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Panic swept through the European debt markets in early July as the long-feared spread of peripheral debt concerns to larger eurozone economies became a reality.
The markets seem to have been wrong-footed by the key link in the contagion chain – Spain – being bypassed for concern to focus on Italy. At one point on July 12, Italy’s benchmark 10-year bond yields hit 6.09%.
Spain, with €650 billion of outstanding debt, was supposed to be small enough for the fallout from a default to be contained but large enough to elicit a policy response. It is now too late for that. The crisis has moved from the narrow periphery to the broader periphery of Spain and Italy and even threatens the soft core of France and Belgium.
Liquidity ambush
“Any indebted sovereign can be subject to a liquidity ambush and, while there were some minor concerns about Italy’s fundamentals, there was nothing to surprise the markets in Italy or Spain to have triggered a fundamental change,” observed Citi’s chief economist, Willem Buiter, on July 12.
But he pointed out that the country (which has €1.6 trillion tradable debt and €1.8 trillion total debt) has a refinancing requirement of €900 billion over the next five years, together with a deficit of €100 billion over the next three years – something that its recent weak €40 billion austerity package will do little to tackle. “These are numbers that cannot be managed through existing facilities,” he said.
Failed policy response
Buiter attributed the sudden turmoil to the failure of the July 11 meeting of 17 European finance ministers to come up with any concrete proposals to tackle the crisis. “Market panic is due to a disenchantment with the European policy response, which has been a combination of denial and impotence,” he declared.
“There has been a refusal to recognize the insolvency of the Greek sovereign and a refusal by the European Central Bank to contemplate any restructuring that would result in a default or trigger credit default swaps. There is no appreciation of the need to lance this particular boil.”
EFSF must enlarge
Enlargement of the European Financial Stability Fund (EFSF) to a clearly-now-inadequate €440 billion will not take place until the autumn, so European policy-makers have very little ammunition with which to tackle a liquidity crisis that engulfs Spain and Italy. When the ECB closed its Securities Markets Programme last March, it also refused to give the EFSF power to purchase bonds in secondary – two decisions that will probably now be urgently revisited. “The ECB will have to open its coffers and engage in outright purchases of the sovereign debt of Italy and Spain if it is to avoid a catastrophic sovereign default,” Buiter concludes. The recovery in Italian 10-year bond yields to 5.56% by the end of Tuesday July 12 was widely attributed to the ECB buying bonds in secondary although the bank itself declined to comment on whether this was the case.
All attention is now on the bailout fund – which finds itself in the eye of the storm. When Euromoney spoke to EFSF chief financial officer Christophe Frankel in May, he declared that “we don’t expect to get involved in further jurisdictions” and that the scope and remit of EFSF operations was not expected to increase.
But a substantial increase in the size of the fund now seems inevitable. This calls into question the pro rata nature of the triple-A sovereign guarantees that back it and risks a crowding out effect for other sovereign borrowers. Any substantial increase in the EFSF guarantee requirement will lead to an increase in the debt-to-GDP burden of those sovereigns that back it – something that could even put the triple-A status of some (most notably France) in question.
France: The quiet sick man of the eurozone
June 2011
