Investment Research General Market Conditions

22 November 2011

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Euro area: ECB to defend an informal cap on rates
The debt crisis is heading towards the end game. Mistrust has spread to Italy, Spain and beyond. In the absence of further policy action, interest rates spreads would probably continue to widen and the whole euro project could come to an end. A number of feasible backstops are available, but face resistance. The German government as well as the Bundesbank is rejecting the use of the ECB as the lender of last resorts. It is also rejecting the idea that the ECB lends money to the IMF, which could then provide a temporary credit line for Italy. An increase in IMF quotas is an alternative approach, but this also faces resistance from, e.g. the US. The two models for leveraging the EFSF presented at the euro summit a few weeks ago were designed to alleviate the debt crisis, but have attracted very little investor interest and seem unlikely to work unless they are made more attractive to investors. Eurobonds that would allow government to raise funds up to a ceiling with collective guarantees could provide a much needed pause for governments. However, Eurobonds also face German resistance and would probably not be deployable as quickly as needed to combat the current debt crisis. The ECB could provide a backstop by formally announcing a cap on individual countries yield spreads and saying that it stands ready to buy unlimited quantities of government bonds to defend this cap. However, the ECB and not least the Bundesbank, fear that this will remove incentives for structural reform. Therefore, in our opinion, the ECB is not going to make such a formal announcement unless the situation deteriorates significantly. So, with no backstops immediately available will the debt crisis spiral completely out of control causing government defaults and possibly a euro break-up? We do not expect this to be the case. The ECB will not provide any formal guarantees to the market, but that does not mean that it will stop buying. We believe that the ECB will defend an informal cap at possibly 7% interest rates on 10-year Italian and Spanish government bonds. The ECB will be averse to it, but do it nonetheless. This is due to the fact that until austerity measures succeed in restoring confidence in Italy and Spain there are not many viable alternatives if the ECB wants the euro to survive. The ECB has so far used its Securities Market Programme (SMP) to buy peripheral government bonds to the tune of as much as EUR200 bn. We would not be surprised to see them spend half a trillion or more before confidence is restored. It takes a lot of money to defend an informal cap.
Debt crisis is spreading
8 %, 10-year yield 7 6 5 4 3 2 1 jan Germany apr jul 10 okt jan apr jul 11 okt France Spain Italy 8 7 6 5 4 3 2 1

Source: Reuters Ecowin and Danske Markets

ECBs securities market programme

275 EUR bn 250 225 200 175 150 125 100 75 50 25 EUR bn << Asset purchases (covered+government bonds) ECB purchases, per week >> 22,5 20,0 17,5 15,0 12,5 10,0 7,5 5,0 2,5 0,0 -2,5

Securities Market programme

w1 w7 w14 w22 w30 w38 w46 w1 w7 w14 w22 w30 w38 10 11

Source: Reuters Ecowin and Danske Markets

Senior Economist Frank land Hansen +45 45 12 85 26 franh@danskebank.dk

Important certifications and disclosures are contained from page 4. www.danskeresearch.com

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Potential backstops
Formal cap on interest rates
The German government as well as the Bundesbank is rejecting the use of the ECB as the lender of last resorts, see e.g. Spiegel. As late as last Friday, the Bundesbank governor, Jens Wiedmann, stated that, The economic costs of any form of monetary financing of public debts and deficits outweigh its benefits so clearly that it will not help to stabilize the current situation in any sustainable way. The ECB could provide a backstop by formally announcing a cap on individual countries yield spreads and saying that it stands ready to buy unlimited quantities of government bonds to defend this cap, see What the ECB could do to alleviate market stress. However, the ECB and not least the Bundesbank fear that this will remove incentives for structural reform and for governments to provide alternative instruments to combat the crisis. Therefore, in our opinion, the ECB is not going to make such a formal announcement. Yesterday, ECB Governing Council member Ewald Nowotny (Austria) said that the ECB printing money is not an option in its simple form. It could be argued that such statements indicate that the ECB is looking for bolder instruments. If the situation deteriorates significantly we think that the ECB could deliver a 50 basis point emergency rate cut and present a 24 month, long-term refinancing operation as well as stepping up its Securities Market Programme, stopping short of announcing a formal cap.

EFSF
An alternative backstop is the European Financial Stability Facility (EFSF). At the Euro Summit on 26 October it was agreed to leverage the EFSF, which is likely to increase its actual lending capacity four or fivefold to around 1-1.2 trillion. However, details for the two models for leveraging the EFSF are lacking and so far they havent attracted much investor interest. In the current market the incentives provided to investors are likely to prove too small for the models to work. Recently, we have even witnessed the EFSFs own bond auctions themselves becoming less successful and EFSF bond spreads widening.

