Richard Carter, Senior Fixed Interest Specialist at Quilter
Although the second bailout of Greece may have calmed markets in the short-term, the recent volatility in Italian and Spanish bond markets signalled the beginning of a new and critical phase. Europe’s policymakers had always hoped that by bailing out Greece, Ireland and Portugal, the crisis could be restricted to these relatively small economies. This strategy has clearly failed and the measures taken at the recent summit recognise this.
The future shape of the Eurozone will likely be determined by how events unfold in Italy and Spain. Investors are generally making the assumption that what happens today in Greece in terms of bailouts and haircuts on bonds could happen tomorrow in Italy or Spain. Both countries are making efforts to reduce their borrowing and reform their struggling economies but it is a process which could take years and patience is wearing thin.
Of course, the problem with Italy and Spain is that Europe cannot afford to bail them out should they lose access to market funding. Typically, a bond yield of 7% has been seen as unsustainable in a Eurozone country and in the past, a breach of that level has rapidly led to a rush for the exits, followed by a bailout. The situation has not deteriorated to that extent yet, but if it does, the Eurozone’s bailout mechanism, the EFSF, could probably fund Italy and Spain for about 6 months before the money ran out.
So what is the endgame for this crisis going to look like? Given the general lack of cohesion in policymaking, a messy divorce is a real option and this would have hugely negative implications for the banking sector, the global economy and risk assets in general. The only real alternative is much closer fiscal integration and the launch of a single Eurozone bond, jointly guaranteed by all members of the single currency. Whilst it may be hard to imagine at the moment, this could be an attractive proposition for investors.
With the launch of a Eurozone bond, highly-indebted countries would be able to access market funding at significantly cheaper rates, giving them the breathing space to reduce their deficits and reform their economies. This is because markets would focus on the creditworthiness of the Eurozone as a whole and not just worry about the risk of lending to Greece, for example. The joint guarantee would come at a price, namely a further loss of sovereignty, because there would need to be centralised oversight of tax and spending decisions in individual countries.
For some, this may be a step too far down the road towards a federal state but when the alternative is the collapse of the Euro and bankruptcy for certain countries, it would surely be the lesser of two evils. So far, the German government has opposed the idea but there is significant support within Europe for it and not just from politicians in countries such as Ireland and Greece. The chairman of the Euro group of finance ministers, Jean-Claude Juncker has supported Eurozone bonds, as has the leader of the German opposition party, the SPD. The President of the ECB, Jean-Claude Trichet has also pushed the goal of a European Ministry of Finance.
From a competitive point of view, now would be a good time for such a bond. With all the concern over the outlook for the US Treasury market, investors are looking around for alternative ‘safe havens’. That includes nations such as China and Russia, who are searching for other markets to put their massive foreign currency reserves into. Even allowing for countries like Italy, debt as a percentage of GDP is lower in the Eurozone than the United States. Similarly, the overall fiscal deficit in the Eurozone is 6% of GDP – comfortably lower than that of the UK and US.
Also, one of the main concerns of government bond holders is the threat of inflation. If you compare the inflation-fighting credentials of the ECB to the money-printing strategy of the Federal Reserve, it is not hard to imagine why Eurozone bonds would be an attractive alternative to Treasuries. It was no surprise that the AAA rated 5-year bonds recently issued by the EFSF to fund the bailout of Portugal were snapped up, with nearly half of the demand coming from Asian investors.
Of course, the introduction of Eurozone bonds is not going to happen overnight and there will be plenty of opposition to the idea, not least from northern European taxpayers who would complain that they are subsidising the debts of profligate countries. Treaty changes would almost certainly be required. However, the moment will arrive when the EU and Germany in particular, will face the choice of either letting the Eurozone fall apart or taking another decisive step towards fiscal union.
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