- We expect the crisis to continue deteriorating and threaten the entire euro area as European policy makers still misunderstand market dynamics. Short term, a change in stance vis-à-vis Greece has taken place via lower loan costs, loan maturity extension and measures to reduce its debt load. This new approach can also bring relief to the rest of the periphery (Ireland and Portugal).
- Markets will, however, refocus quickly on system wide issues, which remain daunting as policy makers show no sign of catching up with reality. A euro wide policy response is required to address powerful contagion channels which are threatening the stability of the whole region.
- There are solutions available but the cost is rising with mishandling. We believe the price tag to be near €2 trillion via an upsized European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM). However, the lack of political cohesion and rating threats to AAA countries are likely to prove to be a major impediment to actual execution. The likely conditionality attached to any secondary bond market purchase programme will also be viewed as failing to be preventive enough.
- This is likely to see the European Central Bank (ECB) as the only practical backstop under conditions of immense systemic pressure, at least as a bridging support mechanism.
Shifting Stance on Greece
The 11th July Eurogroup statement tried to respond to spreading contagion by committing to review the flexibility and scope of the EFSF. This is a step in the right direction, but at present is not a sufficient condition to calm the markets.
Instead, concrete policy responses are now urgently needed to stabilise the system, and words are no longer sufficient.
So what can be done? The Eurogroup has committed to revisit the Greek situation by aiming to “improve the sustainability of Greek public debt.” Jean-Claude Juncker, President of the European Commission, suggested that this might take different forms.
Alongside his comments we see the following possibilities, which are not mutually exclusive and together can provide a holistic approach to aiding Greece:
- Longer adjustment plan to give growth a chance
- Further reduction in the debt costs
- Possible move to extend the official bi-lateral loans in the Bailout-1 for Greece much further than the 7 ½ years – possibly to 30 years
- A debt swap and buy backs that would look to voluntarily reduce the debt load using funds from the EFSF and/or privatisation receipts
The point here is that an announcement of action ‘soon’ is likely. Many of the options listed above can be executed with little need to go back to parliaments for approvals, although extending the adjustment period for Greek austerity may prove somewhat tricky.
The announcement of a European Union emergency meeting on Friday, 15th July, should be seen in that context and could bring about a mini “shock and awe” response to Greece using market based mechanisms to reduce its debt.
Moreover, the conditions now exist for a more aggressive move to put Greek debt sustainability on a better footing. We believe that the recent stresses in the European Government Bond (EGB) market have galvanised opinion sufficiently for a policy response.
However, we do not expect this policy response to be the one that would turn sentiment for a sustained period. Indeed, we believe the next round of policy announcements to be almost solely targeted at Greece rather than at the whole system.
Failure to Grasp System-Wide Risk
The 11th July Eurogroup statement was clearly aimed at sending a message that Europe is changing its stance on Greece. But it fell short of providing reassurance for the system as a whole.
On the EFSF front in particular, while the Eurogroup committed to increase the flexibility and scope of the EFSF (something the ECB has been calling for in more than 7 months) it fell short of details and did not commit to increase the size of the facility over and above the recently agreed upsizing of €440 billion.
The Eurogroup also approved the final Treaty of the European Stability Mechanism. The key takeaway from the new Treaty is that from June 2013, the ESM will be senior to any country not already under a programme. That is, the lack of seniority (i.e. pari passu loans) is only applied to sovereign countries in a financing programme at the time of the signing of the ESM Treaty (i.e. 11th July) – these are Greece, Ireland and Portugal.
For everyone else tapping the ESM, any loans will be senior from June 2013 (though of course any recourse to the EFSF between now and June 2013 is on a pari passu basis). This outcome is sub optimal in our view: policy makers should have shelved the seniority altogether.
It seems hard to believe but after one year of crisis management, it seems that European policy makers - or at least some of them - are still finding it hard to understand market dynamics. The lack of understanding seems to be coming more from the executive branches rather than from the ECB, which has learned the hard way how powerful these contagion channels can be and has been very vocal on that matter.
We have been warning about transmission channels for a very long time and for the need for a euro wide response since the beginning of the crisis.
Unfortunately this call seems to have fallen on deaf ears, perhaps because the economist community also failed to see the severity of the situation. For the record, since the crisis started we have argued that not enough had been done regarding contagion risks. We have been stressing how ill suited the policy response has been to fend off contagion risks.
There are a number of contagion channels that policy makers seem to have completely overlooked.
The ratings channel: It has been known for decades that rating agencies are pro cyclical. There is no point now in criticising them. Markets always move ahead of rating agencies, which even use market conditions as part of their rating assessment, making the whole thing completely circular.
There will no doubt be more rating actions and they will not please policy makers. But this is not the point. Rather, policy makers should have anticipated their predictable behaviour. A reform of the rating model is long overdue but is not today’s priority.
The risk management channel: Institutional investors like insurance companies, pension funds and mutual funds are the biggest holders of euro area sovereign bonds. They all have an interest in the stability of the European Monetary Union.
Long term investors have typically played the European solidarity game and have ended up being forced sellers as downgrades took place or when risk limits were breached. This behaviour tends to exacerbate market movements as the selling takes place in typically illiquid markets. Margin calls and their pro cyclicality are part of this problem.
Risk management has also evolved over the past year when considering the euro area. Indeed, anecdotal evidence suggests that investors have increasingly aggregated their total exposures across assets by country, for example, looking at an exposure to Spain as the sum of the credit, sovereign and equity exposure to Spain.
This aggregate approach seems to have exacerbated the cross correlation of asset prices within a given country, even if some of the assets in that country might appear somewhat immune from sovereign woes.
The liquidity channel: This is a pretty simple one. When liquidity dries up or when buyers disappear in the market in anticipation of further price declines in the traded security, the price elasticity of the security to supply increases drastically.
Herding: Whether herding is a direct result of the above or whether it is generated by other factors is unclear. However, one can easily imagine that investors might think that there are all the reasons to invest in securities at one point in time as they anticipate further appreciation. When that fad disappears, the trend reverses. So called “crowded trades” suggest that what might look like a rational investment decision at the individual level leads to the wrong asset allocation at the aggregate level; again a very well known feature of financial markets.
Uncertainty: Everyone knows markets hate uncertainty. With the goal posts being moved every so often by policy makers (the seniority of the ESM is one example), markets have struggled to assess with any confidence what the true risk/rewards of owning peripheral sovereign bonds are.
Spain, Italy – and France?
The dominos are now falling one after the other: the correlation between Spain and the three peripheral countries (Greece, Ireland and Portugal) has been rising steadily over the past three months.
On July 8, the correlation of the Spanish 10 year yield with its Portuguese equivalent was the highest since the beginning of the year. The correlation of Italy to Spain has picked up recently to reach 0.80 last week.
Finally, there are also some emerging signs that France could be affected. While the correlation between France and Italy over the past three months has been negative (and around 0.98 with Germany), in the last month, that correlation has increased steadily. In fact in the past month, the correlation was 0.59.
The correlation between credit default swaps (CDS) is even more significant, with Spain displaying a correlation of more than 0.90 with each of the three peripheral countries. Italy has had a correlation of its CDS with the Spanish one of close to 0.90 while the French CDS has had a 0.80 correlation with the Italian one over the past three months.
The correlation of banks’ stock prices with sovereign spreads has also been very high.
The case for a system wide policy response is long overdue. Too much time has been lost with policy makers and economists fantasising with the concepts of decoupling.
End Game Scenarios
The near term action on Greece should be a short-lived positive for general risk market sentiment akin to the recent vote in the Greek parliament to pass a new austerity budget. It is unlikely to be seen as a game-changer for Greece.
Politicians will explore ways to expand the EFSF and seek to enable the fund to be active in the primary & secondary markets.
We expect this move to face huge resistance because it requires unanimity and Europe is simply not that cohesive. Even if a lower size of €1 trillion is agreed, the pivotal point is that its conditionality cannot be usurped and so it is still not pre-emptive. It is a solution to the wrong problem.
The European Government Bond markets may therefore deteriorate much further towards a potential breakpoint for the European Monetary Union.
At this juncture, we expect the ECB to launch massive Qualitative Easing and effectively monetise the high debt burdens. This will buy Europe more time, but the political fallout will be far reaching.
About the Author
This article is excerpted from “Euro area faces breakpoint: Lessons learned and policy options,” a report by Royal Bank of Scotland and affiliated companies that was published on 13 July 2011. This material has been prepared for information purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy.