Even if the Greece package is successfully completed – and doubts abound over this – it does not remove big worries about the sustainability of many European governments’ debts. Nor does it even provide much assurance about Europe’s capacity to withstand renewed market panic temporarily disrupting the financing of fundamentally sound sovereign borrowers.
The EFSF now has greater flexibility to intervene early in a sell-off in the bonds of any government including those not yet receiving multilateral assistance. The threat of a short squeeze is established. But the approval process for intervention looks cumbersome compared with the speed at which markets can unravel, as they nearly did amid sudden and dramatic spread widening on Italian bonds in mid-July.
More worryingly, the firepower of the EFSF remains low calibre. Citi analysts calculate that beyond the Greek, Irish and Portuguese packages, its remaining spare capacity stands at €235 billion, some of which might yet be diverted to recapitalizing banks. That’s modest compared with the size of the still-at-risk peripheral European government bond markets – half the size of Spain’s debts. And it is tiny next to the €1.6 trillion debt of Italy, the third-largest government debt market in the world.
We are still in the early stages of the sovereign debt crisis, and as analysts at Deutsche Bank have argued since last year, the markets must come to terms with defaults, restructurings, haircuts, extreme money printing and even moves towards full fiscal union in Europe being realistic prospects for months or years to come. Periodic illiquidity and volatility will disrupt the markets for the foreseeable future.
Even if the serial, disorderly defaults can somehow be avoided, the key benefits of the euro project – principally a large, homogenous liquid capital market allowing governments and others to fund at low rates – are now evaporating before our eyes. In mid-July, Italian 10-year bonds traded above 6% for the first time in the euro era. By the end of the month, they had tightened again, but only to 5.75%.
It is hard to see spreads on many European government bond markets ever again converging towards those of Germany, as they did in the first years of the single currency. This does not affect just the periphery countries. Société Générale notes that the spread to Germany on 10-year French government bonds widened from 35 basis points in June to 63bp at the end of last month, close to the crisis era high of 70bp.
Holdings of French government bonds outside France are declining for the first time since the euro was created. Foreigners owned 62% of long-dated French OATs in June 2010. Those holdings stood at 54% at the end of the first quarter of 2011.
It is hard to see how eurozone sovereign debt can ever again be regarded as risk-free now that the second Greek bailout package has established the principle of selective default. Banks have offered to exchange Greek bonds voluntarily – albeit after governments threatened them with a bank tax and they analysed the prospect of getting back closer to the market value of 50% to 60% of face value or less – in return for lower-yielding, longer-dated ones at least with principal repayments backed by better-quality collateral. However, this still amounts to a 21% loss of net present value.
The very ostentatious declarations that private-sector involvement applies uniquely to Greece only emphasize the probability that taxpayers in other European countries will now demand their share of debt forgiveness.
Portugal, Ireland and Greece are like busted companies, taken temporarily into private equity ownership to restructure away from dependence on financing at market rates. But they have to restructure still burdened by the uncompetitive exchange rates imposed by the single-currency bargain in return for borrowing at close to German rates. Barclays analysts suggest Greece is struggling with an effective 21% overvaluation of its exchange rate, an adjustment it must make through deflating its economy, given the impossibility of devaluation.
Who knows at what rate the peripheral sovereigns, and other non-core governments, will be required to fund in future once they are exposed again to market rates. To push further the comparison with corporate restructuring, just look at the lousy reception in the public equity market for over-leveraged companies being re-IPO’d by private equity sponsors.