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How do you solve a problem like the Euro?

2012-03-08 15:21

A Market Solution to End the Euro Crisis

This article appeared in an edited version in the Financial Times. It is published here with the permission of the original authors Lee Robinson and Patrick Young

Ultimately the Euro crisis remains a pressure cooker building up steam despite the protestations of the currency system being saved by multiple political interventions. Yet after a half dozen supranational attempts to instil order within the sovereign nations of the EU, the markets are clearly not listening. Instead a market solution is now needed.

Many commentators have been suggesting a Eurobond as the answer to Europe’s problems. However, given that Germany has so far rejected this option, the alternative needs to be a simple programme that rewards prudent levels of debt, while providing a space for errant sovereign states to reorganise their finances.

The best solution would be the creation of two separate tiers of Eurozone sovereign debt, senior and junior. The upper tranche would represent 30-50% of the debt to GDP limit in every nation. Given the high probability of all nations being able to service this debt tranche, these bonds ought to receive the AAA rating.

Given their voracious demand for secure fixed income, global investors would fund this at extremely low rates. Eventually this senior debt could perhaps be issued at levels even lower than current single tier German Bunds. In other words the single Euro yield curve would be secure for fiscally prudent Euro members.

The remainder of the debt above the GDP threshold would be assigned a lower rating, and consequently trade at a yield premium to the senior issues. In other words, the less fiscally prudent would also issue a second tier of debt with a lower rating.

The benefits of this type of eurozone government debt slicing would be significant. Consistent demand for the AAA tranches would provide nations with a means to fund rollover debt while they worked through their problem, with a facility to fund issues at AAA and consequently much lower rates.

The destructive cycle of funding at ever higher interest rates would also be broken, giving errant economies chance to reform. At the same time, domestic holders of debt would be free to roll over into the higher yielding bonds for a better return therefore absorbing a larger percentage of the debt deemed less sustainable.

Any future rescues of European nations would now also involve the 'super senior' top level of debt first, making interventions a more precise and surgical tool to address inconsistencies in an economy rather than simply bailing out long periods of fiscal incoherence. In other words, the stronger nations would not be bailing out recklessly issued debt above the 60% threshold. Rather they would be simply supporting the Euro pacts to maintain stability. Any debt default would be on the junior tranches first, and this will be of smaller size, theoretically creating less contagion risk and permitting a more controlled response.

There would be drawbacks from this proposal, of course. Investors could declare this a breach of contract and sue for damages, but this is a lengthy and arduous process. Rating agencies could call it a technical default, but so long as this didn’t wash with the markets it wouldn’t matter hugely: if bond values rise then the market will ignore the bluster of language, over the hard economics of cash repayments.

For all these issues, however, this proposal has a simple rationale: it would give governments a clear incentive to allocate capital more carefully, while also providing a major fiscal incentive to reduce debts below 60% of GDP.

Ultimately we need a secure basis for bond markets if the Eurozone is to survive. The impetus is for execution to start now with national governments announcing the plan and commencing the legal documentation. The initial announcement of this intent will give the governments time, making this a win-win scenario even if they ultimately fail to execute.

There is no doubt that the market’s feedback response will be swift. Ultimately the separation of debt into senior and less senior tranches may be the best option ahead of the very real threat of the Eurozone itself splitting at the seams. This plan gives solvent economies a window to reform and return to growth.
 
Lee Robinson and Patrick Young created 'The Gathering Storm', a book of essays from leading economic minds with all profits going to the Altana Charitable Trust www.altanacharitabletrust.com