Champions of the euro remain convinced about the long-term viability of monetary union. They recognise, however, that decisive co-ordination and leadership is urgently needed if the euro is to survive the deepest crisis of its short life.
They also recognise that the consequences of failure would be unthinkable.
In this EuroWeek roundtable, economists and investors gathered to discuss what needs to be done to create the roadmap to guide the Eurozone out of its crisis and to restore some much-needed stability to the European government bond market.
Participants in the roundtable, which took place in London in late November, were:
Jacques Cailloux, chief European economist, research, Royal Bank of Scotland (RBS) Global Banking & Markets
Mark Dowding, senior portfolio manager, BlueBay Asset Management
Laurent Fransolet, head of fixed income strategy, Europe, Barclays Capital
Steven Major, global head of fixed income research, HSBC
Gilles Moec, managing director and co-head of European economics research, Deutsche Bank
Helen Roberts, director and head of government bonds, F&C Management
Ken Wattret, chief european economist, BNP Paribas
Phil Moore, contributing editor, EuroWeek
EUROWEEK: In September 2005, Italys finance minister resigned, when his proposals for deficit-cutting measures worth more than 21bn were rejected by his coalition partners. At the time, some press commentators expressed concerns over mounting European debt and the outlook for the single European currency. So why now? Why did it take six years for this crisis to materialise in the way it has? Why did it take six years for Italian government bond yields to shoot up so far and so fast, when macroeconomic indicators in Italy were just as bad in 2005 as they are today?
Jacques Cailloux, RBS: Its a reflection of market behaviour, where you can move from good equilibrium to bad equilibrium on the back of market dynamics. Italys credit risk hasnt really changed since 2005, but we are at the tail-end of a sovereign crisis that has spread from one country to another and it is hitting all countries with any meaningful level of debt, either private or public. Italian bond yields could have shot up a year ago, after the Greek crisis. I dont see much difference frankly in the economic situation now compared with a year ago.
I dont see any single domestic factor that has contributed to driving Italian bond yields higher. Its a pure contagion factor that suddenly drove the market to re-price Italian credit risk. There was no way the credit risk was right before, and nobody knows where the fair value of Italian credit risk is today, at a time when were talking about potential exits and possible defaults in other parts of the European Monetary Union.
Laurent Fransolet, Barclays Capital: An additional factor is the underlying economic situation which has deteriorated at the Italian, European and global level, with economic growth lower in recent years and likely to remain so for many years to come. The result is that the debt sustainability dynamics for Italy have changed.
Mark Dowding, BlueBay: The bottom line is that weve found out that government bonds are not a risk-free asset. But the people who typically own government bonds are risk-averse investors. This is meant to be the lowest-risk asset class. So suddenly you have investors holding an asset which is no longer consistent with their risk profile or requirements.
Normal economic theory would suggest that elasticity of demand for government bonds would lead to demand rising as prices fall. But weve seen less demand at lower prices because the perception of credit risk has escalated beyond a given threshold. A situation has therefore been created where rising yields are leading to further selling pressure which ends up in a death spiral for government bonds as they turn into pure credit plays.
With the euro no longer sacrosanct, and with the growing recognition that countries may be kicked out of the euro, government bonds no longer appear to be risk-free and consistent with the requirements of the investor base which originally invested in government bonds.
Cailloux, RBS: You need to add to that the knee-jerk reaction from regulators which are basically agreeing with the market in saying that these assets are no longer riskless. That obviously aggravates the situation because when you stress-test on the basis of a mark-to-market exercise, youre telling banks that all these sovereigns are potentially risky. That has the effect of killing off another part of the system in terms of potential demand for those bonds. The regulators may have the right attitude in this respect but it certainly doesnt help when in the middle of a crisis they choose to put some counter-incentives in place.
Helen Roberts, F&C: Just coming back to your point about Italy, the size of the market and the downgrades weve seen have meant that everybody has been dreading each new auction, such as the linker auction at the end of November.
Italy only needs to be downgraded by two notches for it drop out of the Barclays Capital inflation-linked index. So there is constantly a big risk of another bond auction failure and the focus once again will remain on Italy, with investors nervous that the market will either reject the auction or make Italy pay up. Any move by the credit ratings agencies and again well see big sales of Italian linker bonds.
EUROWEEK: Might events like the German auction failure in November and concerns about Italys linker auction paradoxically be helpful for this crisis because they may lead us towards a speedier resolution, a quicker endgame?
Ken Wattret, BNP Paribas: There is a paradox, as the worse the situation gets, the more likely this is to elicit a policy response. In the last few weeks we have clearly seen the contagion broaden out from the usual suspects in the sovereign market. Youve had the core and soft core markets experiencing increased funding difficulties as well, and the cost of sovereign issuance for those borrowers has changed radically in a relatively short period of time.
We would hope that this galvanises a broader political desire to take more radical action. But at the moment were seeing a broadening of the contagion, and the underlying problem here is that there is no longer a marginal buyer for some markets.
A circuit-breaker is needed to turn sentiment around. Its very difficult to see where that circuit-breaker will come from in the absence of the ECB becoming more involved.
At the moment, one of the main concerns in the market is that there is clearly a time-line problem. Markets want an immediate response, and what weve learned throughout this crisis is that institutionally the response, either from the policy or the political side, has generally been very elongated and sub-optimal.
