Cinzia Alcidi: “The blanket of guaranties required is too big for many countries”

Another week of crisis psychology inside the Euro Zone. Ireland jumps to 6th in a default probability worldwide ranking monitored by CMA DataVision. The price of its credit default swaps jumped to more than 400 basis points in the morning of September 8. Its 10 year government bonds’ yields were for the first time above six per cent the same day. Its banking system has huge ‘toxic assets’ – some say half of Irish GDP.

The Anglo Irish Bank (AIB) jumped to more than 796 basis points in credit default swaps prices. Ireland already pumped €22.9 billion into AIB, which was nationalized in January 2009. Standard & Poor’s last month said the bailout cost may eventually rise to €35bn, about 10% more than the projected tax revenue for this year, and Central Irish Bank Governor Patrick Honohan estimated a cost of as much as €25bn. The Irish government announced yesterday its decision to split AIB and pass its ‘toxic assets’ to a bad bank. Despite strong economic fundamentals (current balance surplus, exports of high value-added, forecasts for growth above European average), Ireland is in the last thirty days in the eyes of speculators.

Greece, despite Brussels repeated political support to the Athens cabinet, just reshuffled, and IMF and ECB interventions maintains the second place in the probability of default world ranking. Portugal reentered the ranking on August 24 and maintains a high level of cds prices and a probability of default above 25%. The yields of Portuguese OT are rising again, above 5,7 per cent, although below the peak on May 7 at 6,33 per cent. Although the yield premium on September 8 regarding the German Bunds’ yields was for the first time above the peak on May 7 and hit a post-euro record.

The Wall Street Journal, last September 8, reported that the recent European bank stress tests understate some lender’s holdings of potentially risky government debt and focused on the cost of insuring government debt against the risk of default in Spain, Portugal and Ireland, adding more alarm to the speculation.

From London, the Financial Times stated that the eurozone debt crisis is about to enter a critical phase as governments must raise €80 billion in September, more than €70b in October, €75b in November and only €40b in December. Spain must raise €27.5b, Portugal €6b and Ireland 2.5b. according to ING Financial Markets.

Are we approaching a new crisis like the last one from April 21 until May 7? A new high stress period for government bonds yields of peripheral countries may come? interviewed Cinzia Alcidi, Research Fellow from the Centre for European Policy Studies (CEPS), based in Brussels.

INTERVIEW by Jorge Nascimento Rodrigues
© 2010

Q: Almost four months after the Eurozone crisis of last May and more than a month after the European bank stress tests results, probabilities of sovereign default are rising again in the so-called PIIGS. What went wrong?
A: Fundamentally, the current sovereign debt crisis in Europe is a banking crisis. The only exception is probably Greece, where the real issue is about the solvency of the government. In the case of Portugal and Ireland (also Spain) the fundamental problem is in the state of health (or better unhealthy) of banks combined with the weak economic fundamentals of those countries. Banks are huge, sometime their size is comparable to the GDP of the country to which they belong, largely interconnected and leveraged. Some of them are probably insolvent. If a bank gets into trouble, government is expected to intervene. But in some case, it does not have enough resources to guarantee a solution especially if it is already largely indebted. Until now the troubles of the banking sector have been addressed as liquidity problem, by providing cash or guarantee, but now the blanket of guarantees required is too big for many countries. Some countries will need in turn guarantee.

DEFAULT: “I would say NO in the short-term”

Q: Do we risk bankruptcy or debt restructuring in those countries in a five year horizon?
A: I would say no in the short-term, neither banks nor countries, but picture may change in the longer run. The country with the highest probability of debt restructuring is Greece and at the moment the country is benefiting of a special agreement that basically excludes any form of default. After 2013, situation could be different. Markets seem to believe that Greece will not be able to honor its obligations and a debt restructuring is inevitable as soon as the special plan is over (what happened yesterday is again a sign of this belief, despite there was not real breaking news on the Greek front).

Q: Politically debt sovereign default is a word out of the official double-speak?
A: The ECB and the Commission have a clear position against default or restructuring: sovereign nation cannot default. It is also clear that the ECB is playing a crucial role in avoiding or at least postponing a default by proving unlimited financial support to banks and intervening on the government bond markets.

Q: And regarding banks?
A: For banks the situation is very tense. One of the most important lessons from the Great Depression during the 1930s in the US is that one should avoid bank default, as to confirm the lesson after Lehman Brothers was let down we had huge market disruption. Yet, this situation create huge moral hazard that was also one of the elements that contributed to the pre-conditions of the current crisis. Hence, I think that first we need in place a system for bank crisis resolution. European authorities are working actively on this front. This is necessary and urgent, it will reduce moral hazard, protect citizens/taxpayer and safeguard trust in banks that deserve it.

