A new German plan to impose “haircuts” on holders of eurozone sovereign debt risks igniting an unstoppable European bond crisis and could force Italy and Spain to restore their own currencies, a top adviser to the German government has warned.
“It is the fastest way to break up the eurozone,” said Professor Peter Bofinger, one of the five “Wise Men” on the German Council of Economic Advisers.
“A speculative attack could come very fast. If I were a politician in Italy and I was confronted by this sort of insolvency risk I would want to go back to my own currency as fast as possible, because that is the only way to avoid going bankrupt,” he told The Telegraph.
The German Council has called for a “sovereign insolvency mechanism” even though this overturns the financial principles of the post-war order in Europe, deeming such a move necessary to restore the credibility of the “no-bailout” clause in the Maastricht Treaty. Prof Bofinger issued a vehement dissent.
The plan has the backing of the Bundesbank and most recently the German finance minister, Wolfgang Schauble, who usually succeeds in imposing his will in the eurozone. Sensitive talks are under way in key European capitals, causing shudders in Rome, Madrid and Lisbon.
Under the scheme, bondholders would suffer losses in any future sovereign debt crisis before there can be any rescue by the eurozone bail-out fund (ESM). “It is asking for trouble,” said Lorenzo Codogno, former chief economist for the Italian Treasury and now at LC Macro Advisors.
This sovereign “bail-in” matches the contentious “bail-in” rule for bank bondholders, which came into force in January and has contributed to the drastic sell-off in eurozone bank assets this year.
Prof Bofinger wrote a separate opinion warning that the plan could become self-fulfilling all too quickly, setting off a “bond run” as investors dump their holdings to avoid a haircut.
Italy, Portugal and Spain would be powerless to defend themselves since they no longer have their own monetary instruments. “These countries risk being hit by a dangerous confidence crisis,” he said.
The German Council says the first step would be a higher “risk-weighting” for sovereign debt held by banks, and a limit on how much they can buy, with the explicit aim of forcing banks to divest €604bn. They would have to raise €35bn in fresh capital, deemed “manageable”.
It is a neuralgic issue in Italy, where the banks own €400bn of government debt and have effectively used cheap finds from the European Central Bank to prop up the Italian treasury.
Mario Draghi, the ECB’s president, deflected a question on the issue from an Italian euro-MP on Monday. “It is an issue that we do have to deal with. But we have to take a very considered and phased-in approach,” he said.
The move is courting fate at a time when Portugal is already in the eye of the storm, facing a slowing economy and a clash with Brussels over austerity.
The risk spread on Portugal’s 10-year debt surged to 410 basis points over German Bunds last week, pushing borrowing costs back to unsustainable levels in real terms. Portugal’s public debt is 132pc of GDP. Total debt is 341pc, the highest in Europe. The country is in a debt-deflation trap and requires years of high growth to escape.
“Portugal is close to losing market access,” said Mark Dowding, from bond manager Blue Bay. “We saw very ugly conditions last week, and large US managers invested in Portugal have been looking to exit those positions. With fund redemptions going on, it is a perfect storm.”
Mr Dowding said the saving grace for Portugal is that it has “pre-funded” most of its needs for 2016 and can weather the tempest for a while. If the crisis endures, worries about a fresh Troika rescue for Portugal – and what the terms for debt-holders might be – could take hold quickly. There was no haircut on sovereign bonds when Portugal was bailed out in 2010.
The German Council says the “regulatory privileges” of sovereign debt held on bank books should be phased out. It should no longer be treated as “entirely safe and liquid” under the banks’ liquidity coverage ratios, or be exempt from capital requirements. “The greatest risks are for banks in Greece, Portugal, Spain, Ireland and Italy,” it said.
In theory, the aim is to “reduce the sovereign-bank nexus” by partially separating the two, preventing government debt crises spreading and taking down national banking systems.
Prof Bofinger said the real problem is that Germany and the EMU creditor states still refuse to accept the implications of monetary union: that some level of debt-pooling and fiscal union is imperative to hold the experiment together.
He described the whole notion of a sovereign insolvency mechanism as misconceived, perpetuating the canard that fiscal abuse by governments is the root of the crisis. In reality, (with the exception of Greece) public debt exploded after 2008 because crisis states had to take emergency action to prevent their economies from collapsing.
Moreover, the new plan empowers private investors to act as judge and jury on the solvency of states. “We can’t allow a regime where markets are masters of governments,” he said.
The German Council is defiant. It swats aside any talk of an EU treasury or shared fiscal authority. The only way to uphold monetary union is to impose strict control – it said – and “reinforce existing rules”.