13 November 2011

Wolfgang Münchau: The only way to save the eurozone from collapse

In his FT column, Münchau writes that as of last week, the eurozone no longer had a functioning sovereign bond market, S&P is clearly preparing a downgrade of France and the EFSF is therefore also likely to lose its triple A rating. The depressing reality is that the eurozone may be only weeks away from a financial collapse.

With the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders, European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted it – correctly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozone – German government bonds.

Through a combination of short-sightedness and financial illiteracy, the European Council has now put itself in a position where it desperately needs eurobonds, if only to assure the existence of a functioning financial sector.

Actually, they need a very large eurobond. What is now needed is something that affects not only new flows of debt, but also existing stocks. The German Council of Economic Advisors last week proposed an intelligent and ambitious scheme for what they call a “debt redemption fund” (view). Unfortunately, it suffers from the weakness that it is temporary. I am not sure that it is practical to launch a joint-and-several debt security as a pure crisis mechanism, and then to take it away a few years later.

The second reason you need a eurobond is the effective collapse of the silly idea of leveraging the EFSF. Klaus Regling, the EFSF’s head, is wrong to say that market volatility has made it impossible to reach the leverage target. It was the other way round. The eurozone’s refusal to capitalise the EFSF properly contributed to the panic. A leveraged EFSF would have the worst kind of eurobond: a tranche in a toxic debt security. The eurozone needs a risk-free asset class, and this means something boring and simple.

Of course, the EU cannot introduce a eurobond overnight. The most its leaders can do is to issue a credible statement of intent, and set in motion a process to enact the legal changes needed. It will take time.

But once they make such a declaration, there should be no obstacle to endowing the EFSF with a banking licence. The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the eurobonds are in place, EFSF liabilities would simply be transformed into eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible.

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