The only moderate reduction in market havoc on Friday has all eyes on the European officialdom. Will they mount a credible enough plan over the weekend to buy them a bit of breathing room so they can come up a better salvage operation for the euro experiment? The odds are against both steps in the process (calling off the hounds of the market and then patching up eurozone arrangements), but as the wags remind us, it isn’t over till the fat lady sings.
The EU is at least moving decisively to defend the euro. That may not be as nutty as it sounds, particularly if other countries (the US, Japan, and China, none of whom would benefit from a weak euro) join in the intervention. While single country efforts to prop up currencies usually end in tears (by the time the country under attack resorts to intervention, it is typically low on FX reserves and hence lacks firepower and credibiltiy), multi country intervention like the Plaza Accord and the Louvre accord have been effective. Bloomberg has reported that the short interest against the euro is at an all time high; a concerted short squeeze could produce an impressive reversal.
The details on the plans thus far from Bloomberg:
…leaders of the 16 euro countries said the workings of the financial backstop will be hammered out before the markets open on May 10.
“We will defend the euro, whatever it takes,” European Commission President Jose Barroso told reporters early today after the leaders met in Brussels.
Europe’s failure to contain Greece’s fiscal crisis triggered a 4.3 percent drop in the euro this week and led the U.S. and Asia to rally around in a bid to prevent a global sovereign-debt crisis from pitching the world back into a recession.
European officials declined to disclose the size of the stabilization fund, to be made up of money borrowed by the European Union’s central authorities with guarantees by national governments. Finance ministers will meet at 4 p.m. tomorrow in Brussels to flesh out the details.
“When the markets re-open Monday, we will have in place a mechanism to defend the euro,” French President Nicolas Sarkozy said. “If you don’t think that’s significant, you haven’t been to many EU summits.”
Yves here. Although a little punishment of speculators might make for an engrossing spectacle, the question is whether this action is sufficient. Relieving pressure on the euro does not do much for the member states. From the same story:
The extra yield that investors demand to hold Greek, Portuguese and Spanish debt instead of safer German bonds rose to euro-era highs yesterday. The premium on 10-year government bonds jumped as high as 973 basis points for Greece, 354 basis points for Portugal and 173 basis points for Spain.
Some readers have suggested that banning cash settlement of CDS (as in requiring investors to present the bonds to collect on CDS) would make a considerable difference. Note that CDS originally worked that way, that requirement was reworked on the fly in the Delphi bankruptcy when ISDA was faced with CDS of roughly 8X the notional value of outstanding bonds. They decided that the market would lose credibility if, quelle horreur, investors were required to adhere to contract terms and somehow find bonds if they were to collect on their CDS wagers. With the benefit of hindsight, this was a hugely destructive decision. But would the involved governments have the will to issue this sort of prohibition on sovereign CDS? It certainly does not appear to be on the table.
The other wee fly in the ointment is that Eurobanks are seeing their CDS spreads blow out, which again translates pretty pronto into higher funding costs (there is already stress in short term funding markets) And the ECB, unlike the Fed, does not appear willing to pull out all stops to calm markets (mind you, I’m not praising the Fed here; it’s one thing to engage in emergency operations, quite another to write a miscreant banking industry blank checks on a regular basis). From the Financial Times:
Europe’s banks on Friday made a desperate appeal for the European Central Bank to buy the bonds of crisis-hit eurozone members, as a fresh day of turmoil in markets battered share prices around the globe.
Fears that a debt default by Greece could paralyse the world’s financial system – just as the collapse of Lehman Brothers did two years ago – sparked another wave of heavy selling in Asian, European and US stock markets…
Worried bankers from 47 European groups urged the ECB to become a “buyer of last resort” of eurozone government bonds to steady markets.
There was speculation that the central bank could be preparing a €600bn ($762bn) loan facility for one-year loans at 1 per cent to help more than 1,000 banks in their funding.
But as European leaders met in Brussels to give their formal approval to a three-year €110bn rescue plan for Greece, there was no sign of imminent ECB action.
Yyes here. The conundrum is that if the pressure on the Eurobanks is merely a liquidity crunch, then the ECB ought to, per Bagehot’s rule, lend freely against good collateral, at penalty rates. Buying bonds does not fit that picture. And are the banks solvent? Ah, in many cases, that becomes a bit circular. Can the EU contain the mess to Greece, come up with credible plans for Portugal and Spain? If so, it might not be so nutty for the ECB to LEND against non-Greek sovereign debt. But right now, that would look like a leap of faith.
And we still have the second leg of the equation: how will the EU move forward? Right now, it looks to have an unworkable mix of national autonomy and EU level fiscal strictures. The public responses in Germany and Greece to the sacrifices required to make the current budgetary arrangements work send the message loudly and clearly that national identities and national prerogatives still have the upper hand. Moreover, any approach within the current framework would probably serve to attenuate the process of meeting fiscal targets. The problem is that any program to meet the goal of reducing fiscal deficits when the private sector is also deleveraging is certain to be deflationary and thus self defeating (Ireland will be the case example).
The market timetables seem much too compressed to go back to the drawing board and rework the eurozone arrangements. But the process of working out how to allow current members to exit, which would be the other end game, would also be a very protracted affair. Perhaps someone more clever can figure out a way to cut these Gordian knots, but there is no obvious surgical resolution, and the markets appear unwilling to tolerate much more ambiguity.