TRUST: “It will be extremely difficult to restore market confidence and go back to the previous situation.”

Q: Yields for 10 year Irish bonds maturities are near 6%. In the case of Portugal also near 6%. The deterioration of the credit conditions of these countries, despite the intervention of the European Central Bank and the IMF, is again uprising. How those countries can reverse this trend?
A: It will be extremely difficult to restore market confidence and go back to the previous situation. At best it can take years and markets do not seem very patient. Markets are still very nervous and my impression is that uncertainty about the real situation is still playing an important role. Yesterday spreads reached new highs because of bad news about banks. After the stress tests we should not observe these phenomena. In peripheral countries, banks rely almost completely on the ECB as source of funding. In other words, Greek, Portuguese and some Irish banks seem unable to find other banks to lend to them except the ECB. The reason is that potential lenders do not trust the ability of repayment of those banks short of liquidity. The main purpose of the stress tests was exactly to shed light on the real situation of individual financial institutions, and by reducing uncertainty restore the function of some segment of the interbank market. Some banks can be cut out of the market because they have solvency issue. When the entire banking system of a country is cut out it’s because the worst scenario is applied to the whole country without distinction between the different entities and this is the case when uncertainty is high.

Q: And the climate is even worse, after the articles published at Financial Times and The Wall Street Journal this week…
A: Yesterday the tests were discredited in the international press, as providing incomplete information, and raise a lot of questions about the true exposure of some banks and the financial market reacted simply by selling. Until volatility in the markets is so high it will be very difficult to find some normality. One has also to keep in mind that fundamentally the intervention of the ECB, IMF and the Commission or even the EFSF are meant to solve liquidity issues (the only one they can address) and buy time hoping that some problems will find a solution. Of course this can help, but in some case, either country or bank, if the real issue is solvency, simply providing money will not cure the disease, only its symptoms and for some time.

GREAT RECESSION: “A double-dip is not necessarily the most likely event.”

Q: How the “unusual uncertain” (to use the words of Mr. Bernanke) forecast for most of the OECD economies, the risk of a double-dip in part of the developed countries or a stag(de)flation, will influence the European situation?
A: Of course the risk of double-dip is concrete. News coming from the US are certainly not re-insuring, but in my view a double-dip is not necessarily the most likely event. I would certainly exclude the kind of growth rates we experience before 2008 over the years to come in all the OECD countries, but a sort of muddling-through seems more likely. In particular, in the EZ, on average, I would expect positive, low growth with large heterogeneity between core and peripheral euro zone countries lasting over some time. The EZ countries need fundamental adjustments, domestically and cross country (convergence), to absorb excesses of the last decade in some countries (mainly bubbles in consumption and housing in some countries) and undertake a convergence path in competitiveness, which can happen largely through market forces driving up wages in some countries (increasing demand and employment in Germany should increase wages) and down in others (falling demand should drive down wages in Spain, Greece and Portugal). These processes are slow and can be painful, but at this stage unavoidable.

ECB ROLE: “My view is that without the support of the ECB we would be in depression!”

Q: Neville Bennet, from Australia, said at LeMetropole Café blog, “My case is that [European Central Bank-ECB] gross over-funding transmitted a terrible shock to the world financial system in late April 2010, and that shock had the effect of compromising the recovery.” Is it fair this hard comment?
A: The ECB is the one avoiding banks and government from falling! It is a very risky approach, it is true that it may imply a cost and it won’t be easy for the ECB too exit (from exception policy measures) but at this stage if the exit strategy comes too early (extraordinary measures removed) the outcome will not be pleasant for anybody. I would also suggest that if now banks sell all the bonds they have from GIPS [Greece, Ireland, Portugal, Spain], those countries will face a substantial risk of default. In fact this is already happening, the more banks sell the higher the risk. We have to be careful what we wish for. We are not in a normal situation on which we have to avoid a crisis, we are in a situation of crisis, we need to manage it. Crisis prevention is different form crisis management. The problem of excessive credit and too loose monetary policy was before 2008. My view is that without the support of the ECB we would be in depression! Just as example in Greece, where there is already a deep recession, without the ECB banks would be completely cut of liquidity (Spain was in a similar situation before stress tests, and Portugal and Ireland are not far from it) and firms and people unable access to credit. I agree we have to exit and go back to market rules, but the situation is still extremely complex.

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