EU’s Next Move: EFSF Leveraging?

With the FOMC finished with its big number this month, all eyes are once again on the euro zone debt crisis. Last weekend, billionaire investor George Soros, U.S. Treasury Secretary Tim Geithner, and even BOC Governor Mark Carney called out euro zone leaders to step up their game. Good thing G20 leaders and a few other market hotshots had a meeting to discuss viable options to ease investors’ concerns.

One of the more interesting ideas is strengthening the power of the euro zone’s European Financial Stability Facility (EFSF) either by increasing its size or by leveraging it. If you remember, the EFSF was created by the EU to help euro zone economies in financial mess.

Leveraging the EFSF would involve putting up the bonds purchased by the EFSF program as collateral in order to obtain more loans from the ECB. This would effectively allow the EFSF to be “expanded” up to a few TRILLION euros.

George Soros also mentioned of turning the EFSF into a bank, making it function as an “insurance company” and to guarantee the investment of euro zone bond buyers.

Of course, these options should be carefully discussed among financial leaders. But with the debt crisis looming over our heads, they’re dealing with a ticking time bomb. For one, Spain and Italy are already dealing with steadily climbing bond yields. If the EFSF’s power isn’t expanded soon, then threats of a debt contagion could intensify.

Expanding the EFSF program won’t be as easy as baking a chicken pie though. In order to even consider the idea of leveraging the temporary fund, all 17 euro zone nations need to agree on the proposal to pass it.

This might not sit too well with Germany, which is already carrying more than its fair share and has been reluctant to grant bailouts in the past. Expanding the effective size of the EFSF may not sit well with German tax payers, as it would expose Germany to having more a bigger scope of responsibility (in terms of payments) should other euro zone nations need bailouts.

In addition, the move would need the approval of the ECB, since the leveraging would be done in partnership with the central bank. The problem is, of course, that the central bank isn’t exactly keen on exposing itself to additional risks.

In any case, news on the EFSF expansion options didn’t exactly give the euro too much of a boost, as EUR/USD has already dropped nearly 200 pips during today’s Tokyo and London sessions.

EUR/USD Daily chart

Looking ahead, even if EFSF leveraging is approved, I’m not quite sure it’ll give the euro much support on the charts. It may take at least six weeks before European leaders decide to expand the program and by that time, who knows what could happen!

Based on what we saw last week, it seems me that risk sentiment is the major driver in the market, and I expect it remain this way for the time being. Take note that equity markets around the world have entered a bear market for the first time this year, and with the outlook of the global recovery looking bleak, EUR/USD may be prone to some weakness over the next few weeks.

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