has created a sensitive dependency on the EU, which is becoming particularly apparent in the current recessionary environment.

Failure to act could cause a second round of systemic meltdowns that would mainly hit Eurozone economies:

Central Europe’s (re)financing needs in 2009 could total EUR ~300 bn (~30% of the region’s GDP). Partial failure to refinance could lead to massive contractions in economic activity and large-scale defaults

A major crisis in Eastern Europe would have global systemic effects:

A 10% default rate on the Eastern European external loan book (at the lower range of previous emerging market crises) would put significant further strain on the solvency of the European banking sector; the capital impact would be at least EUR ~100 bn, or ~10% of European banks’ cumulative tier-1 capital

A 30% drop in the region’s imports would reduce global turnover byEUR ~150 bn and European GDP by ~ 1%

A significant economic crisis in Eastern Europe would trigger political tensions and immigration pressures (with a CEE population of ~350 million, of which 100 million are in the EU, a 10% increase in unemployment would lead to at least 5 million additional unemployed people within the EU).

Despite clear vulnerabilities, no effective stimulus or rescue package has been put in place so far, mainly due to an exceptionally complex stakeholder situation:

Financial intervention (e.g., liquidity provisions, interest rate cuts, capital increases) is largely ineffective:

A few Western European banking groups (domiciled primarily in Austria, Italy, and Greece) have accumulated most of the foreign debt exposure to the region. These groups are currently aggressively deleveraging their subsidiaries, as their central balance sheets are vulnerable3
Interest rate cuts and liquidity provisions could lead to capital flight and currency devaluations, further aggravating the balance sheet situation

National governments, whether in CEE or Western Europe, are struggling to find an angle to tackle European banking groups’ exposure across the region as a whole

Local governments cannot independently launch economic stimulus programs because of the high capital flight risk in the event of large budget deficits or reduced national reserves.
A COMPREHENSIVE multilateral EUROPEAN Stabilization and Integration Program (ESIP) should be LAUNCHED

Despite the challenges mentioned above, we strongly believe in the economic strength of the region and its prospects within the European economic system. In an effort to forestall possible grave economic impact, we are proposing to design and launch a European Stabilization and Integration Program (ESIP), with the following objectives:

Rebuild trust, by implementing support programs tailored to each country, but coordinated in a single transparent framework

Enable a sustainable integration trajectory by offering faster integration with the Eurozone to countries successfully implementing the program, while repairing excessive imbalances and strengthening productivity growth

Ensure transparency and ongoing oversight.

We would consider the following design principles to be critical when establishing the cornerstones of the ESIP:

Maximum economic and social impact. The financial resources activated should target areas of economic activity that will provide the highest economic multiplier (through increases in GDP) as well as positive social impact, with the lowest cross-the-cycle net cost

Fairness and equitability. The distribution of financial resources should be based on objective criteria, and the upside should be shared with fund providers

Transparency and accountability. The initial distribution of funds must be followed by strict control of secondary disbursements by local governments and financial institutions to ensure real impact

Minimal moral hazard. Shareholders and governments should bear the consequences of their own past decisions. This is especially important in the today’s very diverse situation of both individual banks (banking groups) and national economies. More prudent players should not be levied the same costs as bigger risk takers. Economically and financially more stable countries should not carry the same costs as countries with riskier and more unbalanced economic policies in the recent past.

Market driven. Secondary disbursements must be driven by market forces in the respective CEE economies, not by local political objectives.

The main elements of the proposed program are:
1) Establish an ESIP Recovery and Solvency Framework to boost solvency and remove non-performing loans from the CEE banking sector while facilitating effective recovery
2) Establish an ESIP Fund to provide emergency liquidity and capital to the banking system. The funding would come from the IMF, the World Bank, and EU institutions (including the ECB and the EBRD/EIB), with their roles clearly split
3) Establish an ESIP Multi-Year Stabilization Plan to reduce imbalances, including a clear and aggressive timetable for Euro adoption in EU and candidate countries and FX debt risk reduction in other countries.

1) Establish a robust ESIP Recovery and Solvency Framework
The ESIP Recovery and Solvency Framework would regulate four key areas, with the objective of establishing a sound legal basis for strengthening the financial sector as well as corporate and household balance sheets:

Strengthen collateral recovery and bank insolvency legislation in each country (accelerate and simplify procedures)

Establish “bad bank” legislation in each country to allow non-performing loans to be quickly segregated

Establish a coordinated debt restructuring framework (a “Super Chapter 11”) to enable private borrowers which are solvent but illiquid to reschedule their debt

Deploy tighter bank regulations ensuring, e.g., strengthened insolvency limits and increased reserve levels for FX lending.

