How the "Euro penalty" is damaging the EMU?

Europe's immediate challenge is to stave off the possibility of some members not being able to refinance their debts. The bond market yields on government debt of the peripheral economies have been rising swiftly. Markets now perceive the strong possibility of a Euro exit and are pricing in that possibility. And that's being reflected in these higher yields. In the absence of measures to mitigate this concern, a messy unravelling of the Eurozone is inevitable.

In many ways, this run on sovereign debt is surprising. The sovereign debt positions of these economies, except Greece and Italy, is better or no worse than that of many others outside the Eurozone with much lower bond yields. For example, Spain has among the lowest debt-to-GDP ratios among all the major economies. But it is now at the greatest risk of being denied market access for its debt. But United States and Britain with much higher public debt ratios are enjoying historic low cost of public borrowing. Even within Europe, many of the economies outside the Eurozone with higher public debt ratios have much lower yields.

In other words, solvency and economic fundamentals are not at the heart of the issue. All these economies appear to be facing a liquidity crisis. In fact, the financial crisis and economic recession threatens to precipitate a sovereign debt crisis. So clearly, there is something amiss. In his excellent new book, Paul Krugman has this explanation,

Just about every modern government has a fair bit of debt, and it's not all thirty-year bonds; there's a lot of very short-term debt with a maturity of only a few months, plus two-, three-, or five-year bonds, many of which come due in any given year. Governments depend on eing able to roll over most of this debt, in effect selling new bonds to pay off old ones. If for some reason investors should refuse to buy new bonds, even a basically solvent government could be forced into default...

This immediately creates the possibility of a self-fulfilling crisis, in which investors' efars of a default brought on by a cash squeeze lead them to shun a country's bonds, bringing on the very cash squeeze they fear. And even if such a crisis hasn't happened yet... ongoing nervousness about the possibility of such crises can lead investors to demand higher interest rates in order to hold debt of countries potentially subject to such self-fulfilling panic.

The fundamental issue is that all the major economies are backed by their respective central banks which have unlimited cheque writing powers (atleast technically) and are virtual lenders and insurers of last resort. Markets have realized that with the ECB statutorily barred from lending directly to governments, the Eurozone members face no such backstop facility. If Spain or any other country faces a run on their banks, they cannot count on the ECB to step in with emergency cash assistance. Nor can the countries themselves print Euros. Eurozone members, therefore, face a Euro penalty which reflects in their sovereign debt premiums.

In fact, the importance of this is underlined by the manner in which the last round of such panic was redressed with the second round of Long Term Refinancing Operation (LTRO) loans in March. These unlimited three-year loans by the ECB at low interest rates were quickly lapped up by the Eurozone banks and then used to buy sovereign bonds, which in turn experienced a sudden fall in yields. However, once its effects tapered off, market confidence has dipped and yields have been soaring.

Now, instead of this circuitous route, Eurozone needs ECB to explicitly emerge as a lender of last resort. Only this alone can allay market fears and stabilize the sovereign debt market.

Update 1 (9/6/2012)

Nouriel Roubini and Niall Ferguson advocate direct bank recapitalisation (by purchases of preferred non-voting shares of eurozone banks by the European Financial Stability Facility and its successor, the European Stability Mechanism), European deposit insurance (which has to be coupled with appropriate bank levies and a resolution mechanism in which unsecured creditors take the hit before taxpayers money is hit), and debt mutualisation (through some form of Eurobonds) as necessary for any resolution of Eurozone debt problems.

They make the point that the current approach of recapitalising the banks by the sovereigns borrowing from domestic bond markets and/or the EFSF, as was done by Ireland and Greece, leads to a surge of public debt and makes the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands. Spain, which faces a severe banking crisis, wants the ECB or EFSF to make equity injections directly to the banks, whereas Eurozone officials want it to be routed through the Spanish government with conditions.

The FT reports that under the most widely backed scenario, the eurozone’s €440bn rescue fund would funnel loans to struggling banks through the Spanish government, a condition demanded by Germany to ensure the Spanish state bears ultimate responsibility for paying back the loans.

Update 2 (10/6/2012)

After resisting it for so long, Spain has finally sought a bailout of its banks by the EU. The loan, estimated to be upto $125 bn, to Spain will recapitalize ailing Spanish banks (hit by Spain's property bubble) by shoring up their depleting capital base and will impose no new economic reform conditions on Madrid other than existing EU budget rules. However, it will include financial sector and banking reforms. Spain is the fourth country after Greece, Ireland, and Portugal to seek EU's emergency assistance. However, unlike Spain, all the other three had strict macroeconomic adjustment, including sever fiscal austerity, conditions attached to the bailouts.

The money will be channeled through the Spanish bank-bailout fund, Fund for Orderly Bank Restructuring (Frob), which will funnel the funds to needy banks. The bailout loans would be on Madrid’s sovereign books and the Spanish government will ultimately be responsible and will have to sign the memorandum of understanding and the conditions that come with it. Spain's borrowing costs have been pushed to close to record highs in part because of the problems at its banks, which are struggling under the weight not only of significant losses in their real estate loan portfolios, but also the country’s broader economic malaise.

The decision to seek aid was reached after the IMF issued a 77-page report on the Spanish banking sector that found it was suffering through a crisis “unprecedented in its modern history”. In its report, the IMF also urged Spanish and European authorities to move quickly, strongly signalling that Madrid has not done enough to inspire confidence in the sector’s strength in its recent handling of the crisis. IMF officials recommended new capital injections of at least €40bn, but they noted the weakest banks’ needs “would be larger than this” once all bad loans were accounted for and restructuring costs taken into account.

Eurozone leaders did not specify whether the money would come from the current €440bn rescue fund, the European Financial Stability Facility, or the new €500bn fund, the European Stability Mechanism. It could be a combination of the two, since the ESM is due to go into force next month. Loans from the EFSF do not have preferred seniority status; under the terms of the ESM treaty, however, loans from the ESM take priority over all private sector debt, potentially spooking Spanish sovereign bond markets.

Update 3 (12/6/2012)

Gideon Rachman cautions against the fullscale rush to debt mutualization and argues that there are several important issues to be addressed before taking this step. He writes,

Once you take a big step towards the mutualisation of debt across Europe, you are forced towards much deeper political union. It is not just the much-discussed need for a European “minister of finance”, with the power to override national governments. To avoid bitter disputes over fairness, you would also need to harmonise European social-security systems. That would be the work of decades.