Eurozone facing fresh wave of sovereign defaults and bank failures

By Ambrose Evans-Pritchard – Telegraph.co.uk December 22, 2010

Professor Willem Buiter, the bank’s chief economist and a former UK rate-setter, said the eurozone is paralysed by a “game of chicken” between the European Central Bank and EMU governments in charge of fiscal policy.

Both sides are trying to shift responsibility onto the other for shoring up Southern Europe and Ireland, raising the risk of widening contagion. “The market is not going to wait until March for the EU authorities to get their act together. We could have several sovereign states and banks going under. They are being far too casual.” he said.

“This is a combined sovereign and banking crisis and that is a poisonous cocktail. The policy response has been woefully inadequate. There is a very small pot of money for a very big crisis,” said Dr Buiter.

Dr Buiter described the EU’s rescue fund as an “insolvency machine” because it charges punitive rates of 6pc, preventing high-debt countries from clawing their way out of their trap. “I don’t know why they bothered to create it,” he said.

Mark Schofield, Citigroup’s global head of interest rate strategy, said Portugal will need an EU rescue soon and that it is “highly likely that Spain will go the same way”. This risks over-powering the €440bn bail-out fund.

“Restructuring of some sovereign debt is inevitable. There is a chance that Spain could still make it, but the debt trajectory looks unsustainable if a broader EU-wide solution isn’t found,” he said.

Bob Diamond, the next chief executive of Barclays, echoed fears of further eurozone ructions. He told Jeff Randall at Sky News that there is a “distinct possibility’ that one or more countries will be forced out of the euro, though the rest of EMU will hold together.

Moody’s warned that it may downgrade Portugal’s A1 rating by one or two notches on growth worries, but said the country’s solvency is “not in question”.

Europe’s leaders vowed to do “whatever it takes” to save monetary union at last week’s summit but offered no plan. They ruled out an increase in the bail-out fund, or the creation of eurobonds.

Dr Buiter said the ECB has an “intangible asset” of €2 trillion to €4 trillion from its powers to create money and could intervene on much a larger scale if it wished, but this would blur the lines of monetary and fiscal policy. It is anathema to Germany.

“German politicians view the monetisation of sovereign debt as the road to Weimar. They expect the ECB to be the heir to the Bundesbank and not the Reichsbank,” he said. The ECB insists that its bond purchases are “sterilised” – meaning that they do not add stimulus or constitute quantitative easing – but this is a disputed point.

Dr Buiter said most of the Western world faces a fiscal crisis. Japan’s debt dynamics are at the tipping point where debt issuance exceeds domestic savings, forcing it to turn to foreign investors for funding. “Who is going to buy the bonds of a country with debt of 220pc of GDP at risk-free rate 1¼pc,” he asked.

The United States is as heavily indebted as any country in Europe, leaving it highly vulnerable if the yields on US Treasuries rise further. “US public debt is already 93pc of GDP but if you include the debts of Fannie and Freddie [the mortgage giants] it is 130pc, which is exactly the same as Greece. Slam on another percentage point in yields and it will hurt,” he said.

“It is just a question of time before the market turns on the US as well. It will be the last of the Mohicans to be gathered up, and that will leave only Norway.”

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