Graham Bishop: The greatest danger to the euro - Greece or Merkel/Sarkozy?

07 November 2011

A great battle is underway to save the EU's flagship "Euro" but, as in any battle, the fog of war sometimes clouds the vision of the generals.

A great battle is underway to save the EU’s flagship “Euro” but, as in any battle, the fog of war sometimes clouds the vision of the generals. At the pivotal Battle of Deauville Beach on 18th October 2010, the mighty 'Merkozy' cannon was fired towards the enemy’s hedge. Unfortunately, the professional gunnery staff officers were out to lunch at the time and it is now clear that the Merkozy cannon was rather loose when the generals personally fired it. The huge policy projectile is hurtling forward, shattering long-standing defences, scattering dominoes to the left and to the right, and now even tearing through stout Treaty walls. However, it is now possible to calculate the trajectory of the policy projectile with some certainty. Having gone over the top of the enemies in the hedge, it now seems likely to head out to sea and score a direct hit on the flagship itself – unless urgent and bold action is taken to deflect the projectile towards the real enemy.

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For several decades, EU regulations for all sectors of the financial services industry have explicitly stated that the sovereign governments should be regarded as free of credit risk, thereby encouraging financial institutions to make government debt a core asset. In the past year, this assumption has been undermined substantially by the euro area Heads of State and Government (HoSG) – led by Chancellor Merkel and President Sarkozy (Merkozy).

That is bound to change the price that all financial institutions will charge to hold government debt where any perception of unsound polices creeps in. The timeline of the implicit regulatory changes shows an impressive speed and sweep (see detailed timeline below).

Consider the position of a European pension fund contemplating an immediate investment in bank shares:

Shareholders are likely to encourage the management of their banks never again to hold assets that, astonishingly, can turn from risk-free to toxic in just a year. Indeed, recent results from a number of major EU banks show that holdings of doubtful government debt have now been sold, after heavy write-downs. In the new climate of culpability, senior management may not dare take the risk in the future of holding assets that can suddenly swing into such a risky category. Who will buy these bonds now?

From December 2010, Merkozy and the other HoSG repeatedly proclaimed that they would do “whatever it takes” to preserve the euro. In October 2011, they suddenly introduced limits – by declining to extend the guarantees underpinning the EFSF. The change of heart was reinforced by announcing that the general assessment of the minimum necessary size of the fund would instead be achieved by previously-ridiculed techniques of financial engineering.

So the much-vaunted firewall to stop contagion spreading to Italy and Spain was built on sand. Actually, it may turn out to be quick-sand, as the proposal to insure the first loss – perhaps 20 per cent judged by the money available and the HoSG’s desired level of leverage – pales into insignificance against the 60 per cent-ish write-downs just taken on Greek debt. If the remaining 40 per cent loss is to be amortised over the life of a ten-year loan, then even the most rudimentary analysis would suggest an extra yield of perhaps 4 per cent annually.

But the HoSG have now stated twice that there will only be credit risk in Greece and “their inflexible determination to honour fully their own individual sovereign signature”. After the abrupt about-turns in the past year and the commitment to introduce CACs, which investor is going to believe that? Moreover, one of the bulwarks of financial analysis of euro area government debt has been the complete absence in the Treaty on the Functioning of the EU (TFEU) of any exit mechanism from the euro. The only route out is to leave the whole EU – the nuclear option. Then at a post-G20 press conference, Merkozy suddenly dropped the bombshell that Greece might have to leave the euro. Most observers assume that would have to be accompanied by a massive devaluation, so inflicting a correspondingly massive loss on bond-holders.

Against this background, few investors will be surprised to see Italian yields rising above 6 per cent to reflect these sudden and various new risks. But the consequences of such interest charges could be profound: with the new commitment to a balanced budget, the squeeze on other parts of public spending could easily provoke Greek-style protests. That might lead to a demand to take the “easy way out” - leave the euro and stage a massive, and nakedly competitive, devaluation. As the third largest economy in the euro area, that would probably destabilise the Single Market, as many states would scramble to protect their voters against such unfair competition. As other states felt obliged to respond with similar devaluations, the disintegration of the euro and Single Market would poison the European Union as a whole.

So the “Merkozy policy projectile”, launched a year ago at Deauville, could easily sink the EU’s flagship – and probably the EU itself. Bold, and carefully thought–through, policies are urgently needed.

A year that re-shaped European finance

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© Graham Bishop