Tuesday, March 9, 2010

The EU's Ideas to Deal With Another Greece

In the wake of the headline-making story involving Greece's debt situation in the last couple of months, the European Union seems to be setting its eyes on two possible remedies from preventing such crises in the future.

The first one is the project pushed by German Chancellor Angela Merkel to ban the use of CDS on sovereign debt of the eurozone countries. The idea is that this will help curb the speculative fever against the debt of countries with the heaviest bond issuance (namely Greece, Portugal, Spain, and to some extent, Italy and Ireland) and prevent the replay of Greece-style crises in the future. The idea appears to be gathering support among the powers-that-be within the EU and stands a reasonable chance of being converted into tangible regulation in the coming months.

Although such a ban would probably be helpful in that it will remove a relatively inexpensive tool for bet-making, it is far from certain that, it alone, can tame the speculative impulses of markets vis-a-vis countries that have a clear credibility problem in terms of their fiscal policies.

The reality remains that as long as selling a sovereign bond short remains a permitted activity, there is nothing that prevents hedge fund and other speculators from simply retooling their tactics and shifting the emphasis of their arsenal toward more good old-fashioned short selling. A variation on the theme of an outright ban on CDS contracts is a proposal that would ban the use of CDS by those who do not actually own the underlying bonds (that is, it would prohibit, naked short selling). A sensible proposal for sure, but, still, far from a panacea. On that score, it is useful to remind ourselves that the absence of a CDS market did not prevent George Soros from famously breaking the Bank of England in 1992.

The second major proposal that is also promoted by the Ministry of Finance in Germany is the creation of a European Monetary Fund, modeled after the IMF, for purposes of addressing future crises in eurozone countries. The idea seems to have gained traction quickly in the last few days and is even reported that it may become operational by June.

The creation of such a safety net has some downsides and also some powerful detractors. The Bundesbank President, Axel Weber, is already on record describing the idea of the "institutionalization of emergency help" as problematic, as it would detract from the main focus, which should be to force member countries to demonstrate fiscal discipline consistently. The clear risk with the creation of a European Monetary Fund mechanism, is that the existence of a permanent safety net within the eurozone bloc may lead individual countries to feel more confident that they will be rescued internally in the future and, therefore, they can afford to be lax in enforcing fiscal discipline domestically.


Somehow, the focus has not remained sharp enough on the most glaring fault-line that the Greece affair has exposed, which is the lack of any enforcement mechanism to credibly implement the 3% and 60% requirements for all eurozone countries in regards to the size of their deficit as a percent of GDP and total debt respectively. The irony here is that, as recent reports have brought to the surface, nearly all eurozone countries have blasted repeatedly through those ceilings in the last ten years and resorted more than once to obscure derivatives-based transactions to disguise those violations. Therefore, they do not seem to be very eager now to put themselves in a straight-jacket by seriously beefing up enforcement mechanisms and strict monitoring.

In other words, no country has completely clean hands here.

Anthony Karydakis