By STEPHEN FIDLER--
In a column just before Christmas, I outlined some of the dilemmas that European leaders had to confront in dealing with the euro zone's sovereign-debt crisis in 2010. A further related dilemma is how much to charge cash-strapped governments borrowing from the European Union bailout funds.It wasn't much discussed because other governments understood that high interest rates were the price for German participation in the bailouts.
The government in Berlin wanted a signal, not least to its own population, that the bailout wasn't a soft option for spendthrift governments.
The problem is that those high interest rates—Ireland is expected to pay just over 6% for its money from other EU governments, and Greece will pay similar rates—make it so much more difficult to bring down the overall debt burden to levels that are sustainable.
In Paris on Thursday, Greek President George Papandreou hinted he believed the interest rates should be lowered because Greece and its fellow troubled governments can't grow fast enough to bring down their debt burdens. "The loans themselves should...fit better to the characteristics of advanced countries which cannot experience growth rates similar to emerging economies," he said.
Economists at J.P. Morgan have calculated that Greece, by paying interest rates at current rates from the bailout vehicles and then being forced back prematurely to raise funds from the capital markets from 2013, would see its debt pushed up to 184% of economic output by 2020 from 141% now. Ireland's burden would increase to 155% from 97%. And these percentages climb thereafter.
How to escape the dilemma? In a paper published last month and explained in a conference call Thursday, the J.P. Morgan group describes a solution: Subsidize the interest rate. It is, said David Mackie, European economist at J.P. Morgan, "the lesser of the evils on offer."
The economists advocate cutting the interest rate from the rescue funds from a margin of 3.5% over Germany's borrowing costs to 1%. They say access to funds at this lower margin should be contingent on the governments following through on their budget-cutting commitments.
That would put the countries onto a potentially sustainable debt trajectory, if they continued to pursue budget austerity. Doing this would be in effect a fiscal transfer from the core of the euro zone to Greece, Ireland, Portugal and Spain until 2020 of €110 billion ($145 billion), just 2.5% of the combined gross domestic products of Germany and France. But it would be an implicit transfer, embedded in the subsidized rate, rather than a direct burden on the budgets of the core countries.
Moreover, the economists say subsidies would cost much less than direct fiscal transfers from the core governments and it would be far less costly than a default, which would cause huge damage to banks across Europe. Voluntary debt restructurings, as envisaged for insolvent countries in the post-2013 euro zone, historically don't yield big changes to debt dynamics. In the recent cases of Ukraine, Pakistan, Uruguay and the Dominican Republic, the net present value of the debt was cut by less than 20%.
Like Mr. Papandreou, the economists may be talking their own book. In line with most bank economists, they expect Portugal to have to tap the bailout funds soon; on Spain, they are not so sure because of its strong domestic investor base and current low funding costs.
According to Pavan Wadhwa, European rates strategist at J.P. Morgan, the bank is short Spanish and Portuguese bonds "in the belly of the curve." That means they will profit from declines in the price of Spanish and Portuguese bonds maturing in two to 10 years. The bank is also short Belgian and French bonds, he said.
One possible reason for this pessimism: They don't see any sign yet of interest from euro-zone governments in taking up their idea.
***
Some of the uncertainty in the euro-zone government bond markets surrounds how the transition to the post-2013 world of possible sovereign-debt restructurings will occur. "Investors are very unsure how the current regime will transition into the new regime, and how decisions about private-sector participation will be made," the J.P. Morgan economists say.There is a similar transition under consideration for the market for European bank bonds as part of the EU's efforts to find ways to remove implicit state guarantees for failed banks.
That could imply forcing holders of senior bonds in failed banks to take losses when the new bank resolution rules come into effect in 2013 or 2014. In a consultation paper Thursday, the European Commission said: "It is not envisaged to apply [debt write-downs] to any debt currently in issue."
In other words, just as euro-zone sovereign bonds currently in existence are (supposedly) not at risk of default; neither are senior European bank bonds. But at some point in 2013 and 2014 that situation could change. Cue more market uncertainty?
http://online.wsj.com/article/SB10001424052748704415104576065883297224262.html?mod=WSJEUROPE_hpp_MIDDLETopStories
