What if the ‘White Knights’ are an illusion?

As we have seen over the course of 2010, first in Greece and then in Ireland, governments in both countries were effectively priced out of international sovereign bond markets. As Portugal desperately seeks to avoid having to call in emergency financial assistance, we should not forget that the political and central bank authorities in Lisbon are struggling to keep the funding costs below the critical threshold of 7 percent for 10-year sovereign bonds. Key threshold They may succeed in doing so for some time, as was evidenced in the January 12 auction of 10-year Portuguese bonds, which were sold at a yield of 6.7 percent. However, it is too early to conclude that this success may signal a key turnaround in the country’s and the eurozone’s yearlong and ongoing debt crisis. Just a few days ago, the risk premium demanded by international bond traders for 10-year Portuguese sovereign debt breached the symbolically important 7 percent threshold. Why is this threshold so important? Why does it constitute such a critical benchmark in the eurozone? A brief review of recent pricing levels at sovereign bond auctions in Greece and Ireland illustrates the case in point. In the former case, Greece breached the 7 percent yield threshold for its 10-year bonds for the first time on April 6, 2010. Within a timespan of 17 tumultuous days, the authorities in Athens needed a rescue package negotiated with the so-called troika of the International Monetary Fund, the European Union and the European Central Bank. In the case of Ireland, the timespan was slightly longer, but no less painful. A month after yields on its sovereign bonds broke the 7 percent threshold in October last year, Dublin could no longer afford to borrow at these levels on international bond markets. The pricing out of a second eurozone country led to Dublin having to reluctantly accept a bailout by the same troika, but with additional institutions and countries on board three weeks later in mid-November. Retreating from the 7 percent abyss in mid-January 2011 was a successful reprieve for Portugal. But the achievement – important in its own right – might only be temporary and could potentially signal a false dawn. As the Financial Times observed in its January 12 edition, Portuguese 10-year debt has yielded more than 7 percent in 10 of the past 62 days. While many speculators and savvy market observers have taken Portugal’s inclusion in the eurozone’s bailout boat as a foregone conclusion, the matter continues to rather hang in the balance, and a delicate one indeed. The sovereign debt accumulated in the case of Athens and the financial sector-related debt accrued in the case of Dublin could only be refinanced by simultaneously repackaging their respective debts into unprecedented bailout arrangements administered by the IMF in Washington, the EU in Brussels and the ECB in Frankfurt. In the case of Ireland we witnessed the added-on participation of individual countries, such as the UK, Sweden and Denmark, as well as the first-time inclusion of the European Financial Stability Fund (EFSF), which was established after the Greek rescue operation in May 2010. But the challenge that lingers behind these rescue attempts, and that is a special concern for policymakers at the European Commission and at the seat of the ECB in Germany, concerns the following question: When and to whom will the EU and the ECB send the mounting bills the moment one or both institutions have maxed out their individual credit limits? By contrast, the IMF, as the most senior institution in the troika, has both deeper pockets and privileged creditor status vis-a-vis the other two institutions. It is often forgotten in the ongoing debate about financing options for eurozone member states in acute danger of default that the IMF ranks ahead of the EU and the ECB if (or when) the worst-case scenario should become reality, i.e. default of Greece and/or Ireland. Over the course of the past year the sovereign debt crisis in the eurozone has given rise to numerous attempts and initiatives to once and for all seek a comprehensive resolution to the crisis that threatens the stability of the 12-year old, now 17-member single currency union. So far, this umbrella solution has not emerged, and critics from Washington to Berlin and London to Beijing argue that the apparent deficit in the crisis management capacity of the key policymakers in the eurozone is as large as Greece’s public debt or Ireland’s fiscal deficit. They came from the East During this highly charged search process, some unexpected assistance has arisen from various corners of the world and different institutions that have started to implement unorthodox measures – at times contrary to their mandate but commensurate with the urgency of the situation. Who are these «White Knights» riding into the cities of Athens and Dublin, promising financial assistance to Spain and Portugal and expressing a manifest self-interest in contributing to the solvency of the eurozone? Most prominently and repeatedly articulated, at least in terms of rhetoric, have been pledges of financial support to individual countries of the eurozone by the political and central bank authorities in China. A recent newcomer to the operating team in the eurozone’s emergency ward is Japan. In the last few days, the Finance Ministry in Tokyo has announced that it intends to invest some of its foreign exchange reserves in buying bonds in eurozone debt when the EFSF, the eurozone rescue fund, issues its first-time bonds to finance the Irish rescue package at the end of January. It is thus a remarkable turn of events within the past six months that potential Chinese solutions and manifestations of Japanese interventions are among the most promising and liquid options available for the attempt to stabilize the eurozone and overcome the sovereign debt crises of various member states. The support from Asian countries with deep financial pockets is being welcomed with a big sigh of relief from authorities in Brussels to Athens, Dublin and Lisbon but, again, a word of caution is in order. The debt crisis spreading across many countries of the European continent during 2010 and refusing to go away in the course of the first weeks of the new year will need additional instruments in order for market confidence to return and solutions to be more than stopgap measures and band-aids hastily applied. At present because of the bond-purchasing activities of the ECB in Frankfurt on the secondary market in favor of Greek, Irish and Portuguese debt, it is rather impossible to identify a true market sentiment regarding appropriate pricing valuations, yields and spread differentials vis-a-vis benchmark German bunds. A more transparent indicator of correct market conditions would be found in Spanish, Italian and Belgian debt where ECB interventions are still absent and thus the price is not tainted. In all three cases the trend curve in bond yields during the past quarter has only known one direction, namely slowly but persistently upward. As long as sovereign bond auctions among eurozone member states are being interpreted by policymakers or presented by speculative traders as a cast-iron external referendum of a country’s financial position, we will not be able to identify sustainable exit strategies from the yearlong crisis. Moreover, hovering over these weekly referenda is the threat of further downgrades by international credit rating agencies. Seldom during the past months have Moody’s, Fitch or Standard & Poor’s missed an opportunity to spoil an emerging vision of light at the end of the tunnel. There is no reason to believe that a sense of reprieve is imminent and that this time the situation is any different. The eurozone sovereign debt crisis is akin to a profound problem of policy issues that will neither settle easily nor quickly. Rather, as the yearlong crisis has shown, Europe is heading toward unsettled politics in 2011 and possibly beyond. * Jens Bastian is a visiting fellow for Southeast Europe at St Antony’s College in Oxford, UK, and senior economic research fellow at the Hellenic Foundation for European and Foreign Policy (ELIAMEP) in Athens.