2) Establish an ESIP Fund of EUR 160-190 bn
The ESIP Fund would act on four key areas, with the objective of strengthening the financial sector and providing solvent borrowers with access to liquidity:

Provide emergency liquidity of approximately EUR 50-60 bn4 (e.g., contingent credit lines or swaps, facilitated by the ECB and the IMF in the most challenging situations):

To CEE central banks, requiring structural economic adjustments in the most imbalanced economies and pricing in the additional country risk (albeit at lower rates and longer maturities than current market conditions provide)

To Western European banks heavily exposed to the region, but only if country exposures are clearly separated and if coupled with capital injections

Support coordinated debt rescheduling of approximately EUR 1.5 bn,5 funded partially by the ESIP:

Under the plan for private debt, the maturity would be lengthened and the interest rate and/or FX rates would be brought below market rates. This plan would be funded by the borrowers (mainly through extensions of terms), the banks (by accepting lower margins), and the ESIP (through providing long-term liquidity). The implementation of the plan could include a large-scale swap from FX to local currency loans (structured to eliminate FX rate impact) to reduce further FX exposure, mainly in non-EU countries

The public debt of selected countries should be restructured along the same lines, as needed on a case-by-case basis

Provide capital injections to restructured banks (e.g., with the EBRD in the lead) of approximately EUR 35-45 bn:6

To Western European banks, but only if country exposures are separated and if pre-specified trigger criteria are met (in conjunction with liquidity provisions)

To CEE banks, together with their respective national banks (international involvement in the capital would reduce domestic political pressures for un-economic lending)

To newly established bad banks, but only in return for equity in “clean” banks

Provide guarantees and/or liquidity to support the real economy, including:

Enhancing the region’s ability to export (e.g., with the World Bank in the lead), entailing approximately EUR 35 bn7 in trade finance

Channeling money to economic areas that are enduring the highest impact, in particular the infrastructure and SME sectors, entailing approximately EUR 40-50 bn or 3-4% of GDP
Ensuring the extension of parent banks’ credit lines to their subsidiaries.

3) Establish an ESIP Multi-Year Stabilization Plan
The stabilization framework for EU and EU candidate countries should be based on a clear, aggressive timeframe for Euro adoption (because CEE countries are structurally tightly linked to the Eurozone economy, failing to anchor them quickly to the Euro would perpetuate the current systemic instability). This would motivate concomitant political action in CEE (as EU accession has done) and strengthen the trust of international investors. The plan should be based on:
More stringent criteria vis-à-vis Maastricht, especially via incentives to increase the savings rate (structurally reducing the need for external investment funding)

Unlocking EU structural funds for rapid spending (including on larger and more targeted projects). The lower EU requirements, control, and oversight would be mitigated by the strong involvement of the ESIP in structuring and disbursing funds

Required legal reforms and meaningful initiatives to fight corruption.

The IMF and EU bodies (i.e., the ECB, EBRD, EIB, and EU governments) would fund the above-described program. The responsibility for specific elements should be allocated based on the current institutional framework and relevant skill sets to ensure swift program implementation. A possible solution might be:

The Recovery and Solvency Framework could be designed by the European Commission, based on input from the IMF

The IMF could directly fund and/or coordinate the liquidity programs and debt rescheduling framework at the national bank/governmental level

The EBRD/EIB could be responsible for capital injections into banking groups

The World Bank could be responsible for the trade finance liquidity program

The European Commission could be responsible for designing and enforcing the Multi-Year Stabilization Plan.

Oversight of the overall coordination and implementation should be provided by an ESIP Supervisory entity representing the key stakeholders providing funds. The ESIP program would be driven by a simplified ESIP Board directly coordinating with the national governments and banking groups within the overall framework.

1 Numbers in this paper refer to CEE-10 EU members plus Croatia and Ukraine.
2 Exports as a percentage of GDP. This ratio exceeds 50% for the region (80%+ in some Central European economies).
3 Due to excessive short-term funding and low capital buffers, caused by the central booking of loans to avoid the high capital ratios required at the subsidiary level.
4 25-30% of short-term gross external debt. If intercompany loans are included, the amount would be EUR 75-90 bn.
5 30% of high-risk FX and 10% of domestic assets rolled over at an overall cost of 15%, with ESIP supporting 1/3 of the cost (the rest would be internalized by banks through lower margins and by ultimate borrowers through longer maturities).
6 4-5% of total banking assets (EUR 875 bn) in the region, assuming a 10% average NPL hit with a 50% recovery ratio and current capitalization above the regulatory minimum.
7 5% of exports.

Har tip, the new UKIP blog

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