Morgan Stanley’s Joachim Fels presents three reasons why last weekend’s bailout of Ireland failed and backfired:
First, markets view the average interest rate of 5.8% that Ireland will supposedly have to pay for the combined IMF/EFSM/EFSF loans, even though this is substantially lower than current market rates, as too high for a country that will struggle to generate much nominal GDP growth over the next several years.
Second, while – apart from the interest rate issue – the overall package for Ireland was in line with expectations and included a much-needed major recapitalisation and reform of the banking system, the announcements provided no clarity on other peripheral countries under selling pressure such as Portugal and Spain.
Third, and most importantly, the Eurogroup probably misjudged the impact on markets of the announcement on the future crisis resolution mechanism, the European Stability Mechanism (ESM), which will replace the temporary EFSF from 2013. By clarifying that participation of private investors in future bailouts would follow IMF rules and would be considered on a “case-by-case” basis rather than being automatic as envisaged by earlier proposals, finance ministers had hoped to calm markets. However, investors (correctly so) took the announcement as confirmation that haircuts for private debt holders would be an option if a country faces a solvency problem in the future. This implies that European government bonds will become a risky asset as they may not be redeemed at par. Moreover, the announcement that future ESM loans would be senior to private creditors’ claims (and junior only to IMF loans) implies that any haircuts for private investors would necessarily be higher than if ESM loans were pari passu with private claims, as is currently the case for EFSF loans.
And as for the ECB, Fels believes Trichet wants fiscal authorities to solve their problems themselves:
In our view, however, the ECB is further away from taking such a drastic step than markets appreciate. This is because of a deeply held view at the ECB that the sovereign debt crisis needs to be addressed first and foremost by euro area governments. ECB President Trichet emphasised this view at his hearing at the European Parliament on Tuesday, when he spoke about the need to complement the monetary union with a fiscal federation and, if memory serves us, for the first time sounded open to the idea of joint euro bond issuance.
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