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News : EU Economy Last Updated: Feb 14, 2011 - 1:42 AM


Eurozone Sovereign Debt Crisis: European Central Bank returns to bond markets to buy Portuguese debt
By Michael Hennigan, Founder and Editor of Finfacts
Feb 11, 2011 - 4:57 AM

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Click here for European Central Bank presentation

Eurozone Sovereign Debt Crisis: The European Central Bank on Thursday returned to the bond markets to buy Portuguese debt, after a recent period of calm.

The ECB's move was in response to a jump in Portugal’s 10-year bond yield to a record euro period high of 7.63%. The ECB had suspended its bond-buying programme in mid-January.

Meanwhile, in the race to succeed Jean-Claude Trichet as ECB president when his 8-year term expires next October, Angela Merkel, the German chancellor, is today expected to urge the former frontrunner, Axel Weber, president of the German Bundesbank, to make way for a new central bank chief, as the heads of government of the 17 Eurozone countries, prepare to appoint a new head of the Eurozone's central bank.

It was reported earlier this week that Weber did not wish to seek a second term at the Bundesbank, a move that's seen as ruling himself out of contention for the ECB job.

In an interview with the Italian newspaper, L’Espresso, Trichet said: "A number of fiscal policies have to be improved very significantly because they are contributing to the creation of financial instability. We are experiencing a crisis of some sovereign signatures in the euro area, namely in Greece and Ireland. On the question of leaving the euro, I do not comment on absurd speculation."

He said it is clear in the eyes of the ECB that sound and rigorous national legislation could very significantly facilitate the implementation of the reinforced Stability and Growth Pact. "We are calling for a reinforcement of European legislation in this domain."

Senior bondholders of European banks should take a haircut on their investments instead of struggling banks being supported by taxpayer bailouts, Citigroup's chief economist, Willem Buiter, said Thursday.

"As soon as the end of this year, all the European zombie banks could be restored to health or put out of business by making senior bondholders pay instead of the taxpayer," Buiter said, adding that state support for failing financial institutions should be removed as soon as possible.

Citigroup was provided with the world's biggest public banking bailout, during the financial crisis. 

The Dutchman who is a former professor of economics at the London School of Economics, has argued that up to €2trn of liquidity support may be needed for Eurozone banks, according to the Economist.

"The real question is will Ireland go it alone, which would upset its European partners and cause market contagion throughout the EU," he said on Thursday at the European Financial Services Conference in Brussels.

FT Video: Greek default not an option, says ECB - - A default by Greece on its debt is not an option, says Lorenzo Bini Smaghi, executive board member of the European Central Bank. He tells FT Frankfurt bureau chief, Ralph Atkins, that EU politicians need to do more about the Eurozone debt crisis

L’Espresso interview with Jean-Claude Trichet, President of the ECB

Ireland: Debt default on sovereign and bank debt or not? - - 4 reports and presentations from the current week; ECB, IMF, European Commission and Dublin stockbrokers, Goodbody.

Folker Hellmeyer, chief analyst at Bremer Landesbank says he concurs with the view that the Eurozone package is sufficient to contain any future crises. He tells CNBC's Rebecca Meehan, Chloe Cho and Yousef Gamal el-Din he is optimistic about seeing a resolution to Europe's debt troubles:

Danish economist, Jacob Funk Kirkegaard, from the Peterson Institute for International Economics, a Washington DC think-tank, said in a commentary this week: "As continued strong real economic indicators lift prospects for recovery in the EU, and important structural reforms continue to be implemented in the pivotal peripheral country, Spain, it is no longer a question of the euro’s survival. (No democratic member - - economically weak or strong - - will ever leave the euro.) Nor is there any longer a question of whether EU leaders have the will and capacity to take the necessary painful economic reform decisions (Prime Minister José Luis Rodríguez Zapatero of Spain illustrates this best). There is finally no longer really a question of whether the Eurozone periphery will achieve debt sustainability. Instead the question is precisely how, and crucially what the core Eurozone countries want in return for providing the necessary assistance to the periphery."

