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Reports suggest sovereign debt default imminent

Mitsubishi claims there is no such thing as velvet insolvency, while Moody’s warns markets that the European System of Central Banks can only provide limited support to sovereign debt markets.

Two reports released on Tuesday hint that a sovereign debt default is highly plausible, and that the defaulter would also likely exit the euro.

In a report by Mitsubishi UFJ Securities International, the investment bank states that the contagion for sovereign debt restructuring is highly plausible as “why wouldn’t every other distressed member country follow in the footsteps of Greece”?

“There is no such thing as a velvet debt restructuring for weak Economic and Monetary Union (EMU) countries,” says Brendan Brown, head of economic research at Mitsubishi UFJ Securities International. “If one country were to obtain this, then rational investors would imagine that the same would occur elsewhere. Contagion would become wildfire.

“If a fence is to be ringed round the country which is engaging in a voluntary debt re-arrangement, then there has to be a penalty in the form of an immediate cessation of privileged access to the European Central Bank. That cessation means most likely EMU exit within 24 hours.”

Brown is particularly vocal on how the current arrangement between Greece and the ECB is likely to collapse, due to the implausibility of containing contagion.

“In the dream world, there may be such a thing as a velvet insolvency – where an EMU member country can repudiate part of its debt and then continue its life in the eurozone as if nothing had happened,” says Brown.

“In the real world, such a scenario is utterly implausible, even if it has entered into some serious market commentaries in recent months and even though some EMU finance ministers may hope that the virtually impossible could indeed become possible.”

Meanwhile, a report by ratings agency Moody’s, titled Central Bank Support for Euro Area Banks and Sovereign Debt Markets, states that ECB has substantial capacity to support euro area banks and sovereign debt markets.

However, the small print reads that “its interventions in sovereign debt markets likely will remain limited”.

Brown therefore questions: “[If] Greece gets away with it so easily, why wouldn’t Portugal, Ireland and even Spain not go down the same route?”

The crux of the Moody’s report states that European System of Central Banks, or Eurosystem, has substantial capacity to support euro area banks and sovereign debt markets, but the ECB is likely to limit is actions on sovereign debt, unless systemic threats catalyse.

"We believe the Eurosystem, headed by the ECB, will continue to support stressed financial institutions," says Alain Laurin, senior vice president of Moody’s and co-author of its report. "However, the central bank's actions with regard to sovereign debt markets are likely to remain limited, conditional and uncertain, unless systemic threats accelerate further."

On Sunday, eurozone leaders will meet to discuss more aid for Greece. Last year, the European Union and International Monetary Fund agreed on a €110 billion bailout, but Greece is set to receive another €8 billion in November.

Mitsubishi’s Brown says that while countries like Portugal, Ireland and Spain may have no current intention of embarking on the same course as Greece, investors may imagine that resolve could soften in the future, meaning an immediate drop or collapse in their bond prices may occur.

“If there is not to be contagion – or at least if contagion is to be held within bounds – there have to be some pretty big disincentives to governments deciding to bring the threat of debt default into play [towards achieving a restructuring of bank-held debt in the first place],” says Brown.

“One such disincentive and the most powerful, potentially, is that debt default in any form means the curtailing of access to any EMU privileges.

“In the case of Greece, this would mean no more ECB back-door lending to Greek banks and no more printing of euros by the central bank of Greece. Greek exit from EMU would occur within 24 hours of the back door being slammed shut.”

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