November 11, 2010 / 3:03 PM / 9 years ago

Analysis Investors assume worst in murky euro reform debate

BRUSSELS (Reuters) - Confusion over governments’ intentions, and poor communications between officials and markets, are causing euro zone bond investors to assume the worst as weak countries grapple with their debts.

The bond yields of Ireland, Portugal and Greece have soared since the European Union agreed in late October to discuss creating a crisis mechanism under which euro zone governments could restructure their debts in an orderly way.

Because of the time needed to agree on details of the mechanism and revise the EU treaty to include it, the reform will most probably not take place before 2013. Until then, current systems to handle euro zone debt crises will stay in place; these focus on keeping countries afloat while they repair their finances, and do not envision debt restructuring.

But bond spreads have jumped to levels where markets are pricing in a significant chance of a restructuring well before 2013. Euro zone officials and analysts say the opaque way in which the debate on the crisis mechanism has been launched, and distrust of governments’ intentions, are fuelling the panic.

“Markets have misunderstood. They seem to be worrying about some form of restructuring or haircut or prolongation of maturities pertaining to current loans, to currently outstanding sovereign bonds, which is not the case,” one frustrated euro zone official told Reuters on condition of anonymity.

“It is really a discussion of what will happen after 2013. Markets have interpreted this as meaning a sovereign restructuring could be imminent, and that is absolutely not what is being discussed.”


The situation resembles the weeks before the EU agreed in May to provide a 110 billion euro bailout to Greece; though the EU tried to calm markets by declaring it would support Greece if needed, uncertainty over the EU’s intentions caused yields to soar and ultimately made a bailout vital to avert disaster.

The October deal to discuss a new crisis mechanism was reached between President Nicolas Sarkozy and German Chancellor Angela Merkel, who then pressed the idea on the rest of the EU.

Since the deal was controversial, details of how restructuring would work were not spelt out. EU diplomats talked vaguely of a range of options such as writedowns (known as “haircuts”), debt rollovers and deferred payments of interest, depending on individual cases.

“It does not really help that they agreed to make changes, without giving us a rough idea of what these changes will be,” said Juergen Michels, euro zone economist at Citigroup.

Since October, various concrete proposals have emerged. Finland has suggested that new euro zone bond issues include a Collective Action Clause letting a majority of holders impose restructuring on the others. The influential Bruegel think tank in Brussels proposed that the European Court of Justice act as a sovereign bankruptcy court.

But much discussion of these proposals has gone on behind closed doors, leaving investors unable to judge the likelihood of them being adopted. So markets have acted defensively by pricing in the possibility of huge markdowns on bond holdings.

Investors have also been alarmed by repeated statements by German officials, including Finance Minister Wolfgang Schaeuble, that the private sector should share the pain of future debt crises. This has caused some investors to price in a risk of a country defaulting considerably before 2013.

The yield on two-year Greek government bonds, for example, has jumped above 12 percent from 9.6 percent at the end of October, even though those bonds will mature before the end of Greece’s three-year bailout program.

“If there is talk of an orderly default mechanism in the future, it may mean it is a preparation for these countries to default,” said Michels.

“It has became obvious that at some stage the private sector would become involved and the market came to the conclusion that this is likely to happen sooner rather than later.”


Senior euro zone official sources said many officials in the bloc had expected markets would be worried by the debate over the crisis mechanism, and had opposed starting the discussion now, preferring to wait until investors were calmer. But Germany ignored the warnings, they said.

“Except for the Germans, everybody anticipated it,” one senior official said. “Especially, (European Central Bank President Jean-Claude) Trichet was very clear...saying: ‘you should not be doing this because it will spook markets.’”

Markets have come to believe that the orderly restructuring mechanism is being created specifically to handle defaults by Greece, Ireland and Portugal, even though this is not the case, the official said.

ECB Executive Board member Lorenzo Bini Smaghi denounced the mechanism this week, saying a default system where private investors were forced to take penalties would destabilize markets and encourage speculation.

Nevertheless, Germany appears determined to press on with the debate, partly because it does not want to pay the lion’s share of the cost of future debt crises as it did with Greece, and partly because of domestic political imperatives.

Germany’s ruling coalition faced widespread public discontent over the Greek bailout, and the German Federal Constitutional Court is expected to rule next year on legal challenges to Berlin’s participation in the rescue.

Markets may get a clearer picture of the restructuring mechanism in mid-December, when the European Commission is to submit an outline of it to a summit of EU leaders. The outline is expected to include details on the exposure of private investors and the role of the International Monetary Fund.

Many investors have already concluded, however, that a debt restructuring for at least one euro zone country is inevitable — and they have pushed yields so high, making borrowing for those governments so expensive, that the countries could now be forced to seek bailouts.

Twenty out of 30 economists and bond strategists polled by Reuters on Thursday expected Ireland to seek an international bailout before the end of next year. They estimated the size of any bailout at around 48 billion euros.

“What we are seeing now is what the Germans wanted to happen only after 2013,” the second euro zone source said.

“Because the discussion is now and because it is structured in such a way, it increases the risk that countries may be forced” to seek a bailout.

Additional reporting by Dave Graham in Berlin; Editing by Andrew Torchia

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