GERMANY NOT IMMUNE TO EUROPE´S CONTAGION / THE FINANCIAL TIMES MARKET ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Germany not immune to Europe’s contagion

By Richard Milne

Published: December 22 2010 16:59

The very idea that Germany could be caught up by contagion from the eurozone debt crisis seems risible. Its benchmark interest rates, those for 10-year Bunds, trade below the equivalent levels for the US, UK and France.


Yields of just shy of 3 per cent for 10-year money hardly smack of trouble. Inflation is unlikely to cause problems soon, unlike in the UK and potentially in the US thanks to quantitative easing. It also enjoys a sizeable current account surplus, meaning it is not at the mercy of foreigners for financing, unlike many in Europe. In short, its bonds are still seen as the safe haven of at least the eurozone.


Nonetheless, the whispers are starting against Germany. Yields have risen by more than half a percentage point since their lows in October. Unlike the corresponding rise in US yields, which many see as the result of higher growth expectations, few are touting higher output as a reason for Bunds spiking.

Instead, the markets are firmly putting the blame on the prospect of contagion and in particular the fear that Germany could end up coughing up to bail out most of the so-called periphery of the eurozone.

Pimco, one of the world’s largest bond investors, which by chance is owned by Allianz, the German insurer, has for several months privately been warning that German yields could shoot up once the price of the various European rescue schemes are factored in. Germany’s exposure should remain manageable if the crisis stays restricted to Greece and Ireland (and probably poor Portugal, the next in line for a bail-out).


But the 50-100 basis points question for Germany is what happens to Spain. Should it need a bail-out – and its yields continue to hover close to euro-era highs – then Germany is on the hook for tens of billions of euros more and its yields could well shoot up.


All this helps explain the multiple games of chicken going on inside Germany and the eurozone. Germany is not just in a face-off with peripheral countries about how to deal with the crisis, but its politicians are struggling to deal with their own increasingly euro-sceptic taxpayers. The biggest game of chicken, however, is taking place between the only two institutions with big enough pockets to end the crisis: Germany and the European Central Bank. Neither is willing to take on what it sees as intolerable risks by guaranteeing the entire eurozone.


Germany could do so by agreeing to some kind of fiscal union or common European bond. The downside would be that its borrowing costs would be likely to rise.

The ECB has made it clear recently that it does not want to follow the US Federal Reserve and buy vast amounts of government debt. The dangers to its independence as well as inflation targeting prowess seem enormous. But Germany may be banking on the fact that the ECB has lost two games of chicken already this year: once on accepting Greek collateral and the second time in cautiously starting to  buy  government bonds.


For Germans haunted by the spectre of the Reichsbank in the Weimar Republic, a central bank monetising the debt of weak eurozone states might not seem the ideal answer.


Instead, the favoured approach seems to be to muddle through and hope for the best. 2011 is likely to test this typically European way of doing things to the extreme. Spain and Portugal both have large amounts of debt to refinance, not just in the public sector but among banks and companies as well. Germany may well discover that it has to find extra cash for bail-outs or for topping up Europe’s rescue scheme. Signs of stress for Germany are more apparent in some other markets than Bunds. Its credit default swaps – which offer protection against the risk of default, a seemingly minuscule risk for Germany – are trading close to their highest level if you strip out the panic that followed Lehman’s collapse.


Strikingly, Germany’s CDS prices have risen in the past two months, whereas those of the US have barely budged (France’s have moved to record highs).

Equally, the currency markets are showing subtle distress signs with the Swiss franc, one of the true safe havens out there, which reached record levels against the euro on Wednesday.


All this suggests contagion is indeed lapping at Germany’s borders. 2011 will therefore be a crucial year not just for Europe’s periphery but for its core as well. Grounds for optimism persist.

Germany can take a while to grasp an issue – think of its lack of competitiveness at the turn of the century or of the automotive industry’s lack of green cars – but once it does get it, it tends to work and work at it until it achieves an optimal solution.


The problem is that the markets will not give it a decade to work something out. ECB purchases can be only a temporary measure. Germany should embrace a deeper union or risk seeing the euro implode.


Copyright The Financial Times Limited 2010