Merkozy's eurobond in disguise

The yields on Italian government debt look "very attractive", according to the chairman of Goldman Sachs Asset Management, Jim O'Neill, overnight. Has he lost his marbles?

Actually, no, he hasn't and he isn't alone. After Germany's Angela Merkel and France's Nicolas Sarkozy unveiled their pact on the future of the eurozone earlier this week, yields on Italian bonds fell quite sharply as investors rushed in. It should also be noted that O'Neill qualified his comment by making it conditional on the weekend European Union summit not producing a "complete fiasco".

Buying Italian bonds at the moment is a bet on the eurozone emerging from that summit intact and with a plan that will see pan-eurozone support, whether through new bailout facilities or an about-face by Germany on the issuing of eurobonds. A failure to deal with the immediate threat to the eurozone would shred the value of Italian bonds.

The reason O'Neill, and others, now finds Italian bonds appealing is that they carry a big risk premium – yields have been above 7 per cent. Given the parlous state of Italy's finances that might appear quite rational pricing, but an element of the Merkel/Sarkozy pact appears to have significantly changed perceptions of risk.

Within their plan to create greater fiscal discipline within the eurozone, there was a commitment that perhaps didn't get the initial attention it deserved. That's now changing as its implications are being explored.

The commitment was that in future, private sector bondholders would not be forced to take losses on any future eurozone bailouts.

In October, when the eurozone authorities came up with their response to what was then the Greek sovereign debt crisis, Merkel insisted that the private sector investors had to share the pain of a restructuring of Greece's debts. Very reluctantly, the bondholders were coerced into agreeing to 50 per cent – €100 billion – "haircuts" on the face value of their holdings. The alternative, of course, was a formal collapse.

European post-mortems of that decision have condemned it because it unnerved investors in the bonds of other vulnerable economies, notably Italy and Spain. The prospect of "voluntary" losses as part of the informal restructuring of other sovereign debt obligations created contagion that has destabilised the entire eurozone. Or at least that now appears to be the collective opinion of the eurozone authorities, who now characterise the Greek restructuring as an "extreme" event that won't be repeated.

The problem with that stance is that it is now obvious that Germany and France, having agreed a strategy for harmonising and enforcing eurozone members' fiscal strategies in the longer term, are committed to ensuring that at least the core of the European Union – the eurozone countries – remains intact. The risk of a formal default by a large economy like Italy or Spain is, unless the summit is a complete disaster, receding.

In effect, therefore, the commitment not to impose losses on bondholders in an informal restructuring is akin to a pan-eurozone guarantee of the bonds. It doesn't appear that any of those that have condemned the treatment of private bondholders in the Greek rescue package have yet used the expression "moral hazard".

Providing Germany and France – Germany in particular – remain committed to keeping the core of the eurozone intact (their ability to do so should become clearer after the weekend) buying Italian bonds yielding six or seven per cent is a one-way bet. There's only one direction for the yields on Italian and Spanish bonds to head if there is no prospect of enforced losses for bondholders.

While there is an element of "damned if they do, damned if they don't" in the predicament the European authorities find themselves in, an implicit guarantee will create an incentive for perverse behaviour – investors would rationally sell their holdings of the lower-yielding better credits, like Germany and France, to invest in the high-yielding worst, like Italy and Spain.

If the end result is essentially similar to issuing eurobonds, where the cost of borrowings across the region converge and there is effectively a socialisation of the excess borrowing costs countries like Italy and Spain would otherwise experience, that wouldn't necessarily be a bad thing – provided Germany and France can impose and police strict disciplines and accountability on the rest of the eurozone in future.

While muzzling risk signals and offering investors returns that aren't related to specific risk might appear reckless, the reality in which the eurozone finds itself today, and which Germany and France now appear to accept, is that because of the various inter-relationships and inter-dependencies, including their banking systems, the core members of the region either bind themselves more closely together, at some cost to the stronger economies, or implode together.