After another tumultuous year in global financial markets with more unprecedented government intervention, the outlook remains uncertain to say the least. The guarded optimism at the end of 2009 has been replaced by a more subdued view, seasoned by the realization that although the juggernaut may have slowed, any accurate forecasts of its eventual halt and consequences are probably unintentional. The painful aftermath of years of global imbalances, excess liquidity and imprudent regulation is still with us.
The contagion in the European sovereign debt markets is the latest episode and the EU is most certainly to blame for this. Initially, for the original sin of reverse engineering a currency union without a political consensus and allowing virtually all of the original member states to dodge the entry criteria. This led to an attitude among the members that deficits were relative and acceptable as long as there was an acknowledgment of the problem and the intent to remedy it as soon as feasible. This is a policy well known to many nations, all of which face the possibility of eventually paying the price.
So when the leaders of an already financially stretched EU decided to mention the "role of the private sector" in establishing of a permanent crisis mechanism (since renamed the "stability mechanism"…), the markets — uncertain as to what this meant and afraid that it might signal the end of implicit EU guarantees, — sold the debt of the weaker members wholesale. The sell-off led a scalded EU to arrange a bailout for Ireland without exacting the corporate tax concession they wanted and with an assurance that the current holders of Irish bonds would not be subject to losses of principal in future.
This was a good result for the holders of Irish debt, but the market also has Portugese, Spanish, Italian and Belgian debt on their books and the sell-offs have begun again. The market has decided to skip the starter, Portugal, and go directly to the main course, Spain. The yield on the Spanish 10-year bono came perilously close to triggering the margin clause at the largest European bond clearinghouse on Tuesday when the yield spread over the benchmark German 10-year bund reached 4.35 percent. If any European government bond trades 4.5 percent over the benchmark bond, the margin required for trading that bond can be increased. This last happened to Irish bonds on November 17, when the spread reached 6.50 percent and the margin was increased to 30 percent. Clearinghouses collect cash in the form of margin on individual trades, which they hold centrally to refund members' losses in the event of a default. This selling is understandable as it will either force an 'Irish style" bailout — which would indemnify current bond holders from future clawbacks (the most likely scenario) — or a default (unlikely), in which case no one will want to have any of them.
There is said to be a third scenario which, unlike the cavalry in the movies, is likely to arrive too late. This proposal in the wings would be from the European money man, Germany. The origin of this plan not only makes it credible financially, but also possible as Berlin is in the EU's driver's seat these days. The plan would include a debt restructuring clause as of 2013, a financing facility, a neutral negotiator to mediate between defaulting countries and investors and an analysis of the debt capacity of a country applying for assistance.
The restructuring clause seeks to create a binding change in payment terms for a country which is unable to meet its obligations if a majority of the creditors agree. Possible measures would include payment and repayment extensions, interest rate reductions and debt forgiveness.
The neutral negotiator would be an inter-governmental institution (read IMF) which could also be a lender to the facility for the country in question.
The facility could provide countries under pressure with liquidity as well as longer-term financing for the restructuring of defaults. The money for the facility would come from contributions from member states based on the size of their stake in the ECB — the penalty revenues which members would pay if they repeatedly exceed their deficit limits and possibly from the inter-governmental institution.
The intent of the debt capacity analysis is to provide both the country and its investors with a realistic picture of the situation, which would facilitate the stabilization of the country's credit outlook as well as giving the investors an opportunity to receive some of their investment back.
This all sounds very encouraging, but, it won't work, certainly not now. 2013 is a long way away and the bond market is hardly likely to be buoyed now by a possible proposal and solution — more uncertainty, in other words. The current problem needs to be resolved as soon as possible, most probably via an unconditional guarantee for all debt issued up to certain date. The next step would be to convince the investors that discipline will be enforced firmly and far before the beginning of any transition to the new system.
The guarantee can be issued relatively quickly as long as Germany agrees, but they will want to have guarantees from the rest of the EU that their plan will be adopted and implemented in return. That may not be possible, let alone quickly. The EU needs to resolve this with atypical speed and efficiency. Perhaps a German framework agreement has already been circulated and the signatures are being collected, who knows.
The markets will not wait, that we do know.
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