The European sovereign credit markets are in a danger zone. Italy and Spain need to borrow a combined €590 billion in 2012, their yields remain above sustainable levels, and the European Central Bank’s efforts at buying debt in the secondary markets have so far been ineffective in holding yields down.
Drawing on our experience restructuring companies along with lessons learned in the US following the bankruptcy of Lehman Brothers, we suggest the ECB consider a sovereign debt guarantee program as a solution to the European sovereign debt crisis. Such a scheme would be similar to the successful Temporary Liquidity Guarantee Program adopted by the US’s Federal Deposit Insurance Corp to stem the financial crisis after the failure of Lehman by enabling financial institutions to refinance their maturing debt and avoid a default.
It is clear that existing, piecemeal efforts by European leaders have been ineffective. Even after the ECB bought €208 billion of European debt, Greece, Portugal and Ireland all still required bailouts. Italian and Spanish yields, meanwhile, remain stubbornly high. The European Financial Stability Facility, the eurozone rescue fund, is proving impractical – the recent sale of €3 billion of bonds met only tepid demand, casting doubt on its ability to raise its full €440 billion target, never mind the €1 trillion needed for the credit enhancement insurance scheme. A €200 billion capital boost to the International Monetary Fund was a step in the right direction, but the amount is still not sufficient to alleviate market concerns. Direct purchases of new issues of sovereign debt by the ECB have been ruled out owing to their potential inflationary effects.
Last week’s statement from European leaders should go a long way towards fiscal consolidation, a necessary step towards the long-term viability of the euro. But it did not provide the 'firewall' to address the short-term liquidity needs that the markets wanted.
Italian and Spanish bond yields have subsequently risen casting doubt on their ability to meet their funding needs. The market also remains vulnerable to a downgrade by Standard & Poor’s or Moody’s of either France or the eurozone – which could push yields even higher.
The European banking sector also remains under pressure in large part owing to its exposure to European sovereign credit. A firewall is needed now to stabilise the markets, bring yields down, allow for sovereign refinancings, reduce stress in the banking sector and provide protection against likely future credit events. Acting now would be more effective and cost-efficient than waiting for a crisis that forces such action at a later date.
An ECB sovereign guarantee program would immediately calm the credit markets. It would be non-inflationary and would allow Italy and Spain (and other countries, if necessary) to refinance their maturing debt at reasonable rates. It would also ease pressure on banks as concerns about their sovereign credit exposure would subside.
The sovereign guarantee program would work as follows: in return for a 1 per cent annual guarantee fee, and compliance with the ECB and/or IMF on implementation of structural reform programmes, Italy and Spain would be able to refinance all maturing debt with an ECB guarantee. This would probably cause their 'all-in-financing costs' to fall to the 4 per cent range. The program would be open for two years for maturities of up to 10 years, giving Italy and Spain time to implement their structural reforms.
The benefits to this program are many: it would immediately stabilise the sovereign credit market, it would not expand the ECB’s balance sheet, it would not cause inflation, it would keep interest costs low, and negate the need for the ECB to buy debt in the primary or secondary market. Since Italy and Spain are facing liquidity, not solvency issues, the guarantee would probably never be used, and the ECB would collect fees for its service.
The ECB is the only institution in Europe that has sufficient resources to guarantee European sovereigns. With ECB backing and subsequent debt spreads about 1 per cent above the German Bund, Italy and Spain would have time for new austerity measures and growth initiatives to take hold. There may be a need for a technical adjustment to the ECB’s mandate to implement the guarantee program but there are various options available. Time is running out for the euro. A comprehensive firewall is needed now, before the crisis gets worse. The sovereign guarantee program would provide the firewall to stabilise the market and provide a temporary umbrella to allow the EU and members states to implement their fiscal plans.
The writer is president of investment management firm Paulson & Co.
Copyright The Financial Times Limited 2011.