Daily Themes - 3 December 2010

Euro-zone blueprint for containing bond vigilantes

While it is impossible to predict how long the current standoff between bond investors and euro-zone policy-makers will continue, we believe the eventual blueprint for containing bond vigilantes will involve a substantial increase in central bank bond purchases, an increase in the existing €440 bn European Financial Stability Facility (EFSF), further centralisation of euro-zone fiscal policy and eventual restructuring of some euro-zone government debt.

Markets are pushing for a response from European policy-makers - the European Central Bank (ECB), national euro-zone governments and the EU/eurozone institutions - and are unlikely to be satisfied until they get one.

The ECB acted yesterday, stepping up the size of its purchases of government bonds under its existing Securities Market Programme (SMP). Market rumours suggested purchases in tranches of €100 million, four times larger than usual, and this appears to have temporarily calmed periphery bond markets. But the ECB did not commit to full-blown quantitative easing and in the end we think further, more substantial action will be needed.

ECB will eventually resort to ‘nuclear option’

In the medium-term, to stem contagion and further spikes in bond yields, we think the ECB will eventually have to massively increase its purchases of euro-zone government bonds and do so without attempting to withdraw a similar amount of liquidity from the banking system elsewhere. This is what has been referred to as the ‘nuclear option’ - full blown quantitative easing on a similar scale to the US Federal Reserve. However, some members of the ECB governing council, especially those defending the inheritance of Germany’s Bundesbank, have been reluctant to do this so far.

EFSF will have to be increased

At the same time, a solution would probably also involve increasing the size of the existing EFSF, established after the Greek crisis by the euro-zone governments. This could involve even a doubling from the current stated maximum amount of €440 bn and using it not just to bail out euro-zone governments, but also to recapitalise weaker eurozone banks as well.

Given the way the EFSF has been set up – it needs to be over-capitalised in order to achieve a AAA credit rating and countries being bailed out by the fund cannot also be contributors to it – the effective spending power of the EFSF is a lot lower than its headline €440 bn figure would suggest. With recipients excluded as contributors for obvious reasons, as the number of countries needing help increases the maximum size of any bailout decreases. Ireland is the only country currently tapping the EFSF (Greece’s bailout was under a separate arrangement), but Portugal is likely to also need to tap it. If Spain or another large euro-zone country needed bailing out, it would probably need to be substantially increased.

The remaining contributors, especially Germany, would be the providers of extra funds. Regardless of whether Spain does eventually tap the fund or not, the point is that it must be sufficiently large that investors believe it can be used if required – even for a larger euro-zone country – in order to prevent bond yields spiking higher in the first place. Only then will it have sufficient credibility to reassure investors.

Expanding the size of the fund would effectively involve core euro-zone countries, Germany in particular, taking on credit risk from the periphery. Hence it would be politically difficult to sell to Germany’s domestic electorate. Unless markets force a response before then, an increase in the EFSF is unlikely before German regional elections scheduled for early next year.

Further centralisation of euro-zone fiscal policy is also likely. Indeed, it will probably be a precondition for Germany to agree to increase its contribution to the EFSF. Finally, the IMF may also have to expand the size of its existing commitment of up to €250 bn to the overall bailout fund agreed after the Greek crisis.

Restructuring some sovereign debt looks inevitable

Further down the line, the government debt of one or more of the peripheral euro-zone countries will need to be restructured in order to put it back on a sustainable path. The OECD projects that by 2012, the Greek debt will reach 142% of GDP and Irish debt will climb to 116% of GDP. At these levels, long-term solvency becomes an issue, so a restructuring of debt looks inevitable for Greece and very likely for Ireland.

However, we think restructuring government debt for one of these countries now would likely cause contagion to other euro-zone government bond markets and the wider financial system. As such, it would be a policy mistake damaging to risk assets.

Instead, restructuring Greek or Irish government debt in say two years time would be a more sensible policy solution, as by then it should be clearer which countries’ debt levels are sustainable and which are not. In other words, it would be easier for investors and policymakers to distinguish between countries with underlying solvency problems versus those with liquidity issues, and there would be less chance of contagion to other euro-zone government bond markets. In addition, the European banking system, having been given the time to recapitalise, would be in a better position to handle any write-downs on its sovereign debt holdings.

Will the euro-zone break-up?

We still think the chances of a partial euro-zone breakup with one or more countries leaving the single currency are quite low over the next 1-2 years (5-10%). But the chance of this happening does increase over time, especially because of the political dimension.

Voters in peripheral countries may become fed up with year after year of fiscal austerity, to the point that leaving the single currency area may then seem like a more attractive option. A political party recommending this option could eventually be elected in a euro-zone country. Risks are therefore concentrated around the political cycle from 2012 and beyond.

Conclusion

Economic history teaches us that no single currency across sovereign nations has survived without the combination of both monetary and fiscal union. 2011 is likely to see the EU wrestle with this reality in order to save the euro in its current form. Default or devaluation is the usual route for any country facing the kind of sovereign crisis which has already engulfed Greece and Ireland. Capital markets will press until a credible political solution is found, which will involve much greater centralisation of fiscal policy as well as further involvement from the ECB as a credible buyer of last resort for euro-zone periphery debt.

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