Contagion May Force EU to Expand Arsenal to Fight Debt Crisis
Investors’ no-confidence vote in the aid package for Ireland may force European policy makers to expand their arsenal to fight the debt crisis threatening to tear the euro apart.
Options outlined by economists at Societe Generale SA and Barclays Capital include: Boosting the 750 billion-euro ($975 billion) temporary rescue fund or turning it into an asset- buying program; cutting interest rates on bailout loans; issuing joint bonds for the 16 euro nations or flooding the economy with cash from the European Central Bank.
All would be unprecedented, and none of Europe’s political leaders -- dominated by German Chancellor Angela Merkel -- has indicated the steps are being considered. Earlier this year, they struggled to cobble together the measures that investors and economists now say are proving inadequate to safeguard the euro and keep speculators at bay.
“You’ve had repeated interventions, but the markets are still selling in response,” said Andrew Balls, London-based head of European portfolio management at Pacific Investment Management Co., which runs the world’s biggest bond fund. “Policy makers have to move beyond a country-by-country approach and think about the system-wide challenges.”
Investors punished Europe’s markets in the two days since Ireland became the second euro nation after Greece to get outside aid. Selling extended beyond “peripheral” countries including Portugal to core members of the euro area such as Italy and Belgium.
The euro yesterday fell to a 10-week low versus the dollar and yen. Italian, Belgian and Spanish government bonds fell, driving the extra yield investors demand to hold them instead of German bunds to euro-era records. The ECB bought Irish and Portuguese bonds today, people with knowledge of the matter said. Standard & Poor’s yesterday put Portugal’s sovereign debt ratings on “CreditWatch” with “negative implications.”
Risk premiums narrowed today as Italian, Spanish and Irish bonds rose after ECB President Jean-Claude Trichet signalled officials may be willing to step up their response. The euro gained 0.9 percent to $1.3104 at 11:30 a.m. in London.
Policy makers must assert authority to fight “demanding” market conditions, Trichet said. “We need a sense of direction,” he told lawmakers in Brussels. Observers “are tending to underestimate the determination of governments.”
‘Whatever It Takes’
Behind the selloff are concerns that the European Union is overcharging Ireland; fear that politically unpopular deficit cuts will flop or trigger recession; suspicion some countries may still restructure their debt; doubts that cash injections can treat underlying debt woes, and speculation that the EU’s fractured politics will negate a pledge by Economic and Monetary Affairs Commissioner Olli Rehn to do “whatever it takes” to maintain financial stability.
While euro-area governments can lend to each other, they are barred from assuming each other’s debts under rules dictated by Germany in the 1990s.
The off-the-shelf option is to expand the European Financial Stability Facility, set up in May to lend to distressed treasuries. Ireland was the first to tap it, drawing about 18 billion euros from a 440 billion-euro war chest underwritten by euro-region governments.
War Chest Size
Due to collateral constraints, the EFSF’s actual lending capacity is less than the headline figure, raising doubts about whether it would be able to respond to a fiscal emergency in Spain, the euro region’s fourth-largest economy, according to strategists at Barclays. They say at least another 100 billion euros of funds should be added.
The EFSF needs twice the firepower, said Paul de Grauwe, a professor at the Catholic University of Leuven in Belgium and two-time candidate for an ECB post. Ireland’s average interest rate on the bailout of 5.8 percent is “punitive,” he said, and jolts confidence by showing that European governments aren’t sure they’ll get their money back.
“We shouldn’t be surprised if the markets don’t trust it either if the European leaders don’t trust their own program -- that’s what the high interest rate means,” De Grauwe said. “It really undermines the credibility of this whole program.”
Bundesbank President Axel Weber’s suggestion last week to increase the fund was repudiated the next day by Merkel and French President Nicolas Sarkozy, both targets of domestic criticism for using taxpayer money to prop up Europe’s fiscal weaklings.
