The EU's New Tool To Solve Crises Is Actually Causing One


The European Union has agreed to a new crisis resolution mechanism that will allow states to default within the eurozone.

The impact has been a significant widening of credit spreads between the PIIGS and Germany, even though the details are not yet finalised.

Morgan Stanley doesn’t think this is because markets have yet to price in the costs of the potential 2013 haircuts. In fact, they think this is already priced in.

But, the problem of extension of bond repayments does worry Morgan Stanley. Under the new rules, if countries were to restructure their debt in 2013, the could extend the maturity of current debts.

This hits bondholders, and may be triggering some of the current uncertainty in the PIIGS which has led to spiking yields and spreads in Ireland.

And, oh, about this new set of rules being adequately priced in? Actually markets have no clue how to price this sort of stuff.

From Morgan Stanley:

Whether or not enlisting bond market discipline as an additional plank to safeguard fiscal sustainability in the euro area will work depends on whether bond markets price default risks efficiently. Unfortunately, the EM experience shows that bond markets overestimate the risk of default considerably and that they are subject to serious contagion.

That might go someway towards explaining the increase in CDS prices for Ireland, Portugal, and and Greece in recent days.

Here’s Niall Ferguson’s complete explanation of sovereign debt crises >

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