Keeping Greece in and allowing massive European Central Bank intervention are the best ingredients for saving the eurozone. But the case for common eurozone bonds is less clear.

In early 2010, the eurozone faced an individual challenge as market liquidity began to drain from Greek government bonds and banks, following the revelation by the newly elected government of George Papandreou that the actual budget deficit was twice what the previous government had disclosed.

Two years later, this has migrated into a systemic crisis. Spreads are widening dangerously on government bonds issued by Italy. Interbank lending is freezing up as banks fear each other’s sovereign exposures, forcing the European Central Bank (ECB) to provide ever more liquidity at ever longer tenors. And at the time of going to press, even AAA rated eurozone economies such as France were on watch for possible sovereign downgrades by ratings agency Standard & Poor’s, which cited growing disruption to bond market access across the eurozone.

While the scale of difficulties may seem overwhelming, and the individual problems have undoubtedly become interwoven, it is still possible to disentangle them and refashion a more resilient eurozone. And there are very good reasons to do so,even for the stronger northern eurozone economies such as Germany and the Netherlands, whose politicians are increasingly anxious about the bill for bailing out distressed governments further south.

“The peripheral sovereign crisis is a core banking crisis in disguise. Current account surpluses in the core eurozone were being recycled as bank lending to the periphery, so there is no way for the core to walk away – if they do not bail out the periphery, they will be bailing out their own banks,” says Richard McGuire, senior fixed-income strategist at Dutch co-operative banking giant Rabobank – one of the few entities in the eurozone that still has at least one AAA rating to its name.

Mr McGuire has calculated banking sector exposure to the periphery at 14.7% of gross domestic product (GDP) in Germany, 18.4% in the Netherlands, and 24.3% in France – or 7.5% of French bank assets. The European Banking Authority’s (EBA) bank recapitalisation plan published in December 2011 to help “restore confidence in the banking sector” already calculates a capital shortfall of €7.3bn for French banks, and €13.1bn for Germany banks. And that cost assumes the survival of the eurozone.

IMF gets tough

While no longer the largest problem facing the eurozone, Greece is still the most severe. Its economy is starved of credit, its debt burden is not viewed as sustainable, and no final plan has yet been crafted to return it to sustainability. Under the proposed second private sector involvement debt deal (PSI2), a 50% haircut and maturity extensions would add up to a net present value reduction of about 70% on Greek debt.

But the deal is in theory voluntary, to avoid triggering credit default swaps or cross-default clauses on other liabilities. In its fifth review of Greece’s stand-by agreement in December 2011, the International Monetary Fund (IMF) warned that given “low participation in the debt exchange and a significant amount of hold outs to be amortised with European support – a real risk under a purely voluntary approach – debt could stick above 145% of GDP in 2020.” To reach the goal of 120% debt to GDP by 2020, which the IMF considers sustainable, it believes "near universal participation is necessary".

Gabriel Sterne, economist at specialist distressed and illiquid asset brokerage Exotix, says that prices on many Greek bonds are now trading sufficiently low – sometimes close to 20 cents on the euro – to justify investors exchanging them under PSI2 in any case.

“The March 2012 bonds are the ones to watch. It is a big maturity of €14bn, and prices are more than 40 cents, which is getting to the point where it is worth investors holding out,” says Mr Sterne, who previously worked for the Bank of England and the IMF.

If PSI2 fails to deliver adequate participation rates, Mr Sterne fears the IMF may be reluctant to release another loan tranche, as its mandate explicitly forbids lending money into an unsustainable debt burden. Antonio Borges, the Portuguese head of the IMF’s Europe department, who was perceived as relatively lenient towards eurozone debtors, was replaced in November 2011, and the fifth review overseen by his replacement has a markedly tougher tone.

Italy’s projected sovereign interest costs (Ebn)

Lessons from emerging markets

A suspension of IMF funds would almost certainly lead to a Greek default. That in turn could trigger a run on Greek banks, which the EBA has already diagnosed with a capital shortfall of at least €30bn. Only capital controls could prevent such a run, since depositors can move their money freely to safer banks in the eurozone without even changing currencies.

But capital controls are illegal under EU law, and exit from the euro would be beckoning. Officials at the IMF European department have apparently already approached former central bankers who organised the splitting of the Czech and Slovak currencies that took place in January 1993. For Greece, the more appropriate comparisons would be the collapse of currency pegs in Turkey and Argentina in 2001 and 2002, respectively. In particular, Argentina converted many of the banking system liabilities (deposits and bonds) from dollars into pesos, and imposed sweeping capital controls.

