“The next stage of the labyrinth negotiations to find a solution to the European sovereign debt crisis is imminent. Inevitably this will end in a messy compromise that fails to resolve the peripheral solvency crisis and merely prolongs the agony until the next stage. Ireland is central to the negotiations of debt burden for the small peripheral nations.
“Portugal is resisting the siren calls of the EU to seek funding from the European Financial Stability Fund despite the rise in its benchmark 10yr yield to 7.65%. This is unsustainable for a low growth economy, with high private external debt and intense fiscal austerity. Portugal is waiting until both Ireland and Greece negotiate easier debt terms before seeking assistance.
“The EU is seeking to extend Greece’s three year loan to seven years in line with the tenure of the Irish loan. This extension is likely to be provided at the same 5% loan paving the way for the authorities to reduce the penal rate of interest on Irish borrowing from 5.8% to 5.0%. This will be welcome debt relief, but it is not a game changer and does not prevent eventual restructuring. A 1% reduction in Ireland’s cost of debt will reduce annual interest for the government by the equivalent of 0.4% of GDP. This is not enough for an economy where nominal GDP growth will struggle to reach 1% during 2011. An increase in the EFSF to its full €440bn intended size and easing of Greek and Irish debt terms to pave the way for Portuguese membership of this stigmatised club. It is the least that international investors can expect this month.
“However, with Spanish seven year government debt yielding 5.007%, it is unreasonable to expect Spain to subsidise loans to peripheral economies when it has its own banking problems. After all, the intention of this exercise is to draw a line under speculation that Spain will have to borrow funds from the EFSF. We believe that Spain is different to Greece, Ireland and Portugal. In our opinion, it is not technically insolvent and shouldn’t face eventual debt restructuring. However, if the banking stress tests in June are accurate then the true cost of refinancing the Cajas will lead to an unacceptable increase in Spain’s funding costs and in these circumstances it would be appropriate to seek temporary funding from the EFSF. This effectively turns it into a European-style TARP for recapitalising banks. However, the Spanish government believes that the cost of recapitalisation will be a mere €20bn, a figure that is scarcely believable by the financial markets and there is a clear danger that the regulators produce another unsatisfactory outcome.
“The prospect of unsatisfactory outcomes in both March and June suggests that peripheral spreads will continue their gradual widening. There are two circumstances under which we believe that overweight positions in the periphery would be appropriate. First, if European leaders decide to allow the EFSF to buy peripheral government debt in the secondary market helping to drive down funding costs to the new 5% seven year lending rate. However, German politicians have explicitly rejected this proposal. There is a second best alternative, which Angela Merkel is believed to favour, which is to allow peripheral nations to borrow from the EFSF and buy their own bonds back. This is a second best solution and presents a prisoner’s dilemma for governments. If they bid up their debt prices the effective reduction in the debt burden will be minimal and it is therefore in their interest to retire this debt at the lowest possible cost. This would bring them in conflict with the banks, most of whom still measure their peripheral government debt at par in their balance sheets.
“The second reason for selective overweight positions in peripheral debt would be if Spain seeks support from the EFSF to recapitalise its banks because this would spread out the recapitalisation costs over several years and enable existing yields to fall by a material amount. This remains a low probability event given recent government statements.
“The nuclear option alluded to by the film reference comes from the five stage grieving process for Ireland’s Celtic Tiger economy. The government and electorate have gone through the denial and anger stages and are about to enter the bargaining phase. Bargaining phases in grief are rarely successful, but we do not expect the government to risk the nuclear option of senior debt restructuring until the next phase of depression. This will occur when slower global demand constrains the core.”
These are the views of the author and do not necessarily reflect those of Ignis Asset Management.