The point of no return?



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Tobias S. Blattner, Economic Research
Daiwa Capital Markets Europe Limited
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29 November 2011

So far this week, markets have sounded a more optimistic note. Equities have registered gains and euro area sovereign spreads have narrowed, while Italy and Belgium have managed to sell about €10bn of new bonds. The better performance appears partly to reflect (in our view unfounded) hopes that the long-awaited enhancements of the EFSF’s toolkit, to be agreed this evening by euro area finance ministers, might deliver a remedy to the euro area’s ever-worsening debt crisis. And so, it appears that yesterday’s stark warning by Moody’s, that it is now reviewing its credit ratings of all EU member states, has been largely ignored, at least for now.

Ignoring Moody’s stark report, however, might turn out to be very costly for those who haven’t yet positioned themselves for the most chilling winter in the short life of the euro area. Moody’s message was crystal clear: unless market confidence returns by early in the New Year – through whichever means – Moody’s will give a massive ‘two fingers’ to the whole euro project via an unprecedented series of downgrades of the credit ratings of possibly all euro area member states, including the strongest.

The probability that the present policy toolkit could survive a downgrade of one of its larger AAA-rated countries is, in our opinion, minimal. In this event, the euro area’s first aid kit, the EFSF, already barely credible, would collapse like a house of cards as its current lending capacity hinges critically on the AAA-ratings of the euro area’s core. Maintaining the EFSF’s AAA-rating in this case would involve a substantial reduction in its already insufficient lending capacity of €440bn. Abandoning its AAA-rating would result in a further increase in the EFSF’s funding cost, which at 165bps over Bunds already looks precariously high, and very possibly a complete evaporation of demand for its own bonds and hence its ability to lend. 

So, by further undermining investors’ confidence in the ability and commitment of euro area governments to save the euro, Moody’s action would accelerate the flight of capital out of euro area bond markets. The result would most likely be a broad-based buyers’ strike, ultimately causing an Italian and Spanish default if the IMF was unable to cobble together sufficient resources for Greek-style bailout packages (see blog last week). 

As well as raising the possibility of a downgrade of one of the AAA-rated countries, which we consider as increasingly likely (with France and Austria the most vulnerable), Moody’s explicitly threatened to downgrade Italy and Spain to junk status if those countries were to receive a bailout package. Such a move looks drastic. But given the recent experience of Greece, and the calamitous policy response of euro area leaders to the crisis, it is hardly illogical. Indeed, more than anything it would  reflect the legacy of past policy mistakes, not least Germany’s stubborn insistence on a haircut on Greek bonds and its oft-repeated desire to see private investors similarly bear the costs of any bailouts for other member states enacted after 2013.

So, where does that leave us? Euro area policy-makers think that they have two more shots left to prevent Moody’s (and possibly other rating agencies) pulling the plug on the euro. The first is their flawed insurance scheme for bonds sold in the primary market. The second is their forthcoming plan, due 9th December, to change the Treaty (or establish an intergovernmental agreement) that allows for much tougher controls on fiscal policy of member states that breach the rules.

For Moody’s to hold fire, these policy actions need markedly to change market sentiment. But neither of them, in our view, will. We therefore expect Moody’s to let deeds follow words and downgrade the majority of sovereign and bank credit ratings in the euro area, either before or after Italy and Spain have been forced to ask for financial assistance. That will serve to further accelerate the crisis - there simply is not enough IMF and EFSF resources to bail out both countries at the same time.

At that point it will be crunch time. Either both the ECB and the German government shift from their current deadlocked positions and countenance a significant increase in central bank bond purchases alongside steps to establish new Eurobonds, or the euro collapses. Unfortunately, the longer they don’t back down, even as the crisis reaches its crescendo, the less confidence we have that they ultimately will. The point of no return is almost upon us.


Tobias S. Blattner
Euro area Economist

 

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