Dowding, BlueBay: I would agree that it looks as though things need to get worse before they can get better. The view until now has been that this is a problem for the southern sinners. But when pressure starts to be exerted on countries like France, Austria, the Netherlands and Finland, and perhaps even Germany as we saw with the auction in November, we will move closer to a resolution point.
The question were grappling with, though, is how bad do things need to get in the interim to force a change in attitude on the part of the ECB or within Berlin? We dont know if the trigger point will be OATs trading at 200bp, 300bp or 400bp over Bunds. But we do sense that we are closer to a definitive endgame because if we dont see a softening of the ECBs stance, I dont see how were going to attract the marginal buyer back to government bond auctions. Were now looking at credits trying to fund themselves which at prevailing rates are technically insolvent, inasmuch as they couldnt live with those funding costs in perpetuity.
Gilles Moec, Deutsche: There seem to be very different perceptions depending on whether you stand on the central bank/German side or on the market side of the equation.
Finance ministries will always look at things from the perspective of the primary market. As long as there is no immediate pressure on the issuer, they are to an extent not very concerned about what this means for the bondholders. One thing weve been hearing again and again from the Bundesbank president is that there is no such thing as a 7% yield threshold for Italy, and that Italy can actually survive for many months or quarters or even years with rates at these levels.
So based on this fairly relaxed view of the time line, some policymakers probably feel that they have some scope to extract more from the peripheral countries, that they have time to fine-tune negotiations with national governments.
But the market no longer really cares what happens to the primary issuer so much so that there is nothing that Italy or Spain or Portugal can say or do to change market perception. Weve now probably entered a second stage of the crisis where people are starting to question the sustainability of a number of large sovereign issuers, as well as that of private investors overly exposed to this risk.
Fransolet, Barclays Capital: The biggest harm is simply being done by the sheer volatility were seeing. The moves in yields were seeing on a daily basis are such that at the moment it is very difficult for investors to remain invested or add to their exposures to Euro government bonds. At the same time, in the context of deleveraging, dealers are heavily reducing their balance sheet commitments, especially ahead of year end. The damage being caused to demand and also to the micro structure of the market is irreversible.
Cailloux, RBS: I agree that policymakers seem to have very little appetite to support the secondary market. Their focus is absolutely on the primary market which I can understand, because from the standpoint of the policymaker you want to ensure that your sovereign can repay its debt and issue new debt. The problem is that in a mark-to-market world, the idea that the secondary market does not really matter represents a complete misunderstanding of the situation.
The consequence is that in countries like Spain and Italy, where the press looks at secondary market spreads as an indicator of confidence in the market, popular perception is that the bond market is not buying into policy announcements. A similar thing has already happened in Greece, Ireland and Portugal.
This is a big problem, because it feeds into expectations and therefore into the policy debate. And yet at a regional level, the focus on the secondary market is pretty limited. We see this in the policy of the ECB, which is not buying aggressively enough to stabilise the secondary market.
Roberts, F&C: In terms of the timeline that Gilles mentioned, although we are all sceptical at the moment, lets hope that future summits are more decisive than Novembers meeting in Cannes, which was a disaster. The risk is that investors only believe these summit resolutions will last for a day or two and then the honeymoon period will be over again and spreads will start widening again.
Next year, however, political risk will resurface. With the French elections coming up, the danger is that politicians will be more concerned about their own survival prospects than with those of the euro.
EUROWEEK: This all sounds like bad news as far as crisis resolution is concerned, because it suggests that there are still plenty of vested interests that will prevent any consensus being reached.
Fransolet, Barclays Capital: There is no single silver bullet here, and as you say, lots of different interests. It essentially comes down to a few governments, the ECB and the IMF. But time is running out. This is no longer only about the medium term.
Wattret, BNP Paribas: Were talking about a fundamental clash between the time horizons for markets and politicians. Electoral cycles generally last four or five years, and only one or two years in extreme cases. But markets are focused on debt sustainability, and the policies that can deliver sustainability have a much longer time horizon. That is a very big problem. I sympathise with the view that we are suffering from disappointment fatigue from all the summits that have been held since the start of the crisis.
However, progress is being made. If you listen to some of the comments coming from Chancellor Merkel recently, they are radically different to what we were hearing just a few months ago. She is now saying, very clearly, that what is needed is a big step towards fiscal union.
The debate up until recently was which direction Germany would choose when it reached a fork in the road closer European integration or disintegration. Its clear that Germany has now chosen the former. The problem is that it has taken it so long to reach that decision.
One would have hoped that there would have been a more positive market reaction to the statements that have been made after some of the key meetings in the euro area, because the underlying framework is changing radically in terms of political integration. But the market reaction has been limited.
Cailloux, RBS: I think the reason for this is that until six or nine months ago this was largely a political crisis. Now it has become more of a financial problem, because even if they have the political will, you have to question if governments have the financial resources that are needed. This is because the costs of maintaining monetary union are rising on a daily basis and will continue to rise until a firewall is implemented.
In June or July there was talk about the EFSF having 2tr of resources available, but this was before Spain and Italy lost access to the market. That 2tr is now no longer sufficient to backstop the system.
EUROWEEK: Has the EFSF been totally discredited?
Dowding, BlueBay: EFSF as a solution has been dead in the water from the moment it was announced.
