Monday, June 13, 2011

Tabled policy options vs. CDS pricing in Europe: similar but not the same

The discord in Europe across policy lines is growing. I thought it prudent to jot down a few notes regarding the different initiatives being tabled out there. The fact is, that betting on default, at this point, is essentially betting on the near-term outcome of an organic policy negotiation process. In my view, that's impossible, so market pricing cannot be predictive of the near- or even medium- term outcomes.

As illustrated above, a hard and possibly quite disorderly restructuring is being factored into credit default swap (CDS) pricing. The chart lists the 5-yr CDS-implied probability of default by included Euro area countries (a credit event that would trigger CDS payments - see 'credit event' under the ISDA glossary). The pricing is based on a 40% haircut to the bond principal, so we're talking a 'hard' debt restructuring. This may occur at some point, especially in the case of Greece, but a hard restructuring is not being negotiated at this time.

Over the near- to medium- term, policy makers are generally tabling the following options: (1) a Vienna Initiative part Deux, a type of voluntary rolling over of Periphery debt, (2) a debt swap now, and/or (3) extending Greek loans via the EFSF.

(1) Vienna Initiative part Deux. (see this working paper for information on the original meetings). This is what the ECB wants - a purely voluntary solution. It would involve (probably) an agreement among the banks and the ECB to A. not sell current Periphery (Greek) holdings, and B. buy new bonds by rolling over existing debt for a period of time (perhaps 5 years). All parties involved would be part of the negotiation process - German and Frence banks, the ECB, and Greek banks - and would involve no haircut to the Greek debt. Roubini writes of "The Nonsense of Purely 'Voluntary' Bail-Ins of Greece's Sovereign Bank Creditors".

(2)Debt Swap. This is what Schauble wants and involves more private-sector involvement up front. A debt swap would be more secure than a Vienna initiative part Deux, since the private sector exchange would occur at the outset of the agreement, rather than as the debt matures in the future. He offers that bond holders will eventually be made whole, but this option would likely trigger CDS contracts so is more contentious (see daily from Eurointelligence blog).

(3) A loan from the Euro area states via the EFSF. How big is this loan depends on (1) and (2).

Now that the economic cycle is mature, I think that policy makers finally realize that fiscal austerity only works when the following conditions are met:

A. Devaluation. Not an option in a single-currency union.
B. Strong global momentum. Has occured to date, although the pace of global economic activity is peetering out now (see Edward Hugh's report on April PMIs).
C. Loose monetary policy. There is clearly a tightening, rather than loosening, bias at the ECB.

So if a country cannot grow and pay its bills, default is likely. But voluntary debt re-profiling requires agreements among all interested parties. That seems like a stretch, given that the Heads of State (still) haven't fully resolved simpler issues at this point, like 'how' to increase the capacity of the EFSF to euro 440bn?

Rebecca Wilder


  1. welcome back, rebecca..

  2. Rebecca:
    Excellent to see you back! I'll add more considered comment later on your excellent piece.

  3. glad to see you back! is the possibility of an EU breakup part of this discussion??  aj

  4. Roubini was in the FT today takling about a breakup.

    Also he has this article on Roubini Global Economonitors website (free, no membership required to the Economonitors).

    Generally, though, when I read about the breakup situation, it's usually a medium-term possiblity, i.e., after everything else has been tried.