Euro zone bond frenzy echoes past battles

PARIS Reuters Paul Taylor

The feeding frenzy in bond markets over highly-indebted southern euro zone 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 to defend the European Monetary System.

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

Then as now, traders made money by probing perceived weak links in the EU, forcing the Italian lira and the British pound out of the Exchange Rate Mechanism in 1992 and repeatedly attacking the French franc.

Then as now, there were accusations that the attacks were driven by "Anglo-Saxon" speculators hostile to European monetary union. Markets went wild on Friday afternoon rumours of secret weekend meetings of European finance officials. After a four-year battle that began in 1992 when Denmark rejected the Maastricht treaty in a referendum, political will eventually prevailed over market forces.

The last great challenge to the franc-deutschemark exchange rate at the heart of the ERM was repelled in 1995 once new French President Jacques Chirac had made clear his determination to pursue orthodox fiscal policies. Today's debt crisis is both similar and very different. The mounting market frenzy feels eerily familiar.

It began with pressure on Greece, the country with the biggest public finance problems in the 16-nation euro area, but spread last week to Portugal and, to a lesser extent, Spain. The premium that investors demand to hold Greek bonds rather than benchmark German Bunds narrowed on media reports or rumours 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 sovereign debt against default on the highly speculative credit default swaps (CDS) market.

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. "We don't see any fundamental moves at all. It's purely speculative," said Patrick Smith, senior investment manager at Santander Asset Management. That speculation is easier because markets are still awash with cheap liquidity injected by the European Central Bank to avert a credit crunch during the financial crisis.

Borrowing money from the central bank at 1 percent and lending it to Greece at nearly 7 percent 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 attention 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 euro zone 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. Compounding the problem, those countries have lost economic competitiveness, and austerity will further slow their recovery from recession. Euro zone countries cannot devalue their way out of trouble.

The alternatives for Greece are to make painful and politically risky cuts in public spending, to seek abail-out or to default. Athens has to refinance 54 billion euros in public debt this year, 20 billion of it in the second quarter. It faces a crunch at the end of the year if Moody's joins two other credit ratings agencies in downgrading Greek debt below A grade.

Unless the ECB changes its mind, that would cut Greek banks off from central bank refinancing operations by disqualifying their government bonds as collateral. Analysts say that would trigger a chain reaction of bank defaults.

Outgoing EU Monetary Affairs Commissioner Joaquin Almunia shrugged off such disaster scenarios in a Jan. 29 Reuters interview, underlining to the fickleness of financial markets.

You know the markets," he said. "On other occasions, they became nervous one day and receded a week afterwards. I'm sure they'll find something bigger to worry about soon."