Research Blog
Time running out for a happy ending?
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
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18 November 2011
Just three weeks on from the summit at which euro area leaders supposedly delivered their comprehensive solution to the debt crisis and things are worse than ever. Having tightened immediately after the summit, spreads have subsequently widened markedly. And not just for the usual PIIGS suspects – the French 10Y spread to Bunds is now around 60bps higher than on the day of the summit, while both the Netherlands and Finland, previously largely immune to contagion, have also seen their spreads rise.
Change in euro area sovereign bond spreads since summit*
*Change in the 10Y spread to Bunds between 26 October and 18 November. Source: Bloomberg and Daiwa Capital Markets Europe Ltd.
Numerous factors, including the threat of a Greek referendum and political uncertainty in Italy and Spain, have contributed to the deterioration in market conditions. But, fundamentally, it has been the lack of policy clarity, and a growing realisation that the policy options available to deal with the crisis are both few and unpalatable, that have been the main drivers behind recent market moves. Public utterances from policymakers that some countries could possibly leave the euro area, a previously taboo subject, have added to those fears.
It quickly became apparent that the so-called “comprehensive solution” offered at the 26 October summit was nothing of the sort. The proposal to use the EFSF as an insurance scheme for new primary bond issuance looks unworkable. Even ignoring the myriad technical questions that remain unanswered, recent weeks have seen the EFSF itself increasingly questioned by markets – the spread of EFSF bonds to Germany has increased markedly (see chart), while it struggled to issue just €3bn of new bonds last week. Meanwhile, it rapidly became apparent that the hoped-for rescue funds from the rest of the world were not going to materialise, killing off the proposed SPIVs as a meaningful source of firepower.
EFSF spreads*
*Spread of EFSF 2.75% 07/16 to DBR 4% 07/16. Source: Bloomberg and Daiwa Capital Markets Europe Ltd.
So, the euro area’s best effort at delivering a comprehensive policy package has been given a decisive thumbs down. Euro area leaders, of course, continue to hope that individual countries themselves can restore market confidence. The installation of so-called “technocratic” governments in both Rome and Athens is designed to provide renewed impetus to delivering fiscal and structural reforms in Greece and Italy. But it is highly doubtful that markets will be willing to give these new governments the benefit of the doubt – market participants are now looking for guarantees, not promises. So, what options are left?
Previously, when euro area countries’ funding costs have reached the sort of unsustainable levels currently now facing both Italy and Spain, they have been offered multi-year financial assistance packages funded primarily by the EFSF and the IMF. But there are simply not enough resources in the EFSF and IMF at present to offer the sort of comprehensive package required for Italy, let alone Spain as well. At a stretch it may be possible to cobble together an 18-month package together for Italy. But that would leave the cupboard bare for Spain, while leaving serious doubts that market confidence would recover sufficiently to allow Italy to return to markets at reasonable rates by the end of the programme.
Another option would be to return to the original plan of the EFSF becoming a purchaser of bonds. But that faces the same constraint as the previous option – a lack of resources. On the assumption that the EFSF is able to continue to raise funds, it might have around €300bn of resources left after the bailouts of Greece, Portugal and Ireland, that would leave enough resources for perhaps only six months of bond purchases.
Of course, euro area leaders could theoretically agree to increase the resources available to the EFSF. But France is constrained by the potential impact on its AAA rating of offering additional guarantees, while Germany is adamant that no more money will be forthcoming. A bigger EFSF does not look to be on the cards.
The EFSF route is perhaps, therefore, now a busted flush. There is no political will to increase its resources, while there are serious doubts over its ability to fund itself fully. The reception to its most recent bond auction suggests that the initial enthusiasm for the credit has rapidly waned. Finding sufficient investors to take the full €440bn of debt permissible under the current arrangements now looks set to be a significant challenge. So what’s left?
With the euro area’s politicians repeatedly failing to deliver, all eyes have inevitably turned to the ECB to save the day. And, having unlimited firepower, it certainly could. But that doesn’t mean that it will (or should). German opposition to the ECB acting as lender of last resort to euro area governments appears implacable. Indeed, the President of the Bundesbank recently upped the stakes, arguing that it would actually be illegal for the ECB to go further, raising the possibility that any expansion of the ECB’s bond purchase scheme would trigger legal action by the Bundesbank against the ECB. In any case, there is no indication that there is any appetite within the ECB itself to expand significantly its bond purchase programme. And those arguing against an ECB-led solution are right. While unlimited ECB purchases would solve the immediate problem, it would do nothing to address the deeper issues that underlie the euro area’s current difficulties. Indeed, if the ECB was to step in, the incentives for both individual countries and the euro area as a whole to reform themselves would disappear. And no currency that requires its central bank to finance governments on a long-term basis is going to be a success. On this the Germans are spot on. Unlimited ECB buying looks most unlikely.
That leaves closer fiscal union. But here too, while all governments accept the need for closer fiscal coordination, what that means in practice means different things to different governments. For the Italians, closer fiscal integration means joint and several guarantees of all euro area government debt by all other member state governments (effectively a German guarantee on all euro area debt). For the Germans, on the other hand, closer fiscal integration means stricter controls on errant member states’ fiscal policies. But it is the Italian version that the markets are looking for. And even if, in the face of severe market pressure, the Germans were to acquiesce to some form of Eurobond, to deliver it would require changes to the EU Treaty, something that would likely take many years, require an enormous amount of negotiation and be subject to potential rejection by any one of the 27 EU countries, particularly those committed to holding referendums. A move towards eurobonds, itself, would not therefore remove uncertainty immediately, although a commitment by euro area leaders to do so may provide the ECB with cover to up its bond purchases while negotiations get underway.
The repeated failure of euro area policymakers to get ahead of the crisis has left them facing a situation much worse than anyone ever imagined, and has meant that their policy options have narrowed alarmingly. Having lost so much market credibility, to regain it now will require something extraordinary. Certainly, the EFSF route, the basket into which policymakers have so far put all their eggs, increasingly looks a dead end. So the key issue is increasingly whether domestic politics in the 17 countries, and in Germany in particular, can coalesce around some sort of eurobond proposal. We continue to believe that it will. But with 17 (and arguably 27) governments needing to agree, there is plenty of scope for a spanner to be thrown into the works even if the German government backs down. The danger is, the longer the crisis goes on, and the more contagion spreads from the countries currently requiring support to the countries that are supposed to be providing the bailout funds, the more dangerous and intractable the situation becomes. We still hope for an eventual happy ending to the crisis. We don’t believe that any euro area government wants to see the euro fall apart, and attach only a small probability to that ultimately happening. But the longer that a truly comprehensive solution to the crisis proves elusive, the greater the chance that some form of break up is where we eventually end up, if only by accident.
Grant Lewis, Head of Research
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