„The political problem of Europe’s sovereign financing risks“

10.03.2010 11:41

„The political problem of Europe’s sovereign financing risks“
with Jon Levy, Eurasia Group Analyst

 Mr. Jon Levy provided some terrific insight into Europe’s current financial situation and discussed some possible outcomes for the near future. The topic of sovereign debt markets was an important one. In recent history, for example between 2005-2007, there was no real difference in owning debt from any country in the Eurozone; they all produced similar yields. However, that has changed. Bond markets are diverging, and show no signs of coming back to the same level. There are now different yield rates on the sovereign debt of different countries. Now, one should not be too worried about this divergence; it is highly unlikely that this development will lead to a dismantling of the Eurozone. More importantly, one can no longer treat all debt from different countries as having the same impunity to credit default risk. It would be easy to assume that Greek bonds would be the best to buy, seeing as they offer a higher yield, and there is no way the Greek government would not be “bailed out” from going bankrupt. However, Levy said, that is no longer an assumption. There is uncertainty on how support will arrive in Greece, or for that matter if any will arrive at all. In fact, Levy advised purchasing Latvian bonds over Greek bonds. They share a similar high yield, but there is more clarity surrounding the Latvian bailout, and there is better policy in place to ensure a rebound, meaning a smaller chance of default.
 This brings us to the important issue of a country in the Eurozone defaulting, as Mr. Levy pointed out. The largest concern in this area for nearly everyone is Greece. The possibility of default in Greece first became an issue in early 2009, and the ECB responded by injecting liquidity. While this did help momentarily and move the issue to the back of our minds, it did not fix the fundamental problem with Greece. Merely injecting liquidity, explained Levy, creates a situation where the markets do not show what is actually happening and therefore do not encourage a correction in fiscal policy. Greece presents an even more confusing problem, because the last two administrations have claimed that the previous one had faulty deficit numbers. These factors, coupled with bad fiscal policy, have lead to another bankruptcy scare for Greece. Mr. Levy had a very interesting take on the risk of a country’s default in the Eurozone; he pointed out that Ireland may be the first country to ask for help from the IMF. He described it as a balance between the political will to change and the financial ability to do so. As for now, Greece does not have the political backing for a change to correct policy, but they also have a little room for error before default. Ireland, on the other hand, has the political will to change policy for the better, but they are in a much tighter spot. This balance could lead to Ireland being the first country that needs support from the IMF. Levy also mentioned that this situation could lead to a fundamental change in the IMF, going from their role in emerging markets back to their traditional role of providing financial assistance to Europe if needed. The most important factor in these tough economic times is fiscal policy, Levy said. Fiscal policy is what can determine if a country will default or not; however, fiscal policy is fairly unpredictable across Europe.
 Mr. Levy also touched on some other issues during a question and answer session. In regards to a possible inflation problem, he said that such a slow economy definitely points away from such a problem, but there is a good deal of money creation, and monetary policy tools put in place may not have a strong effect due to cross-border lending. On the strength of the Euro, Levy said markets could have forced a “Euro bubble” in the quest to find a match for the American dollar, but a decline in the value of the Euro (perhaps due to a country defaulting) could help several Eurozone countries by increasing exports. China came up in the discussion, and Levy felt that there would not be a protectionist response to any Chinese policies regarding the exchange rate. As for a prediction of the near future, he believed that the slow erosion of the clarity of political parties will continue, and several “micro-interventions” would define the prevailing fiscal policy in Europe.