Mario Blejer, today the vice-chairman of Banco Hipotecario, was promoted from vice-governor to governor of the Argentine central bank in January 2002, just days after default and devaluation. He notes that Argentina introduced capital controls in December 2001 in response to an 18% deposit outflow over the preceding months.

Deposit outflows in Greece since the start of 2010 have already exceeded that level, and Mr Blejer is surprised more Greeks have not moved their savings to relative havens in the eurozone. He says the first task for Greece after any return to the drachma would be to restore the confidence of its own citizens. In Argentina, this meant efforts to stop the peso depreciating beyond the disastrous 80% decline that occurred in the opening weeks after the peg to the dollar was broken.

“Our slogan became doing everything possible so that people’s greed exceeds their panic, and it worked at the time. We offered 140% interest rates on central bank bills, partly to absorb the liquidity we were injecting into the banks to avoid their bankruptcy. This killed real lending initially, but within a month our interest rate had already fallen back to 17%,” says Mr Blejer.

Even then, banks and companies defaulted as they could not pay maturing bonds in dollars. And the return to stability ultimately requires a strong policy response from the government as well as the central bank. Sureyya Serdengecti, who became central bank governor in Turkey weeks after its maxi-devaluation in February 2001, says pressure on the lira only really abated once finance minister Kemal Dervis had introduced sound policies to reassure the public.

“Even that was not enough. We needed a package from the IMF that was the largest ever at that time. Greece would still need support from the IMF, from the EU, from Berlin,” says Mr Serdengecti.

Italian tipping point

This all sounds rather like the same formula needed to keep Greece in the euro anyway. But staying in would avoid the potential legal and social breakdown resulting from mass defaults and redenominations of Greek debt and deposits. In fact, the only compelling reason for Greece to return to the drachma would be to improve competitiveness without having to cut nominal wages as sharply as Ireland or the Baltic states have done.

Even that advantage could be fleeting. When Greece operated a fixed exchange rate in the 1980s, it devalued twice, but nominal wages increased almost in line with the devaluation on both occasions. Moritz Kraemer, managing director of European sovereign ratings at Standard & Poor’s, warns that competitiveness gains would be quickly eroded if the country does not change the way its labour markets or local monopolies work.

And in Mr McGuire’s words, Greece is the plug in the eurozone bathtub, since fears of contagion would drain remaining liquidity out of the rest of the periphery if Greece were removed. The real concern is Italy, which has more than €300bn in maturing sovereign debt in 2012 alone. Neither the IMF nor the European Financial Stability Facility, nor the yet-to-be completed European Stability Mechanism, would realistically have the firepower to bail out Italy.

Sovereign debts are 120% of GDP, but Italy has historically run a surplus on its primary budget (excluding debt repayments), so its burden is still viewed as sustainable. But only just. Mr McGuire calculates that the rise in interest rates already seen between August and November 2011 was enough to drive Italy’s debt servicing costs up by 4% of GDP by 2016 – about the same size as the 2011 budget deficit (see charts).

Rebuilding confidence

This means the eurozone needs to restore investor confidence in its future, and fast. Michael Hasenstab, portfolio manager of the $61bn Templeton Global Bond Fund, says the December 2011 summit was a start, as eurozone leaders have at least recognised that existing fiscal infrastructure was insufficient to support a monetary union. He says investors can start thinking about what the eurozone may look like a year or two down the road.

But he adds that the number and depth of alternative markets are now far greater than they were even a decade ago. As of October 2011, his own fund was holding less than 3% of its assets in the eurozone, and its three biggest holdings were in South Korea, Poland and Malaysia.

Even so, a sovereign credit analyst for the investment arm of one of the largest US insurers says it is difficult for major institutional investors to avoid eurozone government debt altogether for long periods of time.

“Where else do you put your money? The eurozone remains one of the three largest debt markets alongside the US and Japan. The Swiss National Bank has already made clear that the country cannot handle significant additional inflows, Sweden and Norway might follow suit, and Poland now has 40% of its government debt held by non-residents,” he says.

Maintaining a very short position on the eurozone is not risk-free, he adds. If there is a credible resolution to the crisis or heavier ECB intervention, investor attention could quickly switch to the lack of political consensus on debt reduction in the US, or Japan’s 220% government debt-to-GDP ratio and rapidly ageing population.