Cailloux, RBS: Would you have said that if a sufficiently-resourced EFSF had been launched two years ago?
Dowding, BlueBay: It may have brought us all a couple more years of grace. But these problems would have resurfaced, because the heart of the crisis is that people need to have confidence in the euro project itself, and for that to happen you need to have a central bank that behaves like a central bank. If you have a central bank that says its not going to be a lender of last resort, where does that leave the currency? And where does it leave the whole Eurozone?
The irony is that if Mario Draghi were to come out and say that the ECB were to be lender of last resort, to go down the path of QE and to ensure that yields were capped at, say, 5.5%, the amount of money that the ECB would need to spend might turn out to be very modest. If we suddenly had a credible policy articulated by a credible central bank, the market would do the work of the ECB for it.
Cailloux, RBS: Or it might create more political tension that the market might feel would increase the possibility of a break-up of the Eurozone. This is because the QE solution might be regarded as necessary by some EU members but as highly unsatisfactory by others.
Dowding, BlueBay: But is the answer here that fiscal policy becomes much more Germanic? Are we inevitably going to see more fiscal austerity for long periods together with constitutional debt brakes, offset by more monetary stimulus? If so, from a fiscal perspective well be more Germanic, while in central banking terms well become more Latin or more Anglo-Saxon in our approach.
Cailloux, RBS: For that we would need the Germanic fiscal framework to be written into the law and the ECB to buy more bonds on an ex-ante basis. What weve seen over the last two years is that every time the ECB has done something to support peripheral sovereign borrowers, it has taken away all incentives for an acceleration in fiscal consolidation.
Moec, Deutsche: It boils down to whether or not the ECB is willing to take the leap of faith that we need. There is no way of providing assurance to the ECB that any of the commitments that European governments make at future summits will be respected. The democratic process is such that any such commitments will have to go through a series of ratification, and well have exactly the same drama over any Treaty change and any national debt brakes that we had over the EFSF.
I believe that the ECB is not too far away from making that leap of faith. The calculation that Draghi has to make is, to what extent is anything I do going to be backed up in core Europe, and how far can I persuade them to support the ECB in its new phase of action? And that depends on what governments are prepared to put on the table on December 9.
But clearly the crisis has become existential, and I would venture that within some factions of some core European governments there is support for ECB action. I believe that the German line, which officially opposes ECB action, is to some extent posturing. The Germans understand perfectly well that this is now something that has to happen, so the question for them is at what stage will they be able to start to change tack. They have to believe public opinion has changed sufficiently in support of action by the ECB.
Cailloux, RBS: The necessary change in German public opinion will only come when economic and financial pain begins to reach Germany. From a political perspective it becomes much easier to explain to the population that they need to take the sort of action that it previously thought could never take place when the economic situation begins to deteriorate very sharply.
EUROWEEK: Signs of which are already beginning to emerge in Germany, arent they? Not just in Novembers failed auction but in some of the macroeconomic indicators that are starting to point towards recession even in Germany.
Wattret, BNP Paribas: Through the first year of the debate about what could be done about Greeces problems, Germanys economy looked relatively immune to what was happening in the periphery of the Eurozone. Progress towards a resolution was therefore frustratingly slow. It has been accelerated as it has become more obvious that the economic contagion has spread from the periphery to the core. But that contagion is perhaps still not severe enough to push us towards the endgame quickly enough.
Just going back to what we were saying before about the ECBs framework, we are clearly seeing an acceleration in fiscal tightening. You could argue that Germany has room for manoeuvre to do the opposite. But Germany wants to lead by example and to show everybody else how fiscal tightening can be done.
On the monetary side, the ECB is getting closer to the point where it can introduce a QE programme. But to make this palatable to the sceptics, this would have to be via the framework of the ECBs analysis of the risk to price stability rather than in response to market impairment. That is an easier sell for the new ECB president because the Eurozone economy appears to be going into recession, and over the medium term there are downside risks to price stability.
We heard from Mr Draghi in early November that he respects the traditions of the Bundesbank. So lets follow some of those traditions and focus more on the likelihood of insufficient money and credit growth for the next several years in an atmosphere of bank deleveraging. If the conventional policy ammunition is exhausted, it is natural to consider unconventional ammunition. QE can be framed in that way, and I dont think that is very far away.
Roberts, F&C: But that is a relatively medium term solution. Were looking for a short term fix, arent we? The IMF should come in, sort out the Italian problem by taking Italy out of the market, and Monti needs to announce a very strong policy commitment to more austerity. If we can tackle the Italian situation decisively, then we can move on to the new role of the ECB.
Wattret, BNP Paribas: If the EFSF was properly resourced, perhaps by the ECB, then there would be some conditionality in the credit facilities available through the EFSF. Its not a quick fix to all the problems, but you can provide some assistance for debt financing through a modified EFSF.
The concern for the ECB is that the conditionality of their interventions is informal. As we saw in August with Italy, the moment the ECB steps in, you remove the motivation that politicians have to take the very necessary but unpopular measures that are needed.
For Italy as for a number of other countries, the emphasis in the earlier stages of this crisis has been very much on austerity. There has been virtually no emphasis on the supply-side reforms that will deliver higher potential growth rates over the longer term which in turn will have a positive impact on debt sustainability.