Dealing with the crisis requires a fine balancing act, said Mario Monti, president of the University Bocconi and former EU Commissioner, to CNBC. Monti added that the crisis is also leading to progress in Europe:

Also this week, economists at the London office of US investment bank, Morgan Stanley, published an analysis and a roadmap for investors on the debt crisis.

By the end of March, European policy-makers will present broad-ranging reforms to contain the crisis. The MS economists say that in mapping out the different policy options discussed among European policy-makers, notably in the context of the reform of the European Financial Stability Facility (EFSF), they present an analytical framework to help assess the effectiveness of the measures that will eventually be announced.

The key distinction in this framework is between measures that only provide additional liquidity and those that help to improve solvency directly.  The economists say the former can easily be implemented, because they do not involve any immediate costs. The latter is more difficult to restore, because it involves foregoing income or consumption immediately: either the borrower through austerity measures, structural reforms or asset sales; or the creditor by writing off part of the debt, lowering the interest charged or extending the maturity. 

As long as emergency liquidity is available from the EFSF or other sources, countries will only default on their debt if they believe that it is in their best interest.  Restructuring is a particular concern for the Eurozone because its member states are considered between an emerging market government borrowing in foreign currency and a developed country with its own national currency.  Yet the cost of defaulting is considerably higher for a Eurozone country than it is for an emerging market government.  At the same time, the benefits of defaulting are also considerably smaller.

While even remote prospects of some form of default are rather disconcerting events for bond investors, markets systematically overprice such risks.  "We cannot rule out an involuntary debt restructuring in the euro area in the coming years.  But we believe that the risks are more than adequately priced into government bond markets," MS says.

The restructuring hurdle in the Eurozone is higher than many investors appreciate.  Calls for a default on the debt in the Eurozone periphery tend to be based on a partial analysis, which just focuses on debt sustainability, but does not look at the consequences of debt restructuring across the whole capital structure to grasp the costs and benefits that a rational government will take into account in its decisions.

The economists say the impact of a sovereign debt restructuring on the Eurozone financial sector remains uncertain. However, it is vital for investors to consider the impact of such a debt restructuring, especially a compulsory one, on the different layers of the bank capital structure.  Together with initiatives towards bank resolution legislation and the ESM (European Stability Mechanism, which will take effect from 2013) making private sector involvement compulsory in future debt restructuring, even senior unsecured bank debt has become less safe an asset.

Key Investment Implications

1. Peripheral government bonds have experienced a deterioration of some of their ‘institutional' and ‘behavioural' characteristics. Investors looking for low risk, low return investments that usually characterize government bonds could continue to exclude peripherals from their portfolios, as they no longer exhibit such characteristics.  Such peripheral government-issued bonds will have to cheapen sufficiently to make them attractive within a broader asset-allocation context (e.g., versus credit such as IG & HY corporate bonds, equities, commodities, etc).

2. With country risk back as a main driver of investment decisions and portfolio performance, MS thinks that Eurozone bond markets will continue to exhibit wide spreads, differently sloped yield curves and varying volatility.  And, to the extent that portfolio managers' mandates get changed to a greater extent towards AAA securities, this will further limit Eurozone peripherals' financing possibilities and potentially create difficulties in Eurozone financial markets.

3. Implementing an EMU (European Monetary System) -- wide fiscal transfer mechanism that provides for bailouts of countries in trouble by the economically stronger Eurozone members would certainly help to solve the current sovereign crisis near term.  However, such a move to a ‘transfer union' creates the long-term risk of a political backlash in the countries shouldering the bill, which might ultimately even lead to EMU break-up.  Clearly, leaving the euro would involve serious political and economic costs for the seceding country (or group of countries).

4. The combination of even a remote prospect of EMU break-up and the severe sovereign debt crisis in the Eurozone have brought the country factor back with a vengeance when it comes to portfolio performance - - both in equities and in fixed income.  In  the MS view, country allocation decisions will remain very relevant going forwards over and above sector allocation, duration decisions and credit quality.  In addition, any future rally in the exchange rate will likely be capped by these uncertain but remote prospects of EMU break-up.

European Central Bank president, Jean-Claude Trichet, on the health of the Eurozone:

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