Germany Draws Line in the Sand on Eurozone Bailouts, Insists Bondholders Take Pain

The contradictions of the Eurobailout mechanism were bound to be resolved at some point, smoke and mirror and insufficient firepower relative to the magnitude of the problem will only take you so far. The eurozone rescue operation, although it looked like it was aimed at so called Club Med, aka PIGS sovereigns (Portugal, Ireland, Greece, and Spain) was at least as much about preventing the banks that are exposed to their debt from taking too much pain, and those banks are mainly French and German.

The current vogue, austerity measures, sounds straightforward until the ugly reality kicks in, that all it does is put countries into a deflationary spiral, making debt loads ever worse. As Satyajit Das pointed out a month ago:

The “cure” may be worse than the disease. After implementing austerity measures, Ireland’s nominal gross domestic product (”GDP”) has fallen by nearly 20%. The budget deficit as a percentage of GDP has doubled to 14% from 7% Government debt as a percentage of GDP has increased to 64% from 44% at the start of the crisis. It is forecast to go to over 100% having been around 25% during the boom years. The cost of bailing out Ireland’s banking system has risen and may reach 20-30% of its GDP. Ireland’s credit rating has fallen.

In late September 2010, Ireland announced that in the second quarter the economy contracted by 1.2%, against expectations for 0.4% growth raising renewed concerns about European sovereign risk. Similar scenarios are playing out in Spain and Portugal.

The trigger for action by Germany is that the rescue mechanism put in place last May was temporary and expires in 2013, and any ongoing arrangement requires changes in EU treaties. And Germany, as the strongest nation in the eurozone, insists on exerting considerable influence on the design of its successor. While there was not immediate pressure to develop a permanent mechanism at this juncture, Germany appears to have caught its eurozone partners off guard, to its advantage.

Ambrose Evans-Pritchard of the Telegraph is not terribly popular among European readers of this blog, but his analysis of the implications of the German proposal (of which key elements have been agreed, details to be hashed out over the next several months) is insightful. He points out that the austerity measures are likely to backfire, that as currently structured, they demand too much of local populations and not enough in the way of corresponding adjustments (meaning writeoffs or debt restructuring) by the banks. While the Merkel initiative addresses that imbalance by insisting that bondholders, meaning banks, take losses if things get rocky, there is never a good time to implement a change, since investors will reprice assets based on the weaker guarantees going forward. The issue is that spreads on Ireland and Greek debt have already widened in the last month; this move will push them out further, making any efforts to access the markets more costly. And there is plenty of debt issuance planned.

From the Telegraph (hat tip Richard Smith):

Bondholders will discover burden-sharing. Debt relief will be enforced, either by interest holidays or haircuts on the value of the bonds. Investors will pay the price for failing to grasp the mechanical and obvious point that currency unions do not eliminate risk: they switch it from exchange risk to default risk…

“We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers,” said German Chancellor Angela Merkel.

Or in the words of Bundesbank chief Axel Weber: “Next time there is a problem, (bondholders) should be part of the solution rather than part of the problem. So far the only ones who have paid for the solution are the taxpayers.”

These were the terms imposed by Germany at Friday’s EU summit as the Quid Pro Quo for the creation of a permanent rescue fund in 2013….

Mrs Merkel needs a treaty change to prevent the German constitutional court from blocking the bail-out fund as a breach of the EU law, and a treaty change is what she will get….

One might argue that bondholders should have been punished for their errors long ago. The stench of moral hazard has been sickening, on both sides of the Atlantic. An orderly bankruptcy along lines routinely engineered by the International Monetary Fund is exactly what Greece needs. It makes no sense to push Greece further into a debt compound spiral by raising public debt from 115pc of GDP at the outset of the “rescue” to 150pc at the end of the ordeal.

If you strip out the humbug, the Greek package allows banks and funds to shift roughly €150bn of liabilities onto EU governments, or the European Central Bank, or the IMF. Greek citizens are being subjected to the full pain of austerity under false pretences, without being offered the cure of debt relief.

It is in reality a bail-out for investors. There is a touch of cruelty in this. Needless to say, the Greek Left has noticed. A socialist dissident from the “anti-Memorandum” bloc (ie anti EU-IMF) is likely to win the Athens region in coming elections.

Note too that the ruling socialists have fallen to 25pc in the Portuguese polls, while the Communists and hard-left Bloco are together up to 18pc. Ain’t seen nothing, you might say.

Yet opening the door to bondholder haircuts at this delicate juncture — with spreads reaching fresh records in Ireland last week, and Portugal struggling to pass a budget – is to toss a hand-grenade into the eurozone periphery….

Spain’s premier Jose-Luis Zapatero knew he had been mugged. “We need to listen carefully to what the head of the ECB says about the rescue mechanism. Great care is called for because this message is risky,” he said.

Eurozone sovereign states must issue €915bn in new bonds next year, according the UBS, either to roll over debt or to cover very big deficits – though it is hard to outdo Ireland’s deficit of 32pc of GDP in 2009. Yet investors have just been told in blunt terms to charge a hefty risk premium on any peripheral debt that expires after 2013, with great confusion over what happens even before that date. Can any investor be sure what the terms will be if Ireland or Portugal needs to access the EU’s bail-out fund next week, or next month, or next year? Are haircuts already de rigueur?

A study by Giada Giani at Citigroup entitled “Bondholders Moving Back Home” said data from the second quarter reveals a sharp drop in foreign ownership of debt from Greece (-14pc), Portugal (-12pc), Spain (-8pc), and Ireland (-5pc).

Local banks have stepped into the breach, borrowing cheaply from the ECB to buy their own state debt at higher yields in a `carry trade’ that concentrates risk. These four countries account for the lion’s share of the €448bn in ECB funding for banks (Spain €98bn, Greece €94bn). Frankfurt is propping up this unstable edifice. Mr Trichet may well fret.

A strong case can be made that Spain has decoupled from other PIGS in pain, though the deficit will still be 6pc next year, and the economy is at serious risk of a double-dip recession as wage cuts and higher taxes bite in earnest. But none are safe yet.

An ominous pattern has emerged across much of the eurozone periphery: tax revenue keeps falling short of what was hoped. Austerity measures are eating deeper into the economy than expected, forcing further fiscal cuts. It goes too far to call this a self-feeding spiral, but such policies test political patience to snapping point.

There is little that these nations can in the short-run as EMU members. They cannot offset fiscal tightening with full monetary stimulus or a weaker exchange rate – as Britain can. All they do can is soldier on, sell family silver to the Chinese and Gulf Arabs, beg the ECB to join the currency war to bring down the euro, and pray that the fragile global recover does not sputter out.

Chancellor Merkel is ultimately correct. A mechanism for sovereign defaults is entirely healthy. Had it been in place long ago, EMU would have been stronger. The proper timing for this was at the Maastricht Treaty, or Amsterdam, or at the latest Nice, but in those days the EU elites were still arrogantly dismissive about the implications of a currency union. To wait until now borders on careless.

Yves here. As noted by Evans-Pritchard, the ECB is effectively circumventing the bailout limits, acting as a back door funding mechanism by lending to local banks that in turn buy home country bonds. But the ECB is very serious about its inflation target, and this concern may come to constrain this relief valve.

Originally published at naked capitalism and reproduced here with permission.