Cailloux, RBS: Id agree, but with one big caveat. At some stage the ECB will be in a position to explain why the risk of deflation justifies QE. The problem is that the market is focusing on credit risk, and if the ECB launches a QE programme, the market will respond by selling to the ECB which will be overwhelmed. By contrast if the Fed opts for QE, the market buys with the Fed because it sees no credit risk. In that scenario you expect capital appreciation on your bonds because the yields will effectively be capped.
As long as the ECB is buying from bondholders, the QE option will unfortunately not solve the crisis. It may even make things worse. So I agree with Helen that we probably need IMF intervention. The problem there is that there are not likely to be sufficient resources. If the IMF were to design a solution to the Italian problem in the same way as for other countries, it would need 700bn or 800bn. If Spain went to the IMF it would require about half this total again. So were already talking about well over 1tr just for these two countries.
So we probably need a mixture of the ECB and the IMF both as a way of helping out on the financial side and to provide the expertise and assistance that is needed.
But fundamentally I think there is a problem as long as the ECB is seen as senior and as long as there is credit risk embedded in the system. Yes, the ECB can justify QE on the grounds of deflation, but I think investors would then just turn around and sell their bonds to the ECB. Im very sceptical about the ability of the ECB, even with a large balance sheet, to address this problem.
Moec, Deutsche: On the idea of pooling the IMFs and the ECBs resources, we also need to take into account the fact that the ECB will have to emphasise that the reason behind its intervention is to repair broken monetary policy mechanisms. The ECB doesnt negotiate. It does not participate in grand bargaining with the IMF or the EFSF because if it were seen to do so it would be in blatant contravention of Article 123 of the Treaty [which imposes a legal prohibition on monetary financing]. That is an additional complication.
EUROWEEK: Hasnt the Treaty been torn up so many times already that it is already almost irrelevant?
Moec, Deutsche: It may have been torn up, but if you dont want to end up with a massive problem with the German Constitutional Court, at least respecting the semblance of the Treaty is very important.
But I would be very surprised to see the IMF, the ECB and the European Commission all standing on the same platform explaining how theyre going to give financial support to any individual member state. It is already in the ECBs remit to monitor a countrys policy, but it cant be seen to be contributing directly to that countrys funding.
Dowding, BlueBay: Its incumbent on Europe to sort out its own problems. The clear message that has been coming out of Asia and elsewhere is that this is Europes problem to fix so I dont necessarily see why this needs to be an IMF solution. A better solution would be for the market to do the job of policymakers for them.
Investors will buy Italian bonds as long as they are comfortable that there isnt a massive default risk attached to them. CDS prices today imply a 60% default risk in Italy over the next five years. If the central bank provides a commitment to capping yields and being a lender of last resort, and if we have a policy framework that people intrinsically believe in, investors will be persuaded to buy. But if investors are only encouraged to sell into any quantitative easing because they think the framework is half-baked and unconvincing, then its not going to work.
Roberts, F&C: The problem is that because of solvency concerns and regulation, a lot of investors holding sovereign bonds have been very shocked at their performance. People have voted with their feet and there is a lot of evidence to suggest that clients have come out of the periphery and theyre not going back to those markets any time soon.
Cailloux, RBS: I agree. The difficulty in Europe is that the time that has been spent on mismanaging the crisis has itself created more profound problems in the system. Investors would never have imagined that Italy would get to the levels it is at today. Its such a large market and investors all said that after Portugal they would draw a line in the sand. But now investors are down 15% on their Italian bond holdings, and its difficult to see when they will come back.
Wattret, BNP Paribas: An important point here is that domestic investors in Europe have to be convinced to return to their markets and buy. The question is, when will they come back?
EUROWEEK: Thats an extremely important point, isnt it? I had always understood that one of the safety valves for the Italian market was that there was so much inelastic domestic demand for government bonds that this would act as a natural cap on yields, just as it does in Japan. But much of the recent selling in Italy recently has apparently been coming from the domestic banks, and from the Italian subsidiaries of foreign banks.
Wattret, BNP Paribas: The time it has taken for eurozone policymakers to deal with this crisis decisively has caused the damage and cost of resolution to escalate.
To go back to the fundamental question of who should be responsible for fixing this problem, its useful to look at the overall position of the euro area in terms of fiscal sustainability. Weve just been updating our forecasts, and the primary budget position of the Euro area on aggregate is much better than the UK and the US. Therefore if we ask, can this problem be solved, the answer is of course it can. Its a question of who pays, which is where you encounter the political obstacle. Is there sufficient political will in the richer, stronger core countries to bail out those in the periphery?
Germany wants to see a clear set of rules and a governance procedure put in place, and that process will take time. The gap needs to be bridged between where we are today on the governance side, and where we will eventually be. The ECB is capable of providing that bridge. The question now is whether even with a big ECB intervention that bridge will be sufficient to help turn sentiment around.
When it comes to the willingness of investors outside the euro area to come into the market, again we come back to the theory that things have to get worse before they get better. If were talking about tail risk events, what are the consequences of those for the global economy? It may ultimately be in the interest of those who say that Europe can solve this problem on its own to become involved now. The more this crisis escalates, the more likely it is that this external support will come to the fore. But how quickly?
EUROWEEK: In searching for a resolution to the crisis, can we draw any lessons from historical precedent?
