Tuesday 10 May 2011

Punishment phase: "Somewhere in the scale of over 5.5%, but clearly below 6%":

The interest rate in the Portuguese bailout has been announced to be
"Somewhere in the scale of over 5.5%, but clearly below 6%".

This raises a couple of issues - since the IMF intereste rate is 3.25%, the 2.25 (at least) mean exactly what?
- default risk ? but the default risk is probably larger the larger the interest rate set, it is also dangerously close to the value that will make the plan work or not - see the previous post by Francesco Franco in this blog.

- market power ? another origin of a high interest rate would be exercise of market power - take advantage of the weak bargaining position and lets extract rents. It seems doubtful that this is an issue in this case.

- punishment phase ? make an example out of this small country to avoid larger ones getting into the same troubles. Seems the more plausible explanation to me. But then it should be clearly stated, to avoid misinterpretations about the risk of the bailout plan.

Any competing explanations?

Any vote on which one you think is more plausible?


  1. First reasoning applies to the third: if the reason is punishment but with that you raise default risk to very high levels what would be the logic? Maybe EU leaders think Portugal will default anyways with this package...

  2. The "european interest rate" is different from the IMF rate for two reasons. 1) is due to "technical differences" 2) is due to the design of the EFSF (I hope this comment is not too technical)

    1)The EFSF/EFSM rate is based on the interest rate of the issuance for the respective program, and therefore the best benchmark would be the european swap rate for the relevant maturity. The IMF SDR rate uses a basket of several market rates (Eur, Japan, US and UK)

    2) To this issuance interest rate, a 100bp per year + 50 bp of commission charge is added. This spread is added not only to take into account the credit risk. It is added to assure that this program is only used as a substitute to "disfunctioning markets".
    This assurance is needed in order to comply with the -no bailout- clause in the Lisbon treaty, and this compliance is critical, as it is perceived by previous rulings by the German constitutional court that any failure to comply with the European treaties would imply an automatic exit of Germany from the EU.

    Therefore the European interest rate is designed to guarantee that the loans by the EFSF/EFSM are not interpreted as a "free ride" but only as an assistance to compensate for disfunctioning markets

  3. If the idea is to (i) provide a signal (punishment as suggested by Pedro) and simultaneously (ii) genuinely help Portugal why not go further? A possibility could be to include objective performance criteria in the agreement for lowering the interest rate as the program advances conditional on implementation performance. This would possibly create better incentives for improved performance in implementing the measures and reduce default risk.

  4. ING received €10bn in the middle of the financial crisis. The payback agreement that was made with the Dutch government was to repay with a 50% penalty rate. Ing has payed already €5bn from the bailout money and €2.5bn as penalty.

    This was - they say - the only way the EU would accept the bailout terms, but in closed doors (internal market) dutch state says the penalty is to give a lesson to the banks not to take these risks anymore.

    This example - wich shows the mindset in the Netherlands - might help you reach closer to the answer.

  5. Vote sent by email, anonymous: combination of
    1. marginal rate paid by the funders of the bailout
    2. Punitive mental framework

  6. No, no, no Pedro, 3.25%=5.5%. Not your fault, but the news have been really confusing about this. I'll explain when I get a chance. It's long and technical but in short: these are two different interest rates, apples and oranges.

  7. @Ricardo

    please explain us! my understanding is that what matters for the fiscal consolidation numbers for 2011-2013 to add up (conditional on the deficits and nominal growth) are the interest payments for the next three years. Not an "equivalence" through maturity that affects the roll over. But i am probably missing something.