World Economy

Jul 18, 2011

Euro-zone leaders are hurtling toward a Thursday meeting designed to finalize a bailout package for Greece and prevent the region’s debt crisis from d

Euro-zone leaders are hurtling toward a Thursday meeting designed to finalize a bailout package for Greece and prevent the region’s debt crisis from deepening, while they attempt to overcome a long-running battle between Germany and the European Central Bank over the role of private bondholders.

“If there’s nothing conclusive that makes sense to the markets and eases the burden on the [peripheral nations], the market is not going to be too impressed” and could send borrowing costs for the likes of Spain and Italy to unsustainable levels, said Alan McQuaid, chief economist at Bloxham Stockbrokers in Dublin.

10YR_ITA 5.85, +0.21, +3.75%

Spreading contagion
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Italian government bond yields have jumped in recent weeks on fears the euro-zone's sovereign debt crisis could engulf the region's third-largest economy.
Thursday’s meeting may mark a “last chance” for European leaders to take action needed to avert a breakdown of the economic and monetary union, he said.

A conference call among European Union officials on Wednesday will be closely watched for signs of progress.

Fears of a deepening debt crisis pressured the euro on Monday, contributed to weakness in equity markets worldwide and again sent government bonds issued by Italy and Spain jumping on Monday. The two countries are seen as the next dominoes likely to fall in a crisis that has forced Greece, Ireland and Portugal to seek bailouts.

Bond yields rise

The euro fell versus major rivals and traded at $1.4042 versus the dollar EURUSD +0.05% , a loss of 0.5%. The yield on 10-year Italian-government bonds IT:10YR_ITA +3.75% jumped 0.29 percentage point to 5.97%, after briefly topping 6%, according to FactSet Research data.

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Monday’s yield rise pushed the premium investors demand to hold Italian 10-year bonds over German bunds to 3.32 percentage points.

Spain’s 10-year-bond yield ES:10YR_ESP +4.10% rose 0.21 percentage point to 6.29%, pushing the yield premium versus bunds to more than 3.6 percentage points.

Strategists note that the 7% yield level has been a dangerous one for borrowing costs in the euro zone, marking the point where Greece and other bailout recipients have faltered.

“With contagion already a reality, the greatest danger is to see new delay at the summit,” said Michala Marcussen, global head of economics at Societe Generale in London, in a research note.

Merkel and Trichet remarks

Economists fear the euro zone would be unable to cope with a rescue of Italy, the region’s third-largest economy, or Spain, the fourth-largest.

The jitters come after German Chancellor Angela Merkel on Sunday told state television she won’t attend a special summit of euro-zone leaders set for Thursday in Brussels unless there is an agreement on the table to make private-sector bondholders share in the cost of a new Greek bailout.

Also, in a newspaper interview published over the weekend by Financial Times Deutschland, ECB President Jean-Claude Trichet reiterated that the central bank won’t accept as collateral the bonds of any government declared to be in default. That leaves it up to national governments to come up with a way to ensure financing of Greek banks.

That indicates neither Germany nor the ECB has veered from a collision course as Berlin continues to insist that private bondholders must share in the cost of a new bailout expected to top 100 billion euros (around $140.5 billion).The ECB has warned that such measures would undermine confidence in other euro-zone countries, thus spreading the crisis. Credit-rating firms have warned that recent proposals for voluntary debt rollovers would likely result in some form of default designation for Greek debt.

Such an action would put the onus on national governments to ensure that Greek banks would be able to find liquidity to meet their day-to-day funding needs if they’re unable to pledge Greek debt as collateral for ECB funding, Trichet said.

“If a country defaults, we will no longer be able to accept its defaulted government bonds as normal eligible collateral,” Trichet said. “The governments would then have to step in themselves to put things right. That would then be their duty.”

No ECB intervention

The ECB on Monday said it settled no bond purchases through its Securities Market Program last week, showing that it remained on the sidelines despite market rumors that it had intervened to stem a sharp rise in Italian bond yields last week.

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The lack of action is further evidence “that the ECB is not willing to budge in the controversy with euro-zone governments on how to proceed in the sovereign-debt crisis,” said Carsten Brzeski, senior economist at ING Bank.

Germany has insisted that further aid for Greece can’t be implemented without the private sector sharing in the burden.

And recent comments indicate that Germany is likely to get its way, Marcussen said.

In a statement on Sunday, a spokesman for the Institute of International Finance, an organization representing global banks, said discussions late last week in Rome between private investors in Greek bonds and public-sector officials continued to explore several options related to Greece’s financing needs and the sustainability of its debt burden.

The talks made progress and will continue, the spokesman said.

One particular option

Strategists on Monday increasingly focused on an option that’s previously met opposition from Germany: a buyback of Greek government debt financed by the European Financial Stability Facility, the bailout mechanism put in place by euro-zone countries after last year’s Greek bailout.

“Although there are still likely to be significant obstacles to its implementation ... the solution most likely to be sought for the Greek bailout will be one based on buybacks of outstanding bonds at their present distressed prices, belatedly recognizing that Greece’s problem is one of solvency and not just liquidity,” wrote Chris Scicluna, economist at Daiwa Capital Markets in London.

Bond buybacks have the “major advantage” of not being seen as a credit event, which would trigger payments on credit-default swaps, and are also unlikely to see Greek debt downgraded to selective default by the ratings firms, Marcussen said.

The big question is whether the buybacks would be sufficiently below the par value of the bonds to help reduce Greece’s debt burden and impose a big enough share of the burden of a new bailout on private bondholders, she said.

Scicluna said it would also remain to be seen whether the confirmation of haircuts for private-sector bondholders would contain contagion around the periphery or merely raise expectations for similar action elsewhere.

At the other end of the spectrum of options, bond holders could be forced to swap existing Greek debt while taking write-downs on their holdings, Marcussen said.

Such a move would go a long way toward slashing Greece’s debt burden, but would run the risk of triggering “wildfire contagion” through the euro zone as holders of other peripheral bonds head for the exits, she said.

by erectusplus at 1:45 PM |