Moec, Deutsche: Im personally amazed at the lack of historical understanding in the handling of this crisis. I started my career working on the Italian economy 15 years ago, and it was in a sorry state at the time. In the late 1990s there was a gradual improvement in market perception towards the southern European countries, but what drove this improvement? It was not just the fact that those countries had begun to pursue much sounder economic policies. It was also because they had a clear objective ahead of them in the form of monetary integration. That is what kick-started the improvement in Italy between 1996 and 1999.
These economies managed to get their act together because there was a clear and appealing objective for them to work towards. If they have a similar objective ahead of them today we may work our way out of the crisis, which is why it is so important to have the ambitious goal of fiscal union, even if we know this isnt going to be the solution for the next three to six months. It is essential to give these governments a sense that there is light at the end of the tunnel.
EUROWEEK: How much support is there at a grass-roots level in Europe for the fiscal union which is now regarded as pivotal to a resolution of the crisis?
Moec, Deutsche: Does public opinion in most European countries believe in fiscal union in some form? My contention is yes, it does. If you ask Italian and Spanish voters if they would prefer to maintain the sovereign policies that have been followed over the last 30 years or to surrender part of their sovereignty for something better, my guess is that they would opt for the second solution.
Roberts, F&C: If politicians are able to make it clear that if there is a break-up of the euro, the consequences will be higher unemployment and more social unrest, people will buy in to the idea of having more fiscal union. People in the south of Europe have benefited considerably from monetary union to date, but their perception is that the future will only bring austerity. And who wants to vote for austerity? Nobody. But the reality is that they will have to.
Wattret, BNP Paribas: The cost-benefit analysis is important. If you look at the early response to the crisis in Germany there was very little analysis of what Germany has gained from monetary union. It was all about costs. And the same has been true in the periphery.
In Italy weve seen a move towards a technocratic government, which is clearly positive in the short-run, but is also a reflection of the fact that you need to suspend the democratic process to deliver the necessary economic reforms.
EUROWEEK: Support seems to be growing for Euro-bonds, or stability bonds as they are now being called. Will we see the first of these bonds issued in the next few months?
Fransolet, Barclays Capital: I think we will see Euro-bonds, but not in 2012.
steven Major, HSBC: Whats needed in very simple terms is fresh money. What doesnt help is leveraging existing or even imaginary money.
Its very important that we get a signal that we are stepping towards fiscal union. Its therefore vital that any kind of pooled or common issuance that takes place has some form of credible fiscal authority to underpin it. It needs to be underpinned by real cashflows. Be they VAT or Tobin tax receipts or whatever, there need to be cashflows beneath the fiscal agent that issues the common bonds when they come.
Fresh money could also come from the ECB, but thats not going to happen until all the various pieces of the jigsaw are in place, which means that the PSI [Private Sector Initiative] in Greece needs to be implemented quickly. That in turn will determine the size of the bank recaps that need to be completed.
The fiscal rules and fines that are in place in the six-pack, which is now becoming the 10-pack, need to be observed. We need to have clarity on the bail-out mechanisms, which need to be narrowed rather than widened in scope. And we need to have more clarity about when the ECB will come in.
The thing that joins everything together is common issuance, which is now a question of when rather than if. If the process can at last be started or signalled in the next few months, it would be a big help.
EUROWEEK: Its interesting that you view the idea of a common bond as inevitable, even though Der Spiegel quoted Angela Merkel as reiterating her stance that a Euro-bond would be "absolutely wrong" and "extraordinarily distressing". That doesnt sound very supportive.
Major, HSBC: The people who support common bond issuance will always be right. The reason is that if the euro were to fall apart, and we were to have the creation of a narrow monetary union between Germany, Holland, Austria and possibly Finland, those countries would issue a common bond some time afterwards. So it will happen at some point in the very long term.
But part of the crisis resolution is that if you believe in the long-term survival of the euro, you have to accept that there will be fiscal union. And you dont have to wait for formal fiscal union to issue common bonds.
Regarding the comments you quote from Angela Merkel, Ive been plotting every comment that has been coming out of Berlin on this subject for the last six months and there is a very clear trend in what is being said. Six months ago the message was absolutely no way. The message now is that although Berlin is not a fan of these bonds, attitudes are definitely shifting. At the current rate of change I wouldnt be surprised if Germany comes out in favour of common bonds within the next couple of months.
So I think we are approaching some kind of cathartic moment at which Germany wakes up and smells the coffee. As the German economy slows down and enters recession, and as companies start to go bankrupt, something will trigger this shift in German policy, which I think is already beginning to happen.
EUROWEEK: Would others agree that we are close to an identifiable trigger point in Germany that expedites a resolution to the crisis?
Dowding, BlueBay: Everyone seems to agree that ultimately the right thing will be done, partly because we are all aware of how utterly dreadful the consequences will be if we really stuff things up.
Cailloux, RBS: Maybe. But the history of the last two years demonstrates that there has been such a very high risk of co-ordination failure that you cant rule out people stuffing things up again!
Im much more cautious on the common bond idea than Steven is. It may be an endgame. It may be a necessity. But we need to draw lessons from the experience of the common currency. It is pretty clear that the common currency came too early relative to the economic convergence process in real terms. It was wrong to set out nominal convergence targets when what was necessary was real targets.
