Research Blog
What next for the euro area?
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
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2 November 2011
The surprise announcement by the Greek Prime Minister earlier this week that the government will hold a referendum on whether or not to accept the terms of the latest bailout package triggered a violent market reaction, with equity markets and peripheral euro area government debt selling off sharply and “safe-haven” government bonds heading back towards the record highs seen in September. The market instability even forced the EFSF to postpone a bond sale planned for Wednesday.
That means that, less than a week on from the summit where euro area leaders had promised to deliver a comprehensive solution to the debt crisis, market sentiment is arguably even worse than before it was called. And while it may have been the shock announcement from Athens that triggered the violent market reaction, arguably all that news did was to accelerate what would have happened anyway following the disappointing conclusion to last week’s summit.
So, is there any hope that euro area policymakers can make the decisions announced last week ultimately work? We are doubtful. But there are several key events worth watching over coming weeks.
This week’s G20 summit is clearly crucial. Markets are looking (hoping?) for any signs that other G20 countries are prepared to put money into the SPIVs that euro area leaders proposed would be established to take over the ECB’s current job of buying peripheral sovereign debt. But any expectations that such a SPIV can be established, in the near term at least, are likely to be disappointed. Many countries have already expressed scepticism at suggestions they might put funds into a euro area-administered SPIV. Rather, any support, they have indicated, is most likely only to be made available via the IMF, which is unlikely to allocate its own funds to SPIVs to make bond purchases. So, while G20 countries might this week be too diplomatic to kill off once and for all the SPIV proposal, the best that can be hoped for is probably a pledge to provide additional resources to the IMF to be disbursed, if necessary, via bilateral loans to individual euro area countries. That is unlikely to be of immediate help to Italy and Spain, neither of which yet has an EFSF/IMF programme in place.
So, with the G20 meeting likely to leave near-term prospects of setting up any meaningful SPIVs slim, attention will turn to how the euro area anticipates that the proposed use of the EFSF to provide insurance on primary issuance of euro area government bonds will work in practice. As we wrote last week, there are myriad questions unanswered about exactly how such an insurance scheme would work. These issues are due to be hammered out at eurogroup meetings scheduled for 7 November and 29 November. Whether they can indeed be solved by then looks doubtful. And even if they can, we are highly sceptical that such an insurance scheme will definitively stop contagion. First, there is a dangerous degree of randomness embedded in the insurance scheme. Guaranteeing the losses of some government bonds and not others risks generating market instability by creating a multi-tier government bond market. Moreover, the scheme’s focus on the primary market will leave Italy’s and Spain’s secondary market “unprotected”. Ultimately, we believe that the insurance policy option will not get off the ground.
All the while, events around Greece will remain highly uncertain. The government is teetering on the edge, while the referendum pledge has raised the spectre that the next €8bn bailout tranche, which needs to be disbursed by the end of November, will not now go ahead. If it doesn’t, the referendum will be largely academic, with Greece forced into an unmanaged default before the year is out.
Given all of the above, it is therefore difficult to see how market conditions will improve markedly in the near term. Indeed, successive disappointments, whether over emerging market countries’ enthusiasm to contribute to the proposed SPIVs, the realisation that the EFSF insurance scheme is unworkable and/or insufficient, or more turmoil in Greece, could see market conditions worsen considerably. That will leave euro area policymakers back at the drawing board. Their next scheduled summit is on 9 December. Even if they can hold off until then, markets will by then be demanding much more than is currently on offer. But the policy options are narrowing. Indeed, having rejected the option of turning the EFSF into a bank, that may well ultimately be back where we end up, with the EFSF buying bonds and then using the ECB to provide leverage through repurchase operations. That, of course, assumes that the German Parliament would agree to such a scheme, something that is likely to prove a high hurdle.
All the while the ECB will have to remain the buyer of last resort. And it is likely to have to increase the size of its purchases. Even reports of ECB buying in the past couple of days failed to prevent Italian yields hitting euro-era records and spreads hitting the sort of levels that prompted the bailouts in Portugal and Ireland, suggesting that the market’s responsiveness to ECB buying is diminishing. The crisis therefore looks set to have many more twists and turns over coming months. Ultimately we believe that euro area policymakers will find a more profound and lasting solution to the crisis. But the deeper the crisis is allowed to get, the more expensive the eventual solution, while the chances that increasingly desperate policymakers end up blowing up the euro as it’s currently constructed, whether by accident or design, grow.
Grant Lewis, Head of Research
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