SERIOUS MONEY:THE SECOND phase of the financial upheaval that began during the autumn of 2007 got under way during the current calendar year. History illustrates that banking crises are typically followed by sovereign debt crises and the current episode has proved no exception. The global financial crisis precipitated brutal private sector deleveraging, which required massive fiscal stimulus to support aggregate demand and side-step a 1930s-style meltdown.
Though the stimulus averted a global depression, the medicine, combined with sizable fiscal bailouts for the banking sector, led to a dramatic deterioration in the public debt positions of most developed economies. Not surprisingly, the so-called bond market vigilantes returned with a vengeance and focused on the euro zone’s weakest links – Greece, Ireland, Portugal and Spain.
Greece was the first domino to fall, as the bond vigilantes questioned the solvency of the nation’s public sector. Their fiscal profligacy in the years preceding the global crisis meant the Greeks entered the economic downturn with a public debt-to-GDP ratio of 105 per cent and an unsustainable structural primary deficit of more than 10 per cent of GDP.
A marked deterioration in Greece’s public debt position in 2009 coupled with a slew of upward revisions to that year’s fiscal deficit undermined confidence and meant it was only a matter of time before bond investors would bring matters to a head. That moment duly arrived in May and after a delayed, inadequate response, the EU and the IMF finally cobbled together a €110 billion rescue package.
The EU believed this crisis would be easily contained, but this proved not to be the case; the rescue package failed to calm investors’ nerves and concerns soon spread to other high-debt and high-deficit countries.
The EU was forced to respond to the ensuing turmoil and the subsequent creation of the European Financial Stability Facility (EFSF), alongside the declaration by the IMF that it would provide loans of up to 50 per cent of the EU’s potential contribution of up to €440 billion, appeared to be sufficient to thwart the negative feedback loops that threatened to derail the euro project.
However, the creation of the EFSF just addressed liquidity fears, as the authorities continued to deny solvency was the central problem. The vigilantes turned their focus to Ireland, as the insolvent banking sector’s losses continued to mount.
A monumental mistake came when the Government misdiagnosed the banking sector’s woes as a liquidity problem in the autumn of 2008 and guaranteed the banks’ senior bondholders. The seemingly endless upward revisions to eventual losses undermined investor confidence and what was once perceived as a manageable liquidity crisis had become a serious solvency problem.
The Irish cause was not helped by comments made by Angela Merkel, the German chancellor, when she stated towards the end of October that any future euro zone rescue scheme should include a mechanism for an orderly sovereign-debt default. The ensuing turmoil saw the financial markets shut to Irish banks and reluctance on the part of the ECB to provide unlimited liquidity to Ireland’s ailing financial institutions meant the game was up by the latter half of November, which left the Government with no option but to ask for assistance.
Accompanying the decision to provide Ireland with a rescue package of up to €85 billion including IMF support, EU finance ministers also agreed to create a permanent mechanism to safeguard financial stability. The decision to set up the European Stability Mechanism (ESM) came sooner than expected, as market pressures and escalating contagion fears forced their hand.
Not for the first time, action taken by the European authorities not only failed to ease market tensions but contributed to further volatility. Indeed, clarification of the post-2013 permanent crisis mechanism contributed to heavy selling of not just peripheral sovereign bonds, but also debt securities from quasi-core markets like Belgium and Italy.
Panic erupted as the announcement confirmed that haircuts for private debt investors will be a distinct possibility in the future should a member state encounter a solvency problem. Assurances that there will be no private sector participation in haircuts issued for debt issued before mid-2013 is of little comfort to holders of peripheral bonds.
Investors have already driven the yields on Portuguese and Spanish debt to prohibitive levels, as the bond market vigilantes appear to believe the Mediterranean countries’ sizable financing requirements in early-2011 could see both request assistance before the summer.
Meanwhile, the fiscal difficulties facing both Greece and Ireland are unlikely to be resolved for several years and given that debt issued after June 2013 will be subordinate to the outstanding stock of debt, bond markets are likely to remain closed and a request for further assistance is certain to follow if not a debt restructuring or partial default.
Investors should be aware that the euro crisis is far from over and will not end until the solvency problems in the euro zone’s periphery are resolved once and for all.
www.charliefell.com
