That’s not a bazooka…

*This* is a bazooka.

Not a €2,000bn bazooka… a €5,000bn bazooka to repair the eurozone, according to Peter Boone and Simon Johnson, writing for the Peterson Institute where they are both fellows. In fact, somewhere between €2,000bn and €2,500bn is a good scenario, they argue; their base scenario is €2,800bn.

The assumptions in their scenarios are not terribly hard to believe, despite improvements in Spanish and Italian bonds yields, US money market funds creeping back into eurozone debt, and exuberance (umm…) about the next LTRO.

The pair say that investors and European policymakers have only recently begun to appreciate that the European sovereign will no longer be considered risk-free investments, but rather subordinated claims on recessionary economies.

Since the first official acknowledgement that Greece’s debt would need to be restructured, in July, and the subsequent negotiations for private sector bondholder haircuts which began in October, they write, the following clauses have been effectively inserted into all European sovereign bonds:

In the event that the issuing sovereign cannot adequately finance itself in markets at reasonable interest rates, and if a sufficient plurality of the EU Council of Ministers/Eurogroup/ECB/IMF/the Issuer determine it is economically or politically expedient, then this bond may be restructured.

And the other ‘new clause’:

In the event of default (i) any non-official bond holder is junior to all official creditors and (ii) the issuer reserves the right to change law as needed to negate any rights of the nonofficial bond holder

Okay, we’ve heard of this before. But Boone and Johnson seem to feel this shift has not really sunk in. Yields will remain elevated, therefore debt:GDP ratios will remain more challenging, and without the opportunity to adjust through currency devaluations, this leaves sharp cuts to budgets and reductions in wages and prices as the only route to a sustainable debt profile.

Any successful program must recognize the fact that appetite for periphery debt amongst investors will not recover to “precrisis” levels, because default risk is now a reality that was not foreseen prior to 2009 and because debt stocks are now higher in the periphery.

Scanning the disappointing GDP (or GNP in the case of Ireland) outlook for the peripheral eurozone economies, coupled with the similarly dire direction of recent purchasing managers’ index surveys, and little reduction in unit labour costs, investors must realise that there is a serious risk of default, write Boone and Johnson.

And this means the bazooka needs to be really, really big.

Some analysts are now calling for a massive ECB-led bailout to arrest sovereign risk and stop this dangerous trend. The general hope is that, if the ECB offered to massively finance the periphery, investors would return to buying those sovereign and bank bonds. Lower interest rates would give breathing space for sovereigns to correct budget deficits and banks to build capital. To see how feasible this is, first consider the sums required. Any bailout would need to unequivocally convince investors that for several years these nations will simply not see serious financial problems. This means the bailout would need to have enough funds to buy up a large portion of the existing stock of “risky sovereign debts” plus finance those nations for, say, five years. The bailout must buy the debt, rather than simply refinance debt rollovers, since otherwise secondary market interest rates would stay high. The secondary market rates will determine the lending capacity of local banks and their creditworthiness.

That is, the bazooka levels being talked about are barely in the ballpark:

Bazooka scenarios - Boone & Johnson - Peterson Institute

These are the scenarios for each bar:

The second bar of figure 6 shows the sums required to purchase 75 percent of the outstanding government debts of the troubled nations (leaving aside debt owed to official lenders),plus finance their deficits over five years. In this base case we assume troika programs are implemented and deficits decline gradually over five years. The total adds to €2.8 trillion, or 29 percent of euro area GDP.

In the first bar we assume a more rapid reduction in budget deficits, so that by 2016 most nations are near balance.

In the third bar we assume only a modest improvement on 2011 budget deficit levels.

The last bar illustrates the dangerous risk facing the euro area if a “bazooka” is employed and yet the troika programs fail to restore growth and improve budgets. Here we assume budget deficits decline only modestly, and we calculate the financing needed to cover deficits until 2020. Our negative outcome implies nearly €5 trillion would be needed just for GIIPS, something the IMF implicitly flagged when they reported recently that Greece alone may need €500 billion (one half trillion) by 2020.

Boone and Johnson do not like this mega-bazooka, nor do they think it’s likely to happen.

Their preferred way of returning the GIIPS countries to solvency, would be a combination of a pre-emptive debt restructuring and a