Decision time approaches for EU
Is ‘kicking the can’ further down the road still an option?
The sovereign debt crisis just got serious – it is no longer confined to the periphery. Italy is already in the frame, and France and Belgium have seen their spreads against German bonds come under pressure in line with the peripheral nations. So, what now for EU sovereign debt? Is ‘kicking the can’ further down the road still an option?
“I would say, no,” says Neil Dwane, chief investment officer of Europe at RCM, a company of Allianz Global Investors, speaking just before the Italian parliament voted through a €41bn austerity package and the European bank stress tests. “With the EU debt crisis now incorporating Spain, Italy and Belgium, the proverbial ‘can’ has now got too big to kick any further, so expectations must now rise that a series of new policies will be adopted in the coming week, otherwise the future of the euro and the EU may well be in jeopardy.
Willem Sels, HSBC Private Bank’s UK Head of Investment Strategy, says: “Kicking the can down the road no longer seems a viable option for European governments, as markets force their hand. In our view, addressing fundamental problems may be a good-thing in the long run but it may be a bumpy road.”
Policymakers have dragged their feet in trying to assuage the markets probably because they felt they could, says Sels. On their own, Greece, Ireland, and Portugal combined are not really big enough to derail the European economy. In terms of Eurozone GDP combined they make up just over 5.5% – less than a fifth of the size of Germany. Furthermore, their combined outstanding debt is in the region of €650bn (c.7% of Eurozone GDP).
But Italy is a different story. As the third largest economy in the eurozone, the third largest issuer of debt and with the second highest debt to GDP ratio (120%), Italy is probably too big to fail – or too big to save, says Sels. Italy has a few plus points: a resilient banking sector; much of the debt is domestic, funded by a high savings rate; one of the lowest primary budget deficits in Europe; and, when presented to parliament, the austerity package was passed with surprising speed.
Uncertainty is adding to the turmoil in the markets, in the build up to an EU summit on Thursday 21st. Eurozone leaders are under heavy pressure to source a second bail-out for Greece, along with an end to the prevarication over whether private sector bondholders should take some of the pain.
A sovereign default, for Greece or any other country, is out of the question, says Jean-Claude Trichet, president of the European Central Bank. “Who would consider the default of any sovereign issuer – in the context of a European and global crisis of public finances in the advanced economies – a ‘good solution’?”
Analysts may agree on the inevitability of Greece defaulting, but Trichet said another way must be found: “A credit event, selective default or default should be avoided. Those who advocated sovereign default as a desirable way out of the crisis had not thought the matter through.”
He added that the solution had to come from the EU governments, not the ECB, which would not accept Greek bonds as collateral in the event of default. But another ECB governing council member suggested the ECB may yet accept Greek bonds as collateral in the event of a short-term selective default.