There’s some quirky strategy going on in Europe when it comes to a sovereign asking for help due to the financial crisis. It reminds me of the famous scene in “Blazing Saddles” when the bad guys are hiring bad guys to do bad things and giving them sheriff badges. Readers of the BU know we’ve been discussing why Spain has not been forthcoming to request a formal bailout that would allow the EFSF to purchase Spanish debt. Today in the FT, former ECB member Lorenzo Bini Smaghi gives his succinct explanation for why countries are reluctant for the assistance.
“The first is political. By asking for external support a government implicitly recognises its incapacity to act autonomously. It has to accept the terms of an adjustment programme designed by a supranational institution and monitored by a group of inspectors (the Troika) that visits regularly. All these constraints impose a domestic political cost on the government…..The second factor is financial. When countries request financial assistance, interest rates on government bonds often rise. The preferred creditor status of the funds provided by supranational institutions discourage private creditors. As a result, the country’s access to financial markets remains impaired for a relatively long time.”
Smaghi gets it right on, but wrongly suggests that the “ECB’s readiness to intervene in the short end of the market to improve the transmission mechanism of monetary policy should reduce uncertainty and avoid the self-fulfilling, destabilising behaviour of financial markets, once a country implements the agreed programme.” The Draghi Torcere , or twist, is creating a classic unintended consequence of shortening duration for Spain. The central bank indicating that it will buy short-term debt has been greatly beneficial in driving down short-term Spanish rates. However, this incents Spain to issue short-term debt and reduces the duration of the over-all debt. As a matter of fact, this process was already occurring as 10 year rates soared. Bloomberg reports that the average maturity of Spanish debt is the shortest since 2004 as Spain, like Italy, hasn’t issued 15- or 30-year bonds all year.
Why is this an issue? While Spain has been able to refinance 72% of their needs this year already, the government will increasingly be dependent on short-term issuance in the future. This translates into Spain coming back to the market more frequently to roll-over short debt versus issuing longer-term debt. Further, this frequency gives the markets more opportunities to assess the credit quality of the sovereign and vote with its feet should it not like the latest proposals to deal with the fiscal problems. One can envision a time in the not too distant future that neither Spain nor Italy finds the long end of the curve receptive to their issuance and the negative cycle is reinforced.
The irony is that the one entity that could buy long-term debt can only do so if Spain or Italy requested it. Yes, the EFSF or ESM would tackle the problem by purchasing the bonds with the requisite strings attached. The ECB is correct in wanting to only have short-term exposure to Spain and then allowing the more political bailout fund take the bonds and longer exposure. With Spain adamant that they will not need a full bailout or will only ask for assistance with no “programme” attached to it, the European debt crisis appears to be heading to a dangerous place. Unlike Blazing Saddles, the bad guys in this movie need the badges.
