Tuesday, November 15, 2011

Europe: The panic has spread to the core

The eurosystem is a lender of last resort – for solvent but illiquid banks. It must not be a lender of last resort for sovereigns because this would violate Article 123 of the EU treaty [prohibiting monetary financing – or central bank funding of governments]. I cannot see how you can ensure the stability of a monetary union by violating its legal provisions. I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence. (Jens Weidmann, president of the Bundesbank, Nov. 10th, FT interview)

I haven’t been blogging lately because I’ve been waiting for something to happen. Well, it just did.

Apparently, the bad thing has finally started. The eurozone bond market has lost hope, and Europe’s credit system has begun to shut down. Today, the market panic spread to the core AAA nations of France and Austria. Credit spreads for both countries are now approaching 2% over Bunds. A complete loss of market confidence and a closing of the debt capital markets to all but a handful of  eurozone sovereigns now appears inevitable.

The scramble to make the EFSF into a credible “bazooka” has failed, and the ECB has made clear (see above) that, aside from its traditional role as liquidity provider to banks,  it will do nothing to prevent a market collapse.

In credit analysis, a standard question to pose to any debt issuer is: “How long can you avoid default in the event of a loss of market access?” The usual answer to this question was usually “But that could never happen!” Well, now it might. Not just for the hangers on that should have never been in the eurozone, but perhaps even for foundational countries such as France and Austria.

At some point, France may have to answer this question: Should France lose market access, what is her debt maturity calendar and what are her available resources? This is a question no finance minister ever wants to have to answer. (Latin American finance ministers know the answer to this question off the top of their heads. European ones, less so.)

France’s first line of defense is what the peripherals have been doing, which is having its banks borrow against its bonds at the ECB. Ratings on collateral no longer matter at the ECB, so presumably this game could go on for some time. But it will be highly visible, and it will not make the Bundesbank happy to see the ECB become France’s only lender.

In theory, there is a way out: restore confidence by establishing a path to fiscal balance. But it is too late for that. The markets are no longer interested in what Sarkozy, Zapatero, Monti, or Papademos may be able to do to cut expense or raise revenue. What is happening in these parliaments is now a sideshow.

Until now, market panics have been offset by ECB bond purchases (most lately, Italy). But the ECB doesn’t have the resources to take on the combined Italian, French and Spanish bond markets without a major impact on the size of its balance sheet and thus, on monetary policy. This the Bundesbank will not tolerate, as Weidmann indicated above.

Thus, market panic will no longer be intermediated by the ECB, and will be visible to all. The rest of this week will be interesting.

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