November 15, 2010 / 7:54 AM / in 8 years

Analysis: Haircut talk hastens next euro zone crisis

PARIS (Reuters) - Talking about death doesn’t make you die, an old French saying goes. But Europe is learning the hard way that talking about the possibility of default can hasten precisely that outcome.

When the history of the euro zone is written, last month’s German-driven EU summit agreement to devise a crisis resolution mechanism for countries unable to service their debts may well be cited as the event that pushed Ireland over a cliff.

German Chancellor Angela Merkel’s insistence that private sector bond holders be made to share with taxpayers the cost of future euro zone bailouts helped send Dublin’s borrowing costs into the stratosphere in the last two weeks.

“Those who warned that this could become a self-fulfilling prophecy are being vindicated,” said a senior European Union official in the thick of financial fire-fighting.

The deal struck by Merkel and French President Nicolas Sarkozy in Deauville, then thrust on reluctant European Union partners, was not the only factor driving Ireland to the brink.

Deepening political uncertainty in Dublin, with opposition parties refusing to back a jaded and unpopular government’s austerity plans, and growing concern about the ever rising liabilities of state-guaranteed Irish banks also played a role.

But Prime Minister Brian Cowen was clear about where the main responsibility lay in his eyes, telling an Irish newspaper that loose talk by the German and French leaders had complicated his efforts to overcome the crisis.

“It hasn’t been helpful,” Cowen told the Irish Independent of Merkel’s intervention. “What has been said there has had, I think, an unforeseen consequence, perhaps.”

“The consequence that the market has taken from it is to question the commitment to the repayment of debt,” he said.

Even though Ireland is fully funded until mid-2011 and does not need to return to the bond market for now, the huge rise in Irish bond yields on the secondary market has ratcheted up pressure on the country’s already battered banks.

They are now largely shut out of the inter-bank lending market and ever more dependent on the European Central Bank for funding. Meanwhile, the borrowing costs of other peripheral euro zone governments have also shot up.

This was almost exactly the sequence that preceded the emergency bailout of heavily indebted Greece in May by euro zone countries and the International Monetary Fund.

Seeking to douse down a fire that some of their own leaders ignited, the big five EU finance ministers attending last week’s G20 summit rushed out a statement stressing any burden-sharing imposed on bond holders of a euro zone state unable to meet its debts would not be retroactive.

“Whatever the debate within the euro area about the future permanent crisis resolution mechanism and the potential private sector involvement in that mechanism, we are clear that this does not apply to any outstanding debt and any program under current instruments,” the ministers said.

But much damage has already been done and investors weighing the risk of a “haircut” may find that statement less than reassuring.

First, the whole debate about a resolution mechanism has turned market perceptions of the risk that one or more euro zone states may be unable to honor their debts from a possibility to more of a probability.

“The discussion of ‘orderly defaults’ opened Pandora’s box,” Lloyds TSB strategists said in a note to clients. “The sharp rise in yields is now all about expectations of future default — restructuring — and not difficulties in financing.”

Second, the assurance that any new terms would only apply to debt issued after May 2013, when the current temporary European Financial Stability Facility expires, and that all existing bonds are hence safe, may not convince market skeptics.

After all, the problem facing Greece is that when its 110 billion euro emergency loan program expires in 2013, it may not be able to service an existing debt mountain forecast to reach 149 percent of gross domestic product by then.

Thirdly, investors trying to price euro zone sovereign risk face a prolonged period of uncertainty while the EU haggles over a permanent crisis mechanism, then tries to turn it into a treaty amendment and have it ratified by 27 countries by 2013.

Merkel is unlikely to back of because German voters outraged by having to rescue Greece demand that banks share any future pain. Moreover, without some such guarantee against future “moral hazard,” the German Constitutional Court may strike down Berlin’s participation in the existing euro zone safety net when it rules in mid-2011, German officials say.

Ireland has not yet fallen off the cliff, but it is clinging on by its fingernails. It said on Sunday it did not rule out turning to Europe but that no application for aid had been made for yet.

Meanwhile, pressure continues to mount on Portugal, the next high-deficit euro zone weakling in the crosshairs.

If Ireland does have to seek assistance from the 450 billion euro European Financial Stability Facility created for other euro zone states in May, it will be on existing terms, without debt restructuring or “haircuts” for bond holders.

Loukas Tsoukalis, a senior policy adviser to the European Commission, noted that German Finance Minister Wolfgang Schaeuble has quoted Shakespeare’s Hamlet on the need to “be cruel to be kind” in defending Berlin’s hard line on debtors.

“We should remember that Hamlet’s story ends up with far too many deaths. We wouldn’t want to repeat the experience, nor wait for a post-mortem to find out whether his prescription is right,” Tsoukalis wrote in the policy journal Europe’s World.

editing by Ron Askew

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