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Hopes Renewed for the EMU and the Sovereign Debt Crisis

Giordano Lombardo
calender-icon Posted on September 19, 2012

Cosimo Marasclulo is Pioneer’s Head of European Government Bonds and Foreign Exchange. He shared with me his thoughts on the German High Court’s decision to ratify the constitutionality of the European Central Bank’s European Stability Mechanism, ESM, and what it means. Its new program called the Outright Monetary Transaction (OMT) will buy up the debt of troubled countries for those that ask.

The strings attached to the ruling look consistent with the Court’s record and were thus widely expected. A previous finding on the European Financial Stability Fund (the current emergency fund, to be replaced by the permanent European Stability Mechanism with a 500-billion euros capital) had backed the German Parliament’s central role as the legitimate people’s representative. This latest decision seems to us even less constraining at first glance, as it calls for the Parliament to be informed on any change to Germany’s agreed contribution to the ESM (this is the least you could expect in our view from this judicial authority).

Does This Speed Up The Solution To The EMU Sovereign Debt Crisis?

It may give some breathing space to EMU leaders and allow investors to remain confident about a long-term solution to the sovereign debt crisis. The permanent rescue procedure may be tested very soon, with Spain as the likeliest first applicant. Based on current rules for the EFSF, there are two possible credit lines to be tapped: the Precautionary line states that the beneficiary Member State “shall ensure a continuous respect of the eligibility criteria” after it is granted, whereas the Enhanced line calls on the beneficiary “to adopt corrective measures aimed at addressing (…) weaknesses and avoiding any future problems with access to market financing”. Both involve some external supervision but the Enhanced line is much likelier to encroach on the beneficiary’s fiscal sovereignty. Therefore we expect a government like Spain’s to ask for a package modeled after the “light” Precautionary line, although the focus on reforms should be maintained.

How Decisive Was the ECBs Role in Changing Investor Sentiment?

The ECB’s commitment “to do whatever it takes to save the Euro” may have averted the worst-case scenario of a Euro break-up. This prospect built up a “convertibility risk” for all troubled countries and was largely responsible, in our view, for the sharp increase in sovereign credit spreads of EMU periphery. Although only Greece has been on the verge of exiting the Euro, we believe that countries like Italy and Spain have been suffering from these concerns.

The Outright Monetary Transaction (OMT) translates those words into action and is properly-devised in our view. By relinquishing the “seniority” status, the ECB could incur a full market risk on the bonds it is poised to buy under the OMT, so it is entitled to be as demanding as the ESM towards non-compliant governments. The unlimited amount was rather controversial, notably for Germany due to its supposed political significance (present to over-indebted countries. However, we believe that this provision makes the OMT the “fully effective backstop” as claimed by the ECB chairman Mario Draghi. Setting an amount for central bank market intervention has often aroused speculators, who like to test their resolve to the limit.

The Extent of Politics in Determining Events

The political variable is still a source of uncertainty and even the ECB can barely avoid that in spite of its efforts. However this variable may become supportive if all participants continue to behave responsibly. We believe that Germany’s recent flexibility towards balanced policies combining austerity and growth has been helped restore confidence of late. We also expect this change in attitude to be confirmed, provided the countries seeking help may allow some sort of external supervision. We believe that a climate of mutual respect could start a process that may eventually lead to an enforced fiscal union (and that would also be a positive).

Italy does not appear to be in need of help, although the Prime Minister hinted that such a request would be no bad thing. We think he is willing to sign a memorandum of understanding with the European Union in order to secure the current reform program and make it harder for future “political” governments after the elections to derail it. However, we also believe that the conditionality of Italy’s package, if any, would be at least as light as Spain’s (which should come first, anyway)

Investment Strategy

We still hold a favorable view of larger EMU peripherals, as we believe that the path to structural reforms is being pursued despite a few setbacks. Admittedly, sovereign credit spreads have declined in the EMU area since early August and thus for over a month before the ECB unveiled the OMT, as investors correctly assessed its commitment to do “whatever it takes to save the euro”.

The short end of EMU peripheral countries’ yield curves, where the OMT will mostly be targeted, has been even more supported, with yields of Italy’s two-year notes getting close to last March’s levels of 2%. So the market has moved substantially but we believe that investors’ hopes for the OMT to be a real game-changer may provide as much support as the previous “big weapon” deployed by the ECB (Long-Term Refinancing Operations or LTRO) did early this year.

Our opinion is that most market participants are still overweight in safe-haven assets and are realizing that indulging too long there may mean missed opportunities (look at Ireland’s and even Portugal’s recent strong gains). We believe that growth-sensitive assets are still cheap and have further upside potential as market conditions normalize.


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