EUROPEAN SOVEREIGN DEBT CRISIS:
GOVERNMENTS NEED TO GET AHEAD OF THE CURVE

The Greek debt crisis carries the serious risk of spreading to other potential weak links in the Euro area and the market reaction to the bail out plan for Greece has highlighted the persistent risk of contagion that could rapidly morph into an otherwise considerably more serious European debt crisis.

The Greek and European governments took 4 months to come out with an agreement to bail out Greece in exchange for harsh and inevitable measures of fiscal consolidation in Athens. The process has highlighted the degree of unpreparedness of governments on both sides of the table and, at this point, clearly indicates that Europe is still lacking a framework of agreement, let alone a structured program, with its attendant means, procedures and controls to address potential problems arising in other nations.

Given the long and painstaking process that has been seen in the addressing of the Greek problem it’s understandable that markets remain sceptical of the fact that the necessary initiatives to contain problems in other countries are in place. Economic agents act not only in their self interest but in times of crisis adopt defensive postures that are needed to ensure survival. Such behaviour, not speculation, explains how a problem can rapidly elicit hedging decisions to protect from risk that if widely adopted by economic agents result in serious market disruptions.

Seeing how the delay and posturing in the Greek case has allowed the problem to fester and rapidly grow, it is of the essence that now European governments rapidly demonstrate that they can come up come up not only with a framework to handle problems in other countries, even prior to agreeing on a program to strengthen their weak Stability Pact that will hopefully prevent and defuse risks from reaching such critical levels in the future.

In the absence of swift and convincing action of containment applicable to other potential trouble spots, risks will rapidly grow and reach proportions which with every single week carry a considerably higher cost of disruption.

It’s not only the solvency of embattled Governments that needs to be guaranteed in exchange for a serious effort of domestic fiscal consolidation but the potentially even larger risk that a sovereign debt problem can easily morph and threaten the whole European financial system.

Through the fluid linkage of financial markets, mayhem can erupt rapidly in on two fronts: If credit lines to Greek banks dry up they will rapidly collapse opening the second front where any European financial institution that is perceived as potentially threatened by counterparty risk will instantly see itself deprived of access to funds in the money and capital markets. As the Lehman saga in 2008 has demonstrated this situation can arise with lightning speed and lead to a potential implosion of credit markets.

So the risks, as they stand at the present moment, any not limited to the contagion of the sovereign crisis to Portugal, Spain and eventually other dominoes. The ultimate greater risk comes from the exposure of the European financial system to the morphing of the sovereign problem into one of perceived counterparty risk which could swiftly induce a freeze in credit markets and a potential collapse of the banking system.

The swiftness of the response to the problem, by providing a European framework to handle crisis in other countries at risk, will define the cost of the program and ultimately the extent of the potential damage and the ability to contain it to the sovereign debt sphere and avoid contagion into the wider credit markets.

The exposed countries need to show a realistic recognition of the gravity of the situation they let themselves into and their ability to implement a stringent program of fiscal consolidation.

European governments and institutions are nevertheless the only instances with the capacity to master the festering of the crisis. This requires that the bail out agreement for Greece needs to be seen evolving into a comprehensive program to provide loans extensible to other exposed members of the Euro area that may need to ask for assistance. At the same time the European Central Bank will need to extend its acceptance of Greek sovereign debt irrespective of its rating to that of other vulnerable countries. Delaying such initiatives in the face of widening spreads in the market will carry a cost and may subsequently require some form of guarantee for sovereign debt solvency. If the crisis is allowed to spread beyond the sovereign realm and affect the banking system, an even larger response may be required in the form of credit lines to the banking system and eventually the provision of temporary unlimited liquidity to systemically critical institutions facing an eventual disruption of their funding sources.

Confidence is the implicit foundation from which is built a fiduciary system. The larger the damage to confidence is allowed, the greater the cost of containment. Governments need to get ahead of the curve.

Antonio Ferreira
May 5th 2010