The German Constitutional Court has ruled that Germany’s participation in the European Stability Mechanism (ESM) does not infringe on the German constitution. The court dismissed a motion which sought to block Germany’s ratification of the treaty establishing the organization. Opponents, including several politicians, had challenged the ratification, arguing that it violated the country’s constitution. The court did rule that Germany’s liability would be limited to EUR 190 billion unless the German parliament authorizes an increase.
This means that there are currently no pending landmark decisions which could derail the ECB’s efforts to reduce the yields demanded for the government bonds of Greece, Portugal, Ireland, Spain and Italy.
In order to measure the effects of the ruling as the ECB proceeds with the excruciating process, it will be useful to take a snapshot of the status of each country. Below are five brief summaries of their current status and prospects looking forward. Also included are the definitions of the euro zone acronyms (which seem to be multiplying monthly) which are cited in this update.
ESM: European Stability Mechanism - A proposed international organisation which, when established, will provide financial assistance to members of the euro zone in financial difficulty]. The ESM is intended to replace existing temporary funding programs of the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM).
EFSF: European Financial Stability Facility - A limited liability company, established by euro member states, to lend money to fellow members in financial difficulties. The loans are strongly conditional based on joint EU- IMF programs.
SMP: Securities Markets Program – The buying of sovereign and corporate securities by euro zone central banks to ensure depth and liquidity. The intervention is sterilized.
LTRO: Long Term Refinancing Operations – Collateralized, low interest lending to euro zone banks by their central banks
OMT: Outright Monetary Transactions – Secondary market buying of (troubled) euro zone sovereign bonds by the ECB to reduce their yields.
Baa2, Negative Outlook
Barely eligible for investment grade portfolios
Benchmark bonds at 5.07%, traded as a Baa3
As a major economy with EUR 2 trillion of debt, Italy is much too large to be allowed to default. However, refinancing a debt burden on that scale could not be handled by the EFSF/ESM alone. Even the full resources of the ECB would probably not be enough.
Italy's bond yield has been quite volatile. It was as high as 7.2% last fall. Since the OMT was announced, it has fallen to 5.1%, which is still too high.
So far, Prime Minister Monti seems to be hoping that the ECB's OMT announcement plus further reform at home will bring Italy's bond yields down further. If the fiscal situation worsens, and his government's domestic power position continues to decline, Monti will have to apply to the Troika (the IMF, the ECB and the European Commission) for assistance. In this situation, the ECB would have extreme difficulty to establish an informal yield ceiling.
Baa3, on review for downgrade through the end of September
Spain is already ineligible for most investment grade portfolios.
Benchmark bonds trading as a Ba1 at a yield of 5.87%
Spain, with EUR 750 billion of debt, is Europe's other big problem. Although Spain's bond yield has come down since the OMT announcement, it is still high at 5.6%. The Spanish banking system has been steadily losing deposits due to convertibility risk (the risk that investors may be forced to convert their euro-denominated investments into newly re-introduced national currencies). Spain requires help from Europe to pay its maturing debt, recapitalize its banks and bail out its regions. Currently, Prime Minister Rajoy seems to be moving from denial to bargaining.
Because Spain is too big for the EFSF/ESM to rescue, it ultimately will be up to the ECB to bring Spain's yields down to a financeable level. The immediate question is the size of the capital hole in the banking system. The longer that Rajoy waits to apply to the Troika for assistance, the greater the risk that Moody's could downgrade Spain to below investment grade, which would add to the pressure.
Ineligible for investment grade portfolios.
Benchmark bonds yielding 5.05%, trading at its rating level
Ireland is the Troika's shining example for compliance. Ireland has successfully executed its austerity program and is continuing the fiscal consolidation process.
With its full compliance, Ireland will be the first in line for bond purchases under the OMT, without having to request it. Hopefully the ECB will initiate this in order to reward Irelands’ efforts and to reinforce the credibility of ECB policy. The further normalization of yields by the ECB is vital, but the clock is ticking.
Rated Ba3/Negative Outlook
Ineligible for investment grade portfolios
Benchmark bonds yielding 8.02% which is its rating level
Portugal is in a negative austerity spiral, no debt market access, a severely depressed economy, and significant spending reduction is still required. It is nearing the bottom of the “J” curve and should succeed. The negative momentum is slowing, but a positive outcome will require a lot more work and is difficult to anticipate at this point.
Rated C, in default
The remaining bonds yield 20.25%, pricing in a potential second default
Greece is completely dependent on support from Europe and nowhere near to implementing the program which the Troika has demanded. Progress has been minimal and appears to be outweighed by civil unrest. Greece is the proof that there is almost nothing that they could do (or not do) that would get them kicked out of the euro zone. The ECB knows that a Greek exit would cause a global credit event and probably lead to the inevitable exits of the other four distressed members. Of course, Greece is also very aware of this and is probably planning to get its money by once again agreeing to a plan it has no intention of implementing. The obvious dilemma is that while sufficient reform does not appear to be possible at this time, allowing Greece to fail would be the beginning of the end for the euro zone as we know it.
So it appears that the current critical situations are:
- Greece, which will limp along as long as required despite few signs of meaningful reform.
- Spain will have to accept assistance at some point, but anticipate their continued attempts to politicize negotiations for better terms.
- Italy is the least obvious but largest problem with more potential to fail than to succeed currently and further deterioration of their credit cannot be ruled out.
The problems are of such a massive scale that the euro zone will have to undertake unprecedented bond buying, this will require the ECB to commit its resources to such an extent that the markets are convinced that the EMU will survive intact. This commitment is a political issue as the ECB is governed by its board, which is far from unanimous at this time. Additional funding could be provided directly or via the IMF by Asian governments with reserve surpluses, but they (like the rest of the world) are waiting for credible proposals to emerge. The stabilization of the euro zone is vital to the recovery of the global economy and — despite the seemingly insurmountable obstacles ahead —it appears that it will not be allowed to fail at this time.
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