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The long-feared contagion from the sovereign debt crisis in Greece and other "peripheral" European countries arrived forcefully at the doorstep of Italy and Spain this week. But the new turmoil in Europe offers a prospect for rethinking the terms of the Greek bailout, including the role of the banks, and the steps that Italy, Spain and other countries need to take to finally get ahead of the crisis.
At least three factors helped spread the contagion to Rome and Madrid.
First, Italian efforts to pass an austerity budget were impeded by Prime Minister Silvio Berlusconi trying to insert provisions aimed at saving his family's holding company Fininvest several hundreds of millions of euros in damage payments from a recent court loss1. The embarrassment in Italy over Berlusconi’s personal attacks on his fiscally hawkish finance minister Guilio Tremonti added to the disarray. In Spain, meanwhile, some mildly disappointing fiscal data for a small regional government sent a modestly negative domestic economic signal just as the European Union (EU) bank stress test results are to be released2.
Second, at the global economic level, the recent negative U.S labor figures cast doubt about the American recovery, reducing market risk appetite. Combined with fears of a slowdown in Chinese growth rates as the government combats inflation, vulnerable Spain and Italy were hit by these global headwinds.
Third, political leaders in Europe are still struggling to work out the modalities for supplying Greece with more bailout money later this year. The political insistence by the euro area on private sector involvement (PSI) – i.e., losses for lenders, especially European banks -- in the next phase of financing for Greece has led the markets to re-price the risk of all peripheral euro area debt, exposing Italian and Spanish government debt to selling pressure.
Also contributing to that pressure was the decision of credit rating agencies to declare any rollovers of Greek debts as a selective default. The markets immediately feared that bonds would be restructured, not just rolled over. The decision by Moody’s decision to downgrade the debt of Portugal and Ireland to a similar junk status was a clear reflection of market concern that the demand for PSI in Greece impaired the hitherto sacrosanct status of peripheral government bonds.
The spooking of the bond markets by the euro area insistence on PSI for Greece can be viewed as a "Deauville Declaration II," echoing the original announcement by Chancellor Angela Merkel and President Nicolas Sarkozy of potential haircuts on government bonds in the European Stability Mechanism (ESM) in October 2010. But unlike the original Deauville Declaration, which kicked the can down the road by making the haircuts apply only after 2013, PSI for Greece remains imminent. Indeed it is to be completed by no later than September 2011.
With 10-year bonds for both Italy and Spain trading above six percent on ten-year bonds, Europe is once again caught unprepared. This was inevitable, however, given the complexity of EU/euro area decision-making. The multifaceted political constraints on EU policymakers are generally lost on market participants and commentators bent on immediate comprehensive solutions. Market pressure, on the other hand, can force EU leaders to compromise. Regional integration has historically been forged in such financial crises, though fortunately Europe has moved beyond wars to provide that sort of threat.
Against the odds, however, there is reason to be optimistic that a political response can be agreed that will quickly allow both Spanish and Italian bonds yields to drop back down. Both Italy and Spain have sounder economic fundamentals than the three small peripheral countries. There is no reason to believe that the six percent ten-year rate represents a irreversible "credibility watershed" for either country.
Spain and Italy must act, however. They need to address their key domestic concerns, which for Spain centers on the upcoming banking stress tests. The test results, if they are as adverse as seems likely, would ironically offer the Spanish government a face-saving opportunity to expand its previous commitment to spend only up to €15 billion to recapitalize its banking sector. Hopefully, the Spanish government (in collaboration with the European Banking Authority) will use the stress tests to fail some of its weaker Cajas and then make full use of its national bailout fund’s available capital of at least €80 billion.
In the case of Italy, the announcement that an austerity budget will be passed by the parliament, with the tacit support of the opposition, by July 18 -- without sweetheart provisions for Fininvest – reflects a realization by the Italian political system that speed and decisiveness are now required3. It would be wonderful if Rome would show the same purpose and intent when implementing Italy’s long list of structural economic reforms.
The most urgent priority for the euro area is to expeditiously agree to a "non-contagious financing formula" for the second Greek bailout. The group’s statement of July 11 was ambiguous4, unfortunately. It contained no new decisions, but it indicated some significant policy shifts as early as this weekend. It would be ideal for an agreement to be announced just as the Italian budget and the banking stress test results are completed, by market opening Monday morning July 18.5
The euro group expressed its intention to strengthen the "euro area’s systemic capacity to resist contagion risk" through several measures. It endorsed a sensible lengthening of the maturities of European Financial Stability Fund (EFSF) loans and lowering of interest rates. This is good news for Greece, as well as Ireland and Portugal, improving their prospects for debt sustainability because of the availability of lower interest rates (probably, as predicted on this blog, close to IMF lending rates). This would be a further EFSF measure similar to the one taken in March 2011 for Greece’s bilateral loans from the euro group. It would also, similarly, amount to an implicit "fiscal transfer" in another name to the peripheral countries.
