Market volatility limits EFSF firepower

This week’s market upheaval in Europe has made it difficult to increase the firepower of the eurozone’s €440bn rescue fund to the €1,000bn that the bloc’s leaders had hoped for, the fund’s chief executive said on Thursday.

Investors have fled from bonds issued by highly indebted countries. Luring them back by offering insurance on losses – the centrepiece of a plan agreed in Brussels on October 26 – would now probably use up more of the fund’s resources, Klaus Regling, head of the European financial stability facility, said.

His concerns underline Europe’s difficulties in putting in place mechanisms to contain the sovereign debt crisis and, if necessary, help Italy cope with soaring refinancing costs.

“The political turmoil that we saw in the last 10 days probably reduces the potential for leverage,” Mr Regling told reporters. “It was always ambitious to have that number, but I’m not ruling it out.”

The European Commission sharply downgraded its forecast for eurozone growth next year from 1.8 per cent to 0.5 per cent. The global ramifications of Europe’s economic woes became clearer with the growth in China’s exports to the EU slowing in October and a sell-off in Asian equities markets.

The loss-guarantee programme aims to leverage the €250bn ($340bn) remaining in the EFSF to cover more than four to five times the value of bonds than if the fund purchased the bonds outright.

But Mr Regling said heightened investor skittishness meant the guarantees would now have to be bigger in order to convince investors to participate, meaning the fund was likely to have only three to four times the firepower.

Leveraging the EFSF’s dwindling resources is the cornerstone of a plan to increase so-called “firewalls” to prevent the turmoil in Greece from spreading to European banks and its largest economies, particularly Italy.

One of the two options being explored – a plan that some officials say is the most developed – would guarantee Italian bondholders against part of their losses. Officials had hoped new investors could be enticed by a guarantee against a 20 per cent loss but those investors may now be seeking up to 30 per cent – which would limit the expanded firepower of the fund to about €800bn.

Mr Regling said he believed confidence in eurozone bond markets would return, particularly after Greek and Italian politics becomes more settled, meaning the fund may eventually reach the €1,000bn mark.

“At least for a while, maybe the leverage is less than what we hoped three weeks ago,” he said. “My expectation is it will get better because we do have a new government in Greece, and that helps.”

With new powers that were formally granted three weeks ago, the EFSF could assist Italy quickly by buying Italian sovereign bonds at auction, a move that would significantly reduce Rome’s borrowing costs. Italy’s next major bond auction is on Monday.

But Mr Regling said he was reluctant to move so quickly, since he has been told to focus on the leveraging project before deploying the new powers. If the EFSF assisted Italy before leveraging was completed next month, it would have to use its own resources, depleting the €250bn remaining in the fund.

“Most people agree we should first conclude our work on leveraging so the firewalls we are trying to erect are convincing,” he said. “We are not eager to act next week, because we don’t have the leveraging in place.”

Christophe Frankel, the EFSF’s chief financial officer, said the fund was prepared to offer short term bills to raise money quickly and said such an offering was likely before the end of the year. In the past, the EFSF has only been able to raise funds for bail-outs through five and 10-year bond offerings, a long and complicated process that makes it difficult to raise cash in an emergency.

But Mr Frankel said the legal paperwork to issue bills was already in place and the programme could be triggered immediately, if needed.

“The beauty of the bill programme is you can start with an amount which is a few billion and then raise it very rapidly,” Mr Frankel said. “Once it exists, we know we can raise huge amounts in a very short time.”