The danger of a common bond is that you have to put everyones money behind it. If you do that before youve achieved convergence on the expenditure side, you run the risk of creating an unprecedented political crisis because you end up having some countries subsidising social preferences in others that are quite different. Funding hospitals, schools, pensions and so on in this way would create considerable political risk.
Stevens point about starting small and taking this on a step-by-step basis might be the right direction to move in. But to move ahead with a single instrument for everyone would be even more dangerous than the currency proposal was at that particular stage in the union.
Moec, Deutsche: I agree with Jacques that if we move too fast towards the Euro-bond solution we risk ending up with a massive political problem which could break up the entire process.
Only when we have created the necessary safeguards, and once weve checked that countries have been in full compliance with the letter and the spirit of the rules, then Euro-bonds might become an appropriate endgame. They wont solve the crisis. But at least they would give national governments a sense that progress is being made.
On the subject of public opinion and Marks comment about how dreadful a dismemberment of the single currency would be, Im amazed at how little thought there has been about the probable consequences of a break-up of the Eurozone.
Perhaps people have been reluctant to discuss the consequences for fear of precipitating a break-up. But in Germany, for instance, public opinion is clearly not yet abreast of what the impact of a break-up would be, and the same is true elsewhere in core Europe.
We probably need to go through a phase where, having regarded the existence of the union as a given, and where allusions to its destruction were viewed as a complete taboo, there is a need to educate public opinion. This is an area where national governments and probably central banks need to play a lead role.
On the conflict between short and long term solutions, we should probably accept the idea that no matter what, 2012 is going to be a very difficult year and that there is no way we can go back to the perceived normality we enjoyed before the crisis. There is a longing in the market right now for a return to normalcy. But if this return to normalcy means a return to what prevailed before 2010, this is not going to happen. The situation before 2010 was unsustainable because the absence of risk premiums across a number of countries was irrational. The market needs to learn to live with risk premiums again.
Coming back to my point about what happened in the mid-1990s, weve been through this before and we survived. We should not view the solution to this crisis as a binary one.
Muddling through with high-ish interest rates for a number of peripheral and even for some core issuers is probably unavoidable. The question is not how do we return to the rates we saw before 2010, but how do we ensure that the rates dont go even higher?
EUROWEEK: Weve heard that the consequences of the euro falling apart would be unimaginably bad. But youth unemployment in Spain is officially 40%. The size of the informal economy is such that the real number is much lower than this. But if youre part of those unemployment statistics in southern Europe, surely you dont care about what happens to monetary union?
Dowding, BlueBay: Exactly. One of the things I feel quite evangelical about is that there is simply too much debt in the world. You can get rid of that debt by growing your way out. Or you can tackle the debt problem with austerity, although that does not seem to be working. Or you can restructure your debt, although if we have widespread defaults well end up with an economic catastrophe on our hands. The final alternative is to reflate your way out of debt.
On your point about youth unemployment, it almost seems to me to be a point of social justice that we need to re-enfranchise the younger generation. Inflation takes from the old and redistributes to the young, so it may be a very healthy thing if we had reflationary policies. In fact, a canny Bank of England might one day go as far as tearing up half the Gilts it buys, and overnight the debt to GDP ratio in the UK would go from 80% to 40%.
At the same time the government could cut taxes and raise government spending. Sterling would fall, but so what? Exports would go through the roof. There would be a slight inflationary problem but I would contend that such is the financial and monetary destruction that were seeing in terms of money multipliers contracting, inflation might not be as bad as some people are suggesting anyway. But it is appalling that our generation, which got us into these problems in the first place, is saddling future generations with so much debt.
Cailloux, RBS: Its exactly right to say that this is a debt crisis. Theres obviously too much debt in the system. The challenge is to distribute this burden fairly among local taxpayers, foreign taxpayers, the ECB and the IMF, and among investors through bail-ins and haircuts. Its all about finding a balance that achieves a politically, economically and socially acceptable distribution of losses.
The trouble is that every constituent that is put under pressure resists taking its share of the burden. No more austerity, says the taxpayer. Dont put the losses on our shoulders, say the bondholders. The central bank, meanwhile, says it does not have the mandate to accept the losses.
These disagreements are now pushing us to the limits. Ultimately everybody will have to sit around the table, and the IMF will have to be involved in terms of deciding what is the optimal way of spreading the losses, because the debt stock has to be reduced.
Wattret, BNP Paribas: There are various ways of dealing with the debt problem. It may be that the solution is to use a combination of all of them. They dont have to be mutually exclusive.
For the euro area, the underlying driver of the crisis is imbalances, to cite Mervyn King. We also have global imbalances which arent being properly addressed.
Is high youth unemployment in Spain a result of the debt crisis or other factors, including labour market legislation?
In Italy, the government has now outlined a reform programme, and the opinion poll ratings for that government are very high. So although the tendency is to think that in some countries there is opposition to change, Im not sure that is true. People in some countries in Europe are voting for change.
Fransolet, Barclays Capital: In Spain, the PP has just been voted in on an austerity package with the highest margin over the Socialists since 1982.
Roberts, F&C: The UK is probably not the blueprint to follow. I think weve got away with murder so far because we have our own currency and because investors focus has not been on the UK. But we still have a serious debt problem overhanging us and if the problem in the Eurozone does move towards a resolution the focus could well move back to the UK.
