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Solvency fears persist

The European Union’s decision to establish a special purpose vehicle with funds of up to €500bn to provide loans to euro-zone countries caused an initial rise in equity markets. But while it addressed liquidity problems, there remain concerns about solvency issues.

The European Stabilisation Mechanism will provide loans guaranteed by the EU budget up to an estimated €60bn, and it will also provide lending of up to €440bn guaranteed by participating EU member states on a pro-rata basis.

The International Monetary Fund (IMF) is also expected to participate by contributiing around half of what the member states contribute, although Dominique Strauss-Kahn, IMF managing director, said its participation would be on a “country-by-country basis”, with any assistance “broadly in the proportion of our recent European arrangements”.

In addition, the European Central Bank (ECB) has agreed to intervene in the “euro area public and private debt securities market to ensure depth and liquidity in those market segments which are dysfunctional”.

Andrew Balls, head of European portfolio management at PIMCO, says the ECB is offering liquidity provision, which is different to the actions of the Bank of England and the US Federal Reserve which announced targets and bought government bonds.

“It looks more like intervention, where they are coming in to buy particularly Greek and Portuguese debt. I think there are two purposes for that. One is shock and awe - the ECB is involved in the market trying to tighten spreads. Secondly, if you were short, this allows you to cover and if you’re long and want to get out, then the ECB buying [debt] might help.”

Balls says the intervention seemed to have stopped the downward spiral triggered by the debt crisis in Greece that spread to Portugal, Spain and Italy. But he warned the stabilisation package “doesn’t do anything about solvency”.

“It might be successful in stopping the systemic problem now but it’s not obvious it’s a long-term solution. Greece, Portugal and others still have to make their adjustments and it’s very difficult to do, so the threat of restructuring risk is still there,” he adds.

Ted Scott, director of UK strategy at F&C, warns that the austerity packages that need to be implemented by affected countries could cause deep recession and possibly deflation. “This means the spectre of sovereign debt default is likely to return to haunt the markets.”
He also argued that the EU could face “fundamental restructuring” if the euro is to survive as it has “lost credibility, damaged its reputation for sound government and finance, with the result being that the sovereign debt crisis has raised the risk premium for government bonds and equities alike with the negative implications for returns”.

For pension funds and other investors, Balls says that the debt crisis and stabilisation package reinforces the importance of active management over passive.

“You have investors who might have thought of European government bonds as just a block of bonds and it doesn’t matter whether it was Greece, Germany or Spain. If you’d thought about the world like that you’ve got a nasty surprise. You may have investors that just have a passive allocation to European bonds and again they’ve suddenly realised they’ve got this big chunk of debt from southern European countries. It’s a reminder that European bonds are not all the same, because you’ve got credit risk.

“You need to make sure you do your analysis, the right country selection and that you’re getting paid for your sovereign risk, rather than just having a passive allocation. It also reinforces the importance of smart benchmarks.”

For example, Balls suggests that the problem with using market capitalisation and bond indices, is that it is “kind of a reward for failure. If a country has to issue more and more debt because their fiscal situation is deteriorating, then a passive investor or somebody who hugs the benchmark will buy more and more of this southern European debt. That should be an active decision, not something you just do because of the benchmark”.

He also suggests the stabilisation mechanism could be a forerunner of a European Monetary Fund (EMF) as the euro-zone will need better fiscal discipline and a facility to help if a country gets in trouble. But he acknowledges it is unclear how the facility will function.
 

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