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ECB may have to turn to 'nuclear option' to prevent Southern European debt collapse

The European Central Bank may soon have to invoke emergency powers to prevent the disintegration of southern European bond markets, with ominous signs of investor flight from Spain and Italy.

 

By Ambrose Evans-Pritchard, International Business Editor
Published: 7:09PM BST 27 Apr 2010

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Pigeons swirl in front of the National Bank of Greece headquarters' building in central Athens

Greece's fortunes were dealt yet another blow as Standard & Poor's slashed its credit rating to junk status - BB+ - the first time that has happened to a euro member since the single currency was created, pushing yields on 10-year Greek bonds up to a record 9.73pc.

The credit-rating agency also cut Portugal's sovereign debt ratings by two notches to A-, as the swirling storm hit the country with full-force.

 

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"We have gone past the point of no return," said Jacques Cailloux, chief Europe economist at the Royal Bank of Scotland."There is a complete loss of confidence. The bond markets are in disintegration and it is getting worse every day.

"The ECB has been side-lined in the Greek crisis so far but do you allow a bond crash in your region if you are the lender-of-last resort? They may have to act as contagion spreads to larger countries such as Italy. We started to see the first glimpse of that today."

Mr Cailloux said the ECB should resort to its "nuclear option" of intervening directly in the markets to purchase government bonds.

This is prohibited in normal times under the EU Treaties but the bank can buy a wide range of assets under its "structural operations" mandate in times of systemic crisis, theoretically in unlimited quantities.

Mr Cailloux added: "This feels like the banking crisis in late 2008 post-Lehman, though it has not yet spread to other asset classes. The ECB will have to act it if does."

Yields on 10-year Portuguese bonds spiked 48 basis points to 5.67pc, replicating the pattern seen as the Greek crisis started.

Portugal's public debt will be just 84pc of GDP by the end of this year, far lower than that of Greece, at 124pc. However, its private debt is much higher and data from the IMF shows that its external debt position is worse.

Interest payments on foreign debt will be 8pc of GDP this year. Portugal's net international investment position is minus 100pc of GDP, the worst in the eurozone.

The interest rate on a €9.5bn (£8.2bn) issue of Italian notes jumped to 0.814pc, up from 0.568pc in March. The bid-to-cover ratio was wafer-thin, falling to 1.02. Italy has the world's third biggest debt in absolute terms.

The issue of the ECB buying bonds is a political minefield. Any such action would inevitably be viewed in Germany as a form of printing money to bail out Club Med debtors, and the start of a slippery slope towards in an "inflation union".

But the ECB may no longer have any choice. There is a growing view that nothing short of a monetary blitz — or "shock and awe" on the bonds markets — can halt the spiral under way.

The markets are already looking beyond the €40bn to €45bn joint rescue for Greece by the IMF and the EU, questioning whether some form of debt restructuring or managed default can be avoided over the next year or two, or even whether the rescue plan can work at all in a country trapped in debt deflation with no way out through devaluation.

Professor Willem Buiter, a former member of Britain's Monetary Policy Committee and now global economist for Citigroup, said there may need to be a "voluntary restructuring" of debt.

"It is quite likely that a haircut of, say, 20pc to 25pc will be imposed on creditors as parts of the deal," he said.

The bond markets are already "pricing in" a default of some kind in Greece, where rates on 2-year debt spiked close to 15pc in panic trading yesterday. The European Commission and the International Monetary Fund both insist that restructuring is out of the question but investors have become cynical after months of EU rhetoric and foot-dragging by Berlin.

The ECB cannot lightly risk a second sovereign crisis erupting, with dangers of a spillover into Spain.

The exposure of Spanish-based banks to Portuguese debt exceeds $80bn, according to the Bank for International Settlements. There were early signs of strain in the Spanish banking system yesterday.

Banks were forced to pay a premium in the domestic "repo" market on fears of counterparty risk, although the Bank of Spain has so far won plaudits for ensuring that banks have large safety buffers.

It is unclear why the markets are becoming skittish over Italian bonds. Public debt is 115pc of GDP but this is offset by very low household debt.

Italian citizens are among the most frugal savers in the OECD club of rich states. Moreover, the government has weathered the financial crisis with a budget deficit in remarkable good health.

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