Euro crisis: politicians cannot bypass the market

The results of the last EU summit were labelled by politicians as the final step to resolve the eurozone debt crisis. The member states’ guarantees to the EFSF, the supranational rescue fund, have been increased and the fund was enhanced by a leverage mechanism. Both enable the EFSF to prop up its lending power to about one trillion euros. Initially, politicians and financial markets cheered the agreements.

A first leverage option could be for the EFSF to insure new bond issues of indebted countries. The fund would write a Credit Default Swap (CDS) and guarantee a certain share (e.g. 20%) of the face value in the case of a default. The second option would be to establish another fund, a special purpose vehicle, to raise additional capital from investors, namely emerging market governments or state-owned investment funds. In any case, the EFSF needs to attract investors who are willing to take on some of the risk involved.

However, this could be a problem. The EFSF had to postpone a bond issue and the last issue was very disappointing. Compared with a bond issue in January 2011, when the bond volume was nine times oversubscribed, bids of just 3.2 billion euros were received for a volume of 3 billion. Moreover, the EFSF had to offer a substantially higher interest rate of 3.6%. The spread of almost 1.8% to German government bonds was still comparatively low, but the bond issue highlights a weakness of the EFSF.

Investors, who avoid the government bonds of highly indebted countries, do not necessarily buy EFSF bonds to invest indirectly in such countries, whose weak political and economical performance and prospects do not inspire confidence. Moreover, the political uncertainty surrounding future structural reforms and budget cuts in guarantor countries such as Spain, Italyand even Francemay undermine investors’ confidence in the EFSF itself.

Clearly the euro area will not be rescued by the EFSF alone or even eurobonds. National politicians have to do their work. It is their task to undertake substantial and credible budget consolidation, together with structural reforms to make failing economies work again.