December 9, 2011

Near-term risk to peripheral states remains
John Authers
Financial Times
Amid all the heated speculation about the European Union summit’s impact on
Europe’s economic future and Britain’s role in it, traders are asking a more mundane
question: “Has it done enough to get us through to Christmas?” Their answer:
probably not.

The eurozone crisis operates at different levels. Beyond the long-term issue of
European governments’ solvency, which the summit’s “fiscal compact” aims to
address, it also concerns liquidity; whether the funds are available now to keep
Europe’s bond and money markets working.

The sovereign crisis is also tightly linked to the European banking crisis, as
government bonds make up a large chunk of bank capital. For money markets to calm
down, they need confidence that there will be no defaults or partial “haircuts” on the
government bonds sitting on banks’ balance sheets.

Only the European Central Bank, which has the power to print money, can provide
that confidence. And, as far as the market is concerned, it has not done so.

On Thursday, Mario Draghi, the ECB’s new chairman, launched an array of measures
to ease banks’ liquidity problems, such as accepting lower-quality collateral in return
for loans.

But he made clear that while the ECB is the lender of last resort for Europe’s banks, it
is not prepared to play the same role for Europe’s governments.

Traders appear to believe that the ECB cannot backstop banks effectively unless it also
backstops governments. They were disappointed that the summit had not produced a
strong enough deal to persuade Mr Draghi to weaken his stance.

“President Draghi responded positively to the agreement, but we are unlikely to see a
step change in ECB bond purchases in the short term,” said Jens Larsen, chief
European strategist at RBC Capital Markets.

“This makes it more likely than not that Standard & Poor’s will carry out its threat to
downgrade some euro area member states in the coming days.”
Jonathan Loynes of London’s Capital Economics, who accused Mr Draghi of “clumsy
communication,” said: “The bottom line is that even our low expectations for last
week’s supposedly critical advancements in the eurozone debt crisis appear to have
been undershot.” He described further debt writedowns that would affect the private
sector as “virtually inevitable”.

The muted market moves on Friday may be misleading. The euro rose against the
dollar – but this may have been driven by banks repatriating assets.

European bank shares, while above their lows, trade at half their book value, implying
grave fears that some of their assets will be written down.

The yield on Italy’s 10-year government bond fell 30 basis points during the day to
6.32 per cent – but this is still higher than at any point in the eurozone’s history until a
month ago.

The risk remains that the market will test Mr Draghi’s resolve by attacking a
peripheral country’s debt in the two weeks before Christmas – particularly if a rating
agency provides an excuse.