Tuesday, December 21, 2010

Europe must protect government bondholders

Klaus Regling is the head of the European Financial Stability Facility. He recently published an op-ed in the FT titled “EMU’s critics will eat their words again”.

In the column, he does his best to advance the argument that EMU will survive without fiscal union. It is more of an assertion than an argument. He then goes on to state the following (emphasis added):

A monetary union needs a safety net to respond to a crisis. The European Council decided therefore to prepare a permanent crisis resolution mechanism, called European Stability Mechanism (ESM). It will be established in 2013, and will be based on the temporary resolution mechanism, the European Financial Stability Facility (EFSF). The key difference between the two will be the involvement in the future permanent mechanism of private creditors in a crisis resolution on a case-by-case basis. It will follow established IMF policies, which means that debt reduction would be required in cases of insolvency. This will be rare. No industrialised, advanced economy has defaulted since the second world war. The ESM would, as does the EFSF, provide loans – under strict conditionality – to euro area countries that lose access to markets.

This is the problem, which he does not even acknowledge: unless the ESM exists to backstop private creditors, it serves no purpose. It is like a guarantee that is good unless called upon.

The EU will learn next year that the ESM and austerity will not have restored investor confidence and that the markets remain closed to Greece, Ireland and Portugal. At that point it will have to choose between lending with strict conditionality or to involve private creditors in the resolution. My prediction (my hope) is that they will blink, and bail out the bondholders.

One recent ray of hope: China says that it will buy the bonds of the peripherals when they re-enter the market. China exports to Europe, and doesn’t want a European debt crisis. So just as they lend to the US to finance Chinese imports, they would do the same for Europe. If true, this is not trivial. China has almost $3 trillion in foreign exchange reserves. They desire to diversify their currency exposures, and so investing in the government (and bank?) debt of the peripherals serves a number of useful purposes.

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