Eurobonds
Another alternative is Eurobonds. The European Commission will present its proposals for Eurobonds on Wednesday. The paper includes three options. The most ambitious is to convert all euro area government bonds to Eurobonds with collective guarantees. The second most ambitious would allow governments to raise funds up to a ceiling, e.g. up to 40% of GDP, using Eurobonds. Beyond that, countries would again have to issue their own sovereign bonds. The least ambitious model is to have Eurobonds up to a ceiling backed by limited guarantees from the 17 euro area member states. The European Commission concludes that the least ambitious model will not demand treaty changes. If guarantees are very limited the last option is unlikely to be a solution to the debt crisis. According to the Wall Street Journal the European Commissions paper says that the quality of the bonds issued under option three could be further improved by providing collateral, such as cash or gold reserves, or earmarking tax revenues. In our opinion, the second model has the most attractive features. It would create an attractive Eurobond market and it would provide periphery countries with a window of a couple of years to fix their public finances before they have to return to the market, but incentives for reform would remain intact as they would eventually have to return to issuing national government bonds. But for now, Eurobonds face German resistance and will probably not be deployable as quickly as is needed to combat the current debt crisis.

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IMF
Finally, the idea that the ECB could lend money to the IMF so that it can provide a Precautionary Lending Facility for Italy seems to be gaining some traction. The ECB is not allowed to finance euro area governments, but it can conduct banking transactions in relations with third countries and international organisations, including borrowing and lending operations. If all parties agree to this approach a deal could be presented at the EU summit on 9 December. However, Germany and the ECB remain opposed to this idea as well. IMF resources can also be scaled up via quota increases. This approach seems more viable, but it also faces some resistance from the ECB and the US. Finally, the IMF resources could be boosted by bilateral loans from countries like, e.g. China and Japan. At the moment there is no imminent need for new IMF funds. The IMFs free resources are currently estimated to be close to EUR400bn. However, if Italy and Spain need to be bailed out additional IMF resources will be needed.

The ECB may defend an informal cap

So, with no new backstops immediately available, will the debt crisis spiral completely out of control causing government defaults and possibly a euro break-up? We do not think this will be the case. The ECB will not provide any formal guarantees to the market, but that does not mean that it will stop buying. We believe that the ECB will defend an informal cap at possibly 7% interest rates on 10-year Italian and Spanish government bonds. The cap could also be set to secure rates below the 450bp margin requirement threshold at the London Clearing House (LCH) Clearnet. This can be seen as an interim stage until the debt crisis is solved by austerity and structural reforms and institutional changes. The ECB may demand (at least informally) that these changes are expedited in return for keeping an informal cap on interest rates. Defending a formal cap would demand much smaller quantities of ECB government bond purchases than defending an informal cap as confidence would be restored much more quickly (almost instantly) if a convincing cap is announced. If the market knows that a formal cap is defended by the ECB, market forces would eventually help the ECB in achieving its target, as has been the case for, e.g. Danmarks Nationalbanks fixed exchange rate band and the Swiss National Banks announcement of a minimum exchange rate for the CHF. But the ECB appears to be more focused on the moral hazard problems attached to giving formal guarantees than whether this would be the cheapest way to achieve the objective of stopping the debt crisis; so for now, we expect the ECB to continue its purchases without announcing any formal targets. If the situation deteriorates significantly and core countries are affected more heavily, a formal cap could eventually be announced. If the ECB sticks to the informal cap approach it could end up buying government bonds in very large quantities before the crisis has come to an end. The ECB has so far used its Securities Market Programme to buy government bonds for almost EUR200bn, of which probably as much as EUR100bn are Italian and Spanish. This is three times as much as the covered bond programme and a bigger quantity than many observers expected that the ECB would be willing to buy. We would not be surprised to see the ECB spend EUR500bn or more before confidence is restored. We expect that confidence will eventually be restored. Our debt projections show that as long as interest rates are kept at a reasonable level Italy and Spain will remain solvent. Thus, when confidence eventually returns the ECB could make a profit on its purchases of Italian and Spanish government bonds. It is less clear whether the ECB will avoid a haircut on its portfolio of Greek government bonds. The ECB is not included in the voluntary private sector involvement (PSI), but in order to bring Greeces debt down to sustainable levels an Official Sector involvement (OSI) programme might also be needed.

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