SOOTHING, BUT RISKY WORDS FROM E.U. / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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NOVEMBER 15, 2010.

Soothing, But Risky, Words From EU .

By SIMON NIXON

The European Union hopes to stem the latest phase of its sovereign-debt crisis with Friday's soothing statement from finance ministers. Irish and Portuguese bonds rallied sharply. But the EU may only have bought some time and might yet end up making a historic mistake.


The EU finance ministers seemed to suggest any move to force bondholders to share the burden of any future European sovereign-debt default would apply only after a proposed new permanent crisis-resolution mechanism is in place, which is unlikely before 2013. That was designed to reassure existing bondholders who have dumped holdings of peripheral European debt in recent days, spooked by hawkish rhetoric from Berlin.


The risk is that finance ministers have taken a step toward offering current euro-zone bond investors a blanket guarantee similar to the one Ireland fatefully offered bank investors two years ago. If euro-zone bonds do get underwritten, that effectively means doing the same for much of the European banking system, with the burden of national bank guarantees passing to euro -zone taxpayers.


As with the Irish bank guarantee, that is quite a gamble. If peripheral-country borrowing costs return to levels that would allow them to achieve fiscal sustainability, if economic growth meets budget forecasts, and if their banking systems are indeed adequately recapitalized, any guarantees may not be called upon.


But that is a lot of ifs. Investors will rightly wonder what will happen if things don't go according to plan. Bank of Ireland, for example, revealed Friday a worrying loss of confidence by depositors. Its loan-to-deposit ratio rocketed from 145% to 160% in just three months, suggesting depositors aren't convinced Dublin can honor its guarantee. Irish banks can replace deposits with funding from the European central bank, but only if they have sufficient eligible collateral.


The fate of peripheral European countries now partly hinges on whether investors believe European governments are indeed offering guarantees and whether, if losses materialize, they will honor them rather than bow to political pressure to impose haircuts on bondholders.


The EU needs to avoid going any further down this dangerous path or it will find itself with the worst of all worlds: on the hook for a guarantee that it is politically unable to honor while peripheral countries are still unable to raise funding.


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