Given the prospects we have for very low growth in the UK, its going to be a struggle to push the austerity measures through. The social unrest I spoke about earlier on could well pick up again. The factor that could prevent this from happening is that wage inflation is low, so people dont have the power to demand pay increases and are more concerned about keeping their jobs.
EUROWEEK: Staying with the UK for a moment, hasnt recent talk of increased capital spending been hinting at a plan B? As an investor in the UK market, would you worry about the impact on the UKs triple-A rating of a slowdown in the deficit cutting programme?
Roberts, F&C: Yes. I would definitely worry about that. The UKs rating is based largely on goodwill and on confidence that we will balance our books by 2015.
When I ask Moodys if there has to be a triple-A benchmark they say yes. But if no country has the metrics to warrant it, why should there be such a thing as a triple-A rating? The UK Gilt market will continue to look better than elsewhere until the focus returns to the UK, at which point things may suddenly look less rosy than they do today.
Wattret, BNP Paribas: A broader issue is that people need to have their expectations re-set. The period from the late 1990s through to the mid-2000s created the impression that the conditions we enjoyed then were normal. It wasnt normal to have house prices rising by 15% or 20% a year, and for unemployment and policy rates to be at record lows. Circumstances then were exceptionally accommodating.
This is especially important for the Eurozone. The retrospectively unfortunate combination of certain global economic factors that coincided with the launch of the single currency created the impression that it was monetary union that was delivering many benefits.
This turned out to be a mirage, which is why these expectations now need to be re-set. For countries like Greece, again it comes down to the need for an extensive cost-benefit analysis.
Theres a tendency to look for knee-jerk solutions to complex problems and for some countries to assume that if theyre outside the Euro area the answer to all their problems is to devalue their nominal exchange rate. But they will have to finance a large current account deficit, which is easier to achieve inside the Euro area than it would be outside it. Moreover, to think that you can keep on devaluing your way to prosperity is an illusion.
But the difficulty for politicians is the issue of cycles. A politician who has a 20 or 30 year horizon for fixing the economys competitiveness may only be around for a year or two.
Dowding, BlueBay: In that regard, we are fortunate enough to have Japan as a blueprint for what may lie ahead. I think most policymakers should be looking at what happened in Japan and should be very cognizant of the fact that if they dont get their act together and come up with the appropriate policies, were may find ourselves staring at a Japanisation of the European economy.
Cailloux, RBS: You speak of Japanisation as though it would be very negative. I see it as one of the best outcomes that the Euro area can hope for. It would mean we avoid disorderly default and a break-up of the union. If the Euro-area can achieve Japanese-style low growth and relative wealth measured by GDP per capita against the backdrop of high debt, I dont see that as such a disastrous outcome.
Dowding, BlueBay: I strongly disagree because I dont think that from a cultural perspective the populists in Europe would tolerate the same thing that has happened in Japan. The idea of a lost generation where growth is stagnant is a thoroughly depressing thought.
I believe that if you have the right intrinsic policies it is possible to re-set the clock.
Cailloux, RBS: How do you do that?
Dowding, BlueBay: By reflating yourself out of the problem.
Cailloux, RBS: But that does not create sustainable long term growth. It might also push real interest rates to levels that may become destructive, given the debt loads we are bearing.
Dowding, BlueBay: I understand that. But it does address the threat of being caught in a debt trap.
Cailloux, RBS: That depends on what happens to the interest rate trajectory as a response. If youre creating an inflation risk premium that the central bank will have to attack for the next 10 years to regain any kind of credibility, it would be counterproductive.
Dowding, BlueBay: Id rather have 10 years of fighting inflation than 20 years of Japan-style stagnation. I think public opinion would rather go for a 1970s-style boom and bust rather than go through what Japan has undergone during the last 20 years.
Cailloux, RBS: It would be interesting to see what the German population would say if you offered them those two scenarios.
Dowding, BlueBay: In relative terms, Germany has never had it so good, so perhaps it needs to cheer up. There is so much doom and gloom around, but to me these problems are eminently fixable. Its just frustrating that policymakers have been unable to reach an agreement on doing the right thing.
Cailloux, RBS: That is the problem. There are so many different schools of thought across the various countries in the monetary union, and so many different views about how to resolve the crisis. Look at the multiplicity of views that have been expressed about how to deal with Greece, for example. On the one side you have France saying its willing to bail Greece out, and on the other you have Germany struggling to explain the need for burden-sharing to its taxpayers. That deadlock has led to a very expensive bail-out.
This is the main challenge facing monetary union, because every time it comes up against a very serious existential threat, the solutions on the table are pretty much all pro bono when it comes to the important decisions. One country wants a Euro-bond; another doesnt. One country wants QE; another doesnt. How do you resolve that conflict?
EUROWEEK: It also seems to be an irresolvable in-country problem. Apparently 80% of Greeks want to remain in the Eurozone. But 80% also oppose the austerity measures they need to implement in order to do so. Thats a puzzle with no answer.
Cailloux, RBS: Thats right. We need to find a way of reconciling this tension. From a political perspective its probably impossible to reconcile it over the short term. You need generational changes to do so.