More important, the euro group dramatically changed its stance on the likely format and aim of PSI in relation to the Greek program from its previous statement of July 2, 20116. Only nine days earlier, the euro group had stated that "consultations with Greece’s creditors are underway in order to define the modalities for voluntary private sector involvement with a view to achieving a substantial reduction in Greece's year-by-year financing needs, while avoiding selective default." The original intent of PSI was to lower the additional Greek financing need to be covered by euro group governments in the next program.
The euro group shifted its PSI emphasis dramatically in July 11. It stated that "the [newly-formed] Eurogroup Working Group will notably explore the modalities for financing a new multi-annual adjustment programme, steps to reduce the cost of debt-servicing and means to improve the sustainability of Greek public debt." The intention is not simply to lower the Greek refinancing needs but to reduce Greece’s costs of debt service and the stock of Greek debt itself.
Combined with the intention to "enhance the flexibility" of EFSF lending, this change in wording and intention for PSI suggests that the euro group is moving towards providing the EFSF with the previously denied possibility to purchase (Greek) governments bonds in the secondary markets at distressed prices. As previously suggested by the International Institute of Finance ( IIF)7, the financial industry’s leading think tank, the Greek government could retire such bonds at distressed purchasing prices, using the discount to par value to lower their outstanding debt stock. This would be a very different type of operation, but likely one that could satisfy the original eurogroup political requirement for PSI to force private sector banks to participate in the Greek rescue through a realization of their losses.
The interest of the IIF in this type of proposal suggests that many euro area banks would be willing to pay a substantial price to exit their current Greek bond exposures, especially if such an exit were part of an orderly debt exchange process helping Greece to reach a sustainable debt level. The advantages of Greek debt buybacks to both banks and governments are several. Debt buybacks would not necessarily be labeled with a selective default rating by credit rating agencies. Even if they were, the bonds would be retired quickly. In addition, buybacks would not have the contagious effects of PSI’s reliance on supposedly "voluntary" rollovers.
The lack of a PSI precedent for euro group financial aid should prod Moody’s and other credit rating agencies to lift the "contagious junk rating" on Ireland and Portugal. Markets should come to realize that each euro group case is unique, and that there is no general "PSI precedent" for assistance. This again should help restore calm to Spanish and Italian bond markets.
Rumors are spreading that the European Central Bank (ECB) intervened on Wednesday to stop the slide in Spanish and Italian bonds. Such a move would not be confirmed or disproven until next week when the ECB will publish its weekly bond purchases data. But if the rumors are true, it would be another activist intervention by the ECB, a move it would make only if it felt assured of a quid pro quo in the form of a reform of the EFSF or a complete avoidance of a selective default and credit event.
A potential reform of the EFSF would accelerate the time table for moving Greece towards debt sustainability, as outlined by this author. Previously, I had suggested that the political will in Europe to move towards a restructuring of Greek debts resulting in a potential sizable reduction of the debt principal would only occur at the point (likely in late 2012) at which it became evident that Greece would never be able to return to private financing at current projected debt levels.
Recent market contagion to Spain and Italy may therefore once again have forced EU policymakers’ hands and beneficially expedited their necessary compromises. It certainly would not end the Greek debt crisis or restore the country to solvency. But it could rein in contagion. As always, in European crises, the absence of alternatives clears policymakers’ minds marvelously.
Notes
1. http://online.wsj.com/article/SB10001424052702303812104576441703270727990.html?mod=djemTEW_t
2. http://www.bloomberg.com/news/2011-07-11/spain-s-castilla-has-extremely-serious-deficit-leader-says.html
3. http://www.bloomberg.com/news/2011-07-12/berlusconi-vows-to-hasten-passage-of-italy-s-56-billion-deficit-reduction.html
4. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/123601.pdf
5. EU Stress test results will be published by 6pm CET on July 15th, which while the U.S. markets will still be open for a few more hours will be after the close of trading on EU financial markets, where all of the stress-tested banks are listed. As such, Monday morning will be the first market reaction on the EU banking stress tests.
6. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/123385.pdf