Just as U.S. authorities transformed the aim of their Troubled Asset Relief Program from buying illiquid assets to injecting cash into banks, Klaus Baader, co-chief European economist at Societe Generale, suggests EU policy makers may use the facility to buy bonds of peripheral countries.
“They would have to burn short positions with serious amounts,” said Baader, who also says governments may soon threaten to ban certain bets against European bonds.
The U.S. Treasury Department said yesterday that its top international official, Lael Brainard, will visit Madrid, Berlin and Paris this week to meet with senior officials.
Another option is to make the EFSF available to countries before they succumb to a speculative attack, along the lines of a flexible International Monetary Fund credit line tapped by Poland last year, said Andre Sapir, an economics professor at the Universite Libre de Bruxelles and former EU adviser.
“One could discuss which countries would maybe benefit and the system as a whole would benefit from having that umbrella,” Sapir said. “This is the next step that should be considered seriously.”
Joint bond issuance -- an idea kicking around since the pre-euro era -- is also back up for debate. Luxembourg Prime Minister Jean-Claude Juncker, head of the panel of euro-area finance ministers, last week sought to overcome German opposition to forging a common bond market for all euro users.
The upside would be to create a more liquid market, attracting buyers such as China. The downside, in the German mind, is that fiscally prudent governments would end up paying higher interest rates, in effect subsidizing the weaker ones.
“If bond yields keep rising like this then we may see a much faster move towards a de facto fiscal union with a central debt management office and a single European government bond, possibly under the auspices of the EFSF initially,” said Gary Jenkins, head of fixed income at London-based Evolution Securities Ltd.
To ease bank borrowing costs in debt-strapped nations, the ECB should resume purchases of covered bonds, Morgan Stanley analyst Huw Van Steenis says. Its decision to end the program, enacted during the recession in 2009 to encourage lending, on June 30 was “unhelpful,” he wrote.
Another solution suggested by JPMorgan Chase & Co. chief European economist David Mackie is to transfer 350 billion euros from the balance sheets of Greece, Ireland and Portugal to richer sovereigns. Mackie calculates that would reduce their debt to the EU limit of 60 percent of gross domestic product, and push up the debt ratios of core euro economies by less than 5 percentage points.
The result would be a reduction in the fiscal tightening required in the weaker economies and the elimination of chaos caused by a debt restructuring, he said in a Nov. 17 report.
“In the next five to 10 years there has got to be more of a fiscal union within the euro region than we have today,” said Paul Donovan, deputy chief global economist at UBS AG in London. “One of the things that Europe does well is integrate in a crisis.”
Economists such as Charles Dumas, research director at Lombard Street Research Ltd. in London, doubt policy makers would be able and willing to head off sovereign default.
“We’re waiting for someone to say the emperor has no clothes,” Dumas yesterday told Ken Prewitt and Tom Keene on Bloomberg Radio’s “Bloomberg Surveillance.” “We’re waiting for people who have spent 12 years explaining what a great thing euro is to admit they were wrong.”
With politicians sluggish to act, investors are banking on tomorrow’s meeting in Frankfurt of the ECB’s Governing Council amid speculation it will again delay its exit from emergency liquidity measures for the good of the euro.
Peter Westaway, chief European economist at Nomura International Plc, predicts the ECB will delay a return to more limited auctions of three-month loans until after January. It will boost its buying of bonds to include Spanish and Italian assets, he said. The bank already bought the most government bonds in two months last week.
No Time to ‘Experiment’
“This is not the time to experiment with money-market operations,” said Westaway. “A significant increase in ECB bond purchases to the extent that is feasible would signal that it is providing a crucial policy back-stop that would halt the increase in periphery bond spreads.”
The ECB may be forced to follow the Federal Reserve and Bank of England in conducting quantitative easing in which it buys assets to inject cash into the economy and doesn’t offset the purchases as it does now, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York.
“As the crisis deepens and threatens core countries, the future of monetary union continues to be called into question,” said Chandler. “As the situation becomes more desperate, the unthinkable has to be thought. Quantitative easing by the ECB may be one of the few ways out.”
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