Mounting Euro Breakup Danger Seen by Banks as Region’s Debt Crisis Festers

By Simon Kennedy - Nov 28, 2011 7:01 AM GMT+0700

Banks around the world are sounding their loudest warnings yet that the euro area risks unraveling unless its guardians quickly intensify efforts to beat the two- year sovereign debt crisis.

As European finance chiefs prepare to meet this week, and Italy seeks to raise as much as 8.8 billion euros ($11.7 billion) in bond sales, economists from Morgan Stanley, UBS AG, Nomura International Plc and other banks say governments and the European Central Bank must step up their crisis response. Failure to do so threatens to break the 17-nation currency bloc, they told clients in reports published over the past week.

“Markets continue to move faster than politicians,” Mansoor Mohi-uddin, Singapore-based head of foreign exchange strategy at UBS, said in a Nov. 26 note. Investors are starting to “price in the endgame” for the euro, he said.

What Deutsche Bank AG calls “a new stage of the crisis” and Nomura labels a “far more dangerous phase” is dawning as signs mount that investors are even concerned about Germany, the euro’s linchpin economy. It failed to draw bids for 35 percent of 10-year bunds sold last week and the yield on its 30-year securities had the biggest weekly gain in 14 months.

The euro suffered its longest losing streak in 18 months as Spain dropped plans to sell three-year bonds, Italy paid more to borrow for two years than for 10, Standard & Poor’s trimmed Belgium’s credit rating and Portugal’s was cut by Fitch Ratings below investment grade. The Standard & Poor 500 Index had its worst Thanksgiving week since 1932 and Canadian Finance Minister Jim Flaherty said the turmoil is creating global contagion.

Crisis Rethink

Such dangers are forcing governments to rethink their crisis fight before two days of talks starting in Brussels tomorrow and a Dec. 9 summit of leaders.

Remedies previously rejected by policy makers as unpalatable and now increasingly called necessary by economists include the ECB ramping up bond buying and governments issuing common securities in a deeper fiscal union. The debate is prompting banks including UBS and Bank of America Merrill Lynch to begin outlining the likely fallout of a euro-area collapse.

“Failure to come up with a comprehensive solution on Dec. 9 is certainly possible, and we believe that it would open up a much darker scenario that, eventually, could entail a breakup of the euro,” Joachim Fels, Morgan Stanley’s chief economist, said yesterday.

Budget Discipline

Euro-zone countries are considering creating new powers to enforce fiscal discipline, the Wall Street Journal reported Nov. 26. The proposal, which is still being crafted, would let governments reach bilateral agreements on budgets that wouldn’t take as long to complete as changes to European Union treaties, the Journal said on its website, citing unidentified people familiar with the matter. Treaty changes would follow later.

Stricter budget rules are needed if the ECB is to play its “full role” and help troubled countries, French Budget Minister Valerie Pecresse said yesterday.

Officials may also ease market-rattling provisions that require bondholders to share losses in bailouts, German Finance Minister Wolfgang Schaeuble suggested last week.

To increase its potency, the 440-billion euro European Financial Stability Facility may begin insuring bonds of troubled countries with guarantees of between 20 percent and 30 percent of each issue in light of market circumstances, according to guidelines for the finance ministers’ meeting.

IMF Options

Schaeuble told reporters that leaders will seek a “separate path” of aid from the International Monetary Fund to boost the EFSF. The IMF is also readying a 600 billion-euro loan for Italy, giving Prime Minister Mario Monti as many as 18 months to implement reforms without refinancing existing debt, La Stampa reported yesterday, without saying how it got the information.

The ECB must use the unlimited resources of its balance sheet to prevent a disintegration of the euro which “now appears probable rather than possible,” Nomura economists Desmond Supple and Jens Sondergaard said in a Nov. 25 report.

The Frankfurt-based central bank should be able to “avert a full-force financial crisis” for the rest of this year by next week cutting its benchmark rate back to a record low of 1 percent and granting longer emergency loans to banks, they said. Into 2012, they predict the ECB will follow the U.S. Federal Reserve in pursuing quantitative easing through largescale bond buying to reduce regional borrowing costs.

“This could preserve the integrity of the euro, although the risks are sizable and over the coming weeks and months the outlook for financial markets appears bleak,” said Supple and Sondergaard. “Downside economic risks are likely to build.”

Bond Buying

Having bought almost 200 billion euros in bonds to calm markets since May 2010, ECB officials have refused to accelerate the effort or stop sterilizing purchases. They argue that would risk damaging their credibility by encouraging inflation, muddy the legally-mandated divide between monetary and fiscal policies and lessen pressure on governments to restore fiscal order.

President Mario Draghi, less than a month into the job, said Nov. 18 the onus must be on governments to bolster their regional fund and that “we should not be waiting any longer.”

With only “one shot” to get it right, the ECB will await signs its price stability goal is under greater threat from economic weakness and concrete proof governments will ax their debts before it moves to cap yields with “big time” bond- buying, said Deutsche Bank chief economist Thomas Mayer.

“It’s too early to expect the ECB to jump in, but we are moving to a new climax,” Mayer said in an interview.

Euro Bonds

David Mackie, chief European economist at JPMorgan Chase & Co., said the central bank cannot provide a long-term solution, meaning governments will have to at some point start selling so- called euro bonds, he said.

German Chancellor Angela Merkel last week rejected such securities as “not needed and not appropriate” because they would “level the difference” in euro-region interest rates, reducing pressure on profligate nations to cut budgets and forcing Germany to pay more to borrow. The European Commission nevertheless last week outlined how cross-border bond sales could work together with tougher budget controls.

“The German position on euro bonds should not be viewed as a fixed point,” said Mackie.

The failure of policy makers to end the crisis is prompting economists and investors to plot what might happen if the euro- area does splinter.

The recent increase in bond yields suggest investors worry a breakup of the euro would cause the banks of Germany and other creditor countries to incur losses on their bond holdings, raising the possibility of bank recapitalizations, UBS’s Mohi- uddin said.

At Bank of America Merrill Lynch, strategists Richard Cochinos and David Grad said in a Nov. 25 report that if Germany left the bloc, the euro’s fair value against the dollar would fall 2 percent. If Italy exited, the euro’s fair value would rise 3 percent, they said.

Their report was titled: “Euro zone: Thinking the unthinkable?”

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net

To contact the editor responsible for this story: John Fraher at jfraher@bloomberg.net