Italy’s debt sustainability

Eurozone bond unlikely

With yields still widening after the December 2011 summit, it is clear that more needs to be done to achieve that elusive turn in market sentiment. The pan-eurozone funding squeeze is a confidence crisis, because the euro area as a single entity is fundamentally sound. Standard & Poor’s estimates that the GDP-weighted average eurozone rating is only a few notches below AAA.

“The eurozone as a whole is a fairly balanced economy and is fairly creditworthy. Its debt-to-GDP ratio is better than that of the UK or the US. What complicates the eurozone is the fragmentation, which leads people to endorse the notion of eurozone bonds, as it sounds like an easy solution to overcome this,” says Mr Kraemer.

But it only sounds like an easy solution, he emphasises. Common issuance for 17 different sovereign states with 17 very different levels of public debt would be difficult to engineer even in supportive market conditions. So there is understandable reluctance, especially in Germany, to attempt such a radical rebuild of market infrastructure "mid-flight when the engines have stopped", as Mr Kraemer puts it.

The December summit showed that the German government requires closer fiscal coordination as a prerequisite to common eurozone issuance. Amid all the controversy over the proposed fiscal pact, the infrastructure for tighter controls is already in place, suggests Charles Proctor, partner in international financial and monetary law at law firm Edwards Wildman.

“The Excessive Deficit Procedure already exists, and the Stability and Growth Pact should be effective on paper. But it was never properly enforced in practice. By contrast, a central treasury and common borrowing would be much harder, as existing treaties did not contemplate such measures,” he says.

Mr Hasenstab draws some consolation from the December deal because he believes it proposes a clearer enforcement mechanism through the European courts. But he notes that fiscal policies tend to have higher investor credibility in countries that have individual national constitutional debt limits with automatic stabilisers, such as Germany, Poland or Sweden.

In fact, fiscal policies have diverged sharply since the advent of the euro and the Stability and Growth Pact. Mr Kraemer estimates that the dispersion of ratings on eurozone sovereigns has widened from about 1.5 standard deviations in 2000 to almost six today – although that will narrow slightly if some sovereigns lose their AAA rating in the coming days. And Mr Sterne points out that false investor expectations of fiscal convergence played a part in causing the crisis in the first place.

“Before the euro, Greece had higher interest rates. The lower risk perceptions reduced Greek interest rates, and that did sow the seeds of a credit boom and over-borrowing by the government,” says Mr Sterne.

This raises the question of whether proper investor discrimination between eurozone sovereigns might not be a better enforcement mechanism than any pact. As for a full fiscal union involving significant sacrifices of national sovereignty, this is a very long-term project. Axel Weber, the former Bundesbank president who now chairs UBS, apparently told a recent client briefing that he thought genuine fiscal union would take 20 years to create.

Crucial role: all eyes are on new Italian prime minister Mario Monti’s fiscal package to rescue the country’s economy

Reaching the last resort

Italy does not have 20 years to wait. Mr Hasenstab sees Mario Monti’s fiscal package as essentially credible, but says there are still execution risks. That means something more will be needed to bring investors back on board while they await concrete results.

The ECB is the only entity suitable for providing ongoing emergency funding while governments and banks deleverage simultaneously. Mr McGuire says the central bank should contemplate the Swiss currency intervention model – setting a target maximum yield on eurozone government debt and pledging unlimited purchases to keep yields below that ceiling. In the case of the Swiss franc, the mere announcement of such an approach was enough to curb speculation.

But the ECB – and the German government that would ultimately have to recapitalise it – is understandably unwilling to risk heavy losses by buying into an unsustainable debt burden. Drawing on the experience of debt buybacks in emerging markets, Mr Sterne suggests an alternative. The ECB could announce that it would buy unlimited amounts of sovereign bonds, but at a price well below current market levels.

If most investors chose to unload bonds onto the ECB, this would allow its president Mario Draghi to negotiate repayment directly with the affected sovereign, at a price slightly higher than the ECB’s purchase price. That would enable a significant write-down of the sovereign’s debt without incurring large losses for the ECB. If investors refused to sell at that price, then the ECB would have placed a floor under the bonds (and a ceiling on yields) in any case.

This is certainly radical, but having just returned from a very sobering trip to Greece, Mr Sterne warns that the ECB needs to think about the damage it could suffer from a Greek default.

“Greek pensioners have already seen the value of their pensions fall by as much as 75%, because the pension funds were legally required to invest heavily in government debt. If Greece leaves the euro, there would be a real temptation for the government to turn populist, and write off debts owed to the ECB rather than inflicting more pain on Greek citizens,” he says.


All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker

For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Top 1000 2023

Request a demonstration to The Banker Database

Join our community

The Banker on Twitter