EUROWEEK: But in terms of reconciling differences that were previously thought to be irreconcilable, would you agree with Steven that the comments that are coming from Berlin are becoming inexorably more conciliatory? If so, this must suggest that we are stepping closer to a resolution.
Wattret, BNP Paribas: The debate in Germany is no longer about whether or not there will be more integration and fiscal union but how to achieve it. Not so long ago the debate in Germany was about whether there would or should be integration at all.
Germany is in the driving seat in setting the rules. If we had had rules that had been properly enforced from the start we wouldnt be in the mess were in now. And not just rules on the fiscal side. There are also important issues in areas such as competitiveness which are part of the six-pack framework mentioned earlier. So theres a need to focus on the broader economic picture rather than just on public sector deficits.
The debate is moving on in Germany, but its not just about Germany. Its about a number of other countries giving up their sovereignty. If you listen to the debate over sovereignty in France its still a long way behind the debate in Germany.
Cailloux, RBS: The idea that Germany is increasingly willing to give up its sovereignty is interesting, because it is Germany that is drafting the rulebook. Of course Germany is supportive of losing its sovereignty if it can do so in accordance with a rulebook it has written. But Id be interested to see if the French are as eager to jump on to that particular bandwagon.
Wattret, BNP Paribas: To make monetary union function in a more effective way you need to have a more integrated fiscal policy. The question is, how do you get there?
Roberts, F&C: You also need that policy to be expressed by one voice. And that is going to be a German voice, not a French voice. I think France needs to recognise that its financial numbers will not allow it to hold on to its triple-A rating, a fact which the market has already priced in.
Cailloux, RBS: The problem around the negotiation of the new rules is how individual countries can protect themselves. And how can monetary union protect itself from the turmoil that the markets create while the discussion about the rulebook is still ongoing? This discussion is going to be very tough, with countries still disagreeing on bail-out terms, exit clauses and the ECBs mandate. Look at the recent press conference given by Eurozones three largest countries Germany, France and Italy where they agreed on absolutely nothing.
EUROWEEK: So it looks as though we may still be some way from a resolution. But how will this impact the performance of the market over the next year? To wrap proceedings up, where will we be this time next year in terms of the structure of the euro, spreads and the discussion on Euro or Stability bonds?
Dowding, Bluebay: This time next year the euro will still be in place and spreads will be tighter, although in the interim they will have widened. Fundamentally I dont think were going to see mass defaults across the continent because if we do, the outcome will be unbearably bad. Markets are in a dysfunctional panic at the moment but Im looking for some kind of policy intervention to steer us away from the edge of the cliff.
EUROWEEK: If you expect spreads to be tighter this time next year, at what yield level would you start to buy Italy?
Dowding, BlueBay: Its not a question of yield levels. You start to buy again once you can believe in the policy framework and once you see governments delivering on that policy.
Up until that point, valuations are frankly meaningless, because the market isnt just pricing in default risk. Its pricing in re-denomination risk.
Wattret, BNP Paribas: In terms of where well be this time next year, my views are similar. The more stress in markets and the more that stress spills over into the economy, the more likely it will be to elicit the necessary policy response, both from politicians and from the ECB, to put the Eurozone in a better position. I would expect to see a much weaker euro, which could be an important part of the solution. I would also expect spreads to be lower, but I dont envisage a return to the spread levels we had before the crisis. In terms of the economy, I dont expect much change from where we are today. That is, tough conditions, with much work to be done to solve underlying structural problems.
On the subject of Euro-bonds, that is a long-run project. But there are interim measures that could be agreed. For example, there is a discussion about a sinking fund for countries with debt to GDP ratios above 60%. That is potentially another staging post or bridging exercise to push us closer to common bond issuance, but without raising the issue of moral hazard that Germany and others are so fearful of.
Fransolet, Barclays Capital: This time next year I also expect the euro still to be in its current shape and spreads to be tighter.
Cailloux, RBS: Im a little more sceptical. I wouldnt rule out more accidents and defaults down the road.
Dowding, BlueBay: When you say defaults, are you talking about Greece and Portugal or would you also include Italy?
Cailloux, RBS: I think Portugal is insolvent, and how that issue is addressed will in itself create a second precedent. When that happens, the perception in the market will be that the probability of Italy defaulting has risen.
I dont know whether or not Italy will default. But there are issues of solvency in the system, and if you have solvency problems these will need to be addressed through some form of debt restructuring. Hence the importance of having help from the IMF, because it has so much more expertise than any Euro area policymakers which have never been confronted with anything like the present crisis.
Its also important to have an institution to blame from outside the euro area, rather than having the population blaming Europe itself. The last thing you want is to have the Greeks starting to blame Europe for the pain that is being inflicted on them.
EUROWEEK: Just to be clear, does this mean that you wouldnt rule out a break-up of the euro if, for example, Italy defaults?
Cailloux, RBS: Weve had two years of policy co-ordination failure. If this continues, we will eventually reach a point of no return. We are very close to that point. So yes I wouldnt exclude the possibility of a break-up.
Roberts, F&C: We remain euro believers, but of course we are also having internal discussions about what happens if the euro breaks up. Official bodies such as the FSA are also asking asset managers what contingency plans they have in place in the eventuality of a euro break-up. We have to recognise that what we previously regarded as tail risk has now become a real risk. But were of the view that policymakers will do the right thing in the end.