Registered: May 2007
12-14-11 05:22 PM
The European sovereign credit markets are in a danger zone. Italy and Spain need to borrow a combined €590bn in 2012, their yields remain above sustainable levels, and the European Central Bank’s efforts at buying debt in the secondary markets have so far been ineffective in holding yields down.
Drawing on our experience restructuring companies along with lessons learned in the US following the bankruptcy of Lehman Brothers, we suggest the ECB consider a sovereign debt guarantee programme as a solution to the European sovereign debt crisis. Such a scheme would be similar to the successful Temporary Liquidity Guarantee Program adopted by the US’s Federal Deposit Insurance Corp to stem the financial crisis after the failure of Lehman by enabling financial institutions to refinance their maturing debt and avoid a default.
It is clear that existing, piecemeal efforts by European leaders have been ineffective. Even after the ECB bought €208bn of European debt, Greece, Portugal and Ireland all still required bail-outs. Italian and Spanish yields, meanwhile, remain stubbornly high. The European Financial Stability Facility, the eurozone rescue fund, is proving impractical – the recent sale of €3bn of bonds met only tepid demand, casting doubt on its ability to raise its full €440bn target, never mind the €1tn needed for the credit enhancement insurance scheme. A €200bn capital boost to the International Monetary Fund was a step in the right direction, but the amount is still not sufficient to alleviate market concerns. Direct purchases of new issues of sovereign debt by the ECB have been ruled out due to their potential inflationary effects.
Last week’s statement from European leaders should go a long way toward fiscal consolidation, a necessary step toward the long-term viability of the euro. But it did not provide the “firewall” to address the short-term liquidity needs that the markets wanted.
Italian and Spanish bond yields have subsequently risen casting doubt on their ability to meet their funding needs. The market also remains vulnerable to a downgrade by Standard & Poor’s or Moody’s of either France or the eurozone – which could push yields even higher.
The European banking sector also remains under pressure in large part due to its exposure to European sovereign credit. A firewall is needed now to stabilise the markets, bring yields down, allow for sovereign refinancings, reduce stress in the banking sector and provide protection against likely future credit events. Acting now would be more effective and cost-efficient than waiting for a crisis that forces such action at a later date.
An ECB sovereign guarantee programme would immediately calm the credit markets. It would be non-inflationary and would allow Italy and Spain (and other countries, if necessary) to refinance their maturing debt at reasonable rates. It would also ease pressure on banks as concerns about their sovereign credit exposure would subside.
The sovereign guarantee programme would work as follows: in return for a 1 per cent annual guarantee fee, and compliance with the ECB and/or IMF on implementation of structural reform programmes, Italy and Spain would be able to refinance all maturing debt with an ECB guarantee. This would probably cause their “all-in-financing costs” to fall to the 4 per cent range. The programme would be open for two years for maturities of up to 10 years giving Italy and Spain time to implement their structural reforms.