Sunday, August 1, 2010

The furor in bond markets over highly-indebted southern eurozone states recalls the runs on European currencies in the 1990s before the euro was created.

European governments eventually saw off that challenge with a sustained display of political determination backed by central bank intervention.

Whether they can overcome the current panic about sover-eign default risks in the single currency area by showing political resolve - without mutual financial assistance - remains to be seen.

Today’s debt crisis is both similar and very different. It began with pressure on Greece, the country with the biggest public finance problems in the euro area, but spread last week to Portugal and, to a lesser extent, Spain.

The premium that investors demand to hold Greek bonds  narrowed on media reports  of an imminent European bail-out, or of Chinese interest in Greek debt, only to widen further on official denials.

Each strike call, parliamentary setback or glitch in routine debt management triggered a new sell-off or an increase in the price of insuring the Greek government’s debt against default.

Seasoned market watchers say the gyrations are mainly the work of short-term speculators and do not reflect a fundamental rethink about euro-denominated assets.

That speculation is easier because markets are still awash with cheap liquidity injected by the European Central Bank to avoid a credit crunch while the global financial crisis was going on.

Borrowing money from the central bank at one per cent and lending it to Greece at nearly seven per cent on sovereign bonds in solid euros ought to be a hugely attractive investment.

Yet big institutional investors are holding off, partly due to market volatility, but also because they want to see the Socialist government implement tougher public spending cuts.

“Greece in the long term is probably a good play but we have to wait for the government to see more signs on the expenditure side,” said Jorgen Christian Hansen of Danish pension fund Unipension.

“The reason Greece is getting so much atten-tion is that it is the first real test of the euro-system in handling countries with excessive debt and too lax fiscal policies,” he said.

EU governments will try to ride out the crisis without having to bail out Greece, or Portugal or Spain, by pressuring those countries to make draconian fiscal adjustments while declaring political support for them.

A single comment from Germany’s finance minister a year ago that the eurozone would have to help if a member got into a serious situation was enough to calm market fever over Ireland.

The question is whether the EU can enforce budget discipline rules on peripheral euro zone states which its core members mostly failed to respect over the last decade.