EUROZONE NEEDS CLARITY FROM ITS POLICYMAKERS / THE FINANCIAL TIMES MARKET ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Eurozone needs clarity from its policymakers


By Jan Straatman, ING Investment Management

Published: December 6 2010 19:42

At the end of last month, European finance ministers agreed the outline of a permanent mechanism to deal with future eurozone financial crises. The European stability mechanism will be installed as a successor to the European financial stability facility (EFSF) in 2013.


The ESM has a stronger focus on debt sustainability and more effective enforcement measures. Given that in many cases bondholders will also bear some of the burden of any debt restructuring, the disciplinary function of the bond market will be strengthened because investors also run risks.


The main difference is that, upon application, under the ESM there will be a rigorous analysis of debt sustainability by the European Commission, the International Monetary Fund and the European Central Bank. Also any loans will enjoy preferential creditor status.


Overall, the ESM is an important step forward and is consistent with our view of very strong political will to preserve the euro. But there are risks. Some politicians are trying to separate two things: the resolution of the current crisis and the creation of a framework to deal with future crises. But in practice the separation between pre and post-2013 debt is to some extent artificial. By 2013, many peripheral EU countries will not have achieved debt sustainability (defined as a primary balance that stabilises the debt to GDP ratio) and some existing debt will need to be rolled over after 2013.


As a result, there is a risk that the ESM will cause risk premiums to rise, eliciting the kind of self-fulfilling prophecies we have seen this year. This means there is still a risk that the current outstanding debt cannot be serviced fully, which is exactly what makes markets so nervous. It is not yet clear how the EU will deal with this but politicians need to act swiftly to limit negative sentiment.


The ESM will enhance the disciplinary function of the bond market, which will be expressed in the risk premium, and it will encourage countries to pursue a more stringent budgetary policy. However, politicians need to take a uniform stance and agree a clear implementation course. If they do, the markets will price in the new situation, with debt writedowns, or haircuts, as a possible consequence – which may have adverse consequences for some banks.


Of the two alternatives to the ESM, neither is realistic. The first is to relinquish the euro or disintegrate the eurozone. If any country leaves the euro, a substantial haircut is as good as certain. The country would go back to its old currency, which would depreciate considerably, while its debts would still be denominated in euros. The remaining eurozone countries would have to take account of a sharp appreciation of the euro with all the adverse consequences this would entail. Given the political will to maintain monetary union, the chances of this scenario is slight.


The other alternative is a fiscal transfer, or further (fiscal) integration of the eurozone. Core countries would make a one-off transfer – estimated at €350bn – to bankroll the likes of Greece, Ireland and Portugal. The debt to GDP ratios of the weak countries would fall to manageable levels, while debt ratios of core countries would rise by percentage points. So what can we expect in the coming months?


The chances of government debt having to be written down are considerable in the case of Greece and somewhat less so in the case of Ireland. A bigger risk premium is therefore justified. Haircuts, should they take place, will probably not happen next year, if only because policymakers are still not convinced that these are inevitable and will debate this question for some months yet. Also countries have no incentive to default as long as their primary balance (expenditure excluding interest payments) is not negative.


This leaves two possible options. Countries in difficulties will make use of EFSF support whether or not they will need to tap the market in the months ahead. Or they decide to muddle on until they no longer wish to or can raise finance in the bond market.


Until there is greater clarity with the ESM on a number of key issues, there will continue to be volatility. Fears over restructuring of eurozone debt, and worries about the proposed new clauses in the ESM (collective action clauses, or CACs), which will enable creditors to pass by qualified majority legally binding decisions to change terms of payments, could hit liquidity as investors shy away from such bonds. Will debt issued with CACs have to trade cheaper than existing debt, and will it create a two-tiered market? Or is a euro paper market on the cards. These questions are difficult to answer and, until they are, will create uncertainty and volatility.


The only thing that is certain is that as long as European policymakers fail to agree a clear course, volatility in the bond markets will continue.


Jan Straatman is chief investment officer of ING Investment Management


Copyright The Financial Times Limited 2010.