For several decades, EU regulations for all sectors of the financial services industry have explicitly stated that the sovereign governments should be regarded as free of credit risk, thereby encouraging financial institutions to make government debt a core asset. In the past year, this assumption has been undermined substantially by the euro area Heads of State and Government (HoSG) – led by Chancellor Merkel and President Sarkozy (Merkozy).
In fact, the “Merkozy policy projectile”, launched a year ago at Deauville, could easily sink the EU’s flagship – and probably the EU itself - and thus presents far more of a danger than Greek default.
That is bound to change the price that all financial institutions will charge to hold government debt where any perception of unsound polices creeps in. Shareholders are likely to encourage the management of their banks never again to hold assets that, astonishingly, can turn from risk-free to toxic in just a year.
From December 2010, Merkozy and the other HoSG repeatedly proclaimed that they would do “whatever it takes” to preserve the euro. In October 2011, they suddenly introduced limits – by declining to extend the guarantees underpinning the EFSF. The change of heart was reinforced by announcing that the general assessment of the minimum necessary size of the fund would instead be achieved by previously-ridiculed techniques of financial engineering.
So the much-vaunted firewall to stop contagion spreading to Italy and Spain was built on sand. But the HoSG have now stated twice that there will only be credit risk in Greece and “their inflexible determination to honour fully their own individual sovereign signature”. After the abrupt about-turns in the past year and the commitment to introduce CACs, which investor is going to believe that? Then at a post-G20 press conference, Merkozy suddenly dropped the bombshell that Greece might have to leave the euro. Most observers assume that would have to be accompanied by a massive devaluation, so inflicting a correspondingly massive loss on bond-holders.
Against this background, few investors will be surprised to see Italian yields rising above 6 per cent to reflect these sudden and various new risks. But the consequences of such interest charges could be profound: with the new commitment to a balanced budget, the squeeze on other parts of public spending could easily provoke Greek-style protests. That might lead to a demand to take the “easy way out” - leave the euro and stage a massive, and nakedly competitive, devaluation. As the third largest economy in the euro area, that would probably destabilise the Single Market, as many states would scramble to protect their voters against such unfair competition. As other states felt obliged to respond with similar devaluations, the disintegration of the euro and Single Market would poison the European Union as a whole.
Graham Bishop is the author of The EU Fiscal Crisis
, published in February 2011, which predicted accurately the current eurozone crisis. His new book on the future of the eurozone will be available in February 2012.