SEPTEMBER 20, 2010.
The Perils of a Schizophrenic Euro Zone
Policy makers' mixed signals are fueling volatility in sovereign-debt markets.
By MARCO ANNUNZIATA
European Union and International Monetary Fund officials are standing shoulder to shoulder with their Greek counterparts to face investors and assure them in no uncertain terms that debt "restructuring is not going to happen," as Greek Finance Minister George Papaconstantinou said a few days ago in London.
Yet, just four months after the launch of Europe's "shock and awe" €750 billion stabilization package, sovereign bond spreads have risen to new record highs, not only in Greece but also in Ireland and Portugal. While this partly reflects a broader surge in risk aversion, linked to fears of a U.S. double-dip recession, there is no doubt that investors still look at the euro zone's periphery with a robust dose of skepticism. Concerns about the health of these countries' banking systems play an important role: With Irish and Portuguese banks still taking heavy recourse to funding from the European Central Bank, the reassuring picture painted by the EU-wide bank stress tests in July begins to look unconvincing.
More importantly, markets are baffled by the schizophrenic attitude of EU policy makers: On the one hand, they protest that spreads are excessively high, warn investors not to underestimate the value of euro-zone membership, and seem to signal that no euro-zone country will ever default—not even Greece. At the same time, however, they debate the need for a sovereign-debt restructuring mechanism, a framework that would allow debt restructurings to take place in an orderly manner. They acknowledge that spreads were unreasonably narrow before the crisis, but if spreads now widen more than they like, they accuse investors of speculation. They are putting in place measures to curb short-selling on sovereign bond markets and to limit credit default swap trading—in essence curtailing investors' ability to hedge the risks of lending to governments that might surrender to temptations of profligacy.
In the face of such mixed signals it is perhaps unsurprising that investors are reluctant to lend to Europe's weaker governments, and that volatility in the euro zone periphery's sovereign-bond yields remains high.
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Are investors overestimating sovereign risk in the euro zone? It is hard to say. A recent IMF paper argues that "the risk of debt restructuring is currently significantly overestimated." But another IMF paper lists Greece, Italy and Portugal among the countries with "very little or no additional fiscal space," followed by Ireland and Spain, among others. Running out of "fiscal space" here means that public debt has risen so high that stabilizing it will require a stronger fiscal adjustment than these countries have historically been able to muster. While it is by no means impossible that under greater stress countries will show stronger resolve, neither can it be taken for granted, suggesting that investors have reason to be concerned. Given that a widespread underestimation of risk laid the basis for the 2008 financial crisis, it seems rather odd to blame investors for perhaps erring on the side of caution in their assessment of sovereign risk.
EU policy makers are left in a quandary: They want investors to believe that all euro-zone countries are safe investments; but for countries beset by high debt and low potential growth, the only way to do this is to effectively extend a bailout guarantee. This, however, would not only create a serious moral hazard, but also require the politically unpalatable choice of making private investors whole at the cost of taxpayers in more virtuous countries. By now this is a familiar problem, which the IMF has in the past faced with emerging markets: the desire to "bail in" private-sector creditors, forcing them to accept a haircut. This is exactly why some EU members, Germany in particular, are pushing for a sovereign-debt restructuring mechanism to ensure that private creditors are not completely protected from the consequences of unwise lending, and thereby keep moral hazard under control.
Which brings us back to Greece. If a restructuring framework with haircuts is deemed desirable, private investors cannot exclude that it might eventually be applied to Greece. Even with all possible good faith in Athens's commitment to consolidate and reform its finances, the magnitude of the challenge it faces is daunting, and therefore investors' confidence at the moment extends no longer than the three-year horizon of the IMF/EU program. One hopes that market confidence will return in the next twelve months or so, provided that program remains on track. But it may not.
Consequently, policy makers may soon need to discuss a plan B, and this is politically tricky, as it would most likely involve pledging official support for a longer period. For instance, the IMF could roll over its credit via a successor program, and, since the IMF and EU have pledged to move in lockstep, the EU could effectively restructure its existing loans to Greece by extending their maturity. Some EU governments would probably be reluctant to do so, however, especially if at the same time private-sector investors are simply taking their money out as the bonds they hold mature. This probably explains why the EU and the IMF suddenly seem in such a hurry to bolster market confidence, barely four months after the launch of the Greek adjustment program: If only Greece could quickly regain normal market access, they could shelve their uncomfortable discussions of a plan B. The problem, unfortunately, is that Greece has a long history of misbehavior, in the form of unsustainable policies and creative accounting, and a few months are not enough to establish a credible track record.
EU leaders need to choose: They can accept that whenever a member country is in trouble it will be rescued without a debt restructuring, in which case they should impose tight and enforceable fiscal rules to keep members in line and avoid moral hazard. Or they can adopt a sovereign-debt restructuring mechanism, and let markets play their disciplining role by pricing sovereign-credit risk in an environment of greater transparency and predictability—this would necessarily imply wide spread differentiation between euro zone member countries.
Postponing this choice will only keep the pressure on Greece and other peripheral countries high, requiring ever stronger efforts to improve fiscal balances and bolster potential growth. It will also delay the appropriate repricing of sovereign risk that is an essential component of the sought-after stabilization in financial markets.
Mr. Annunziata is chief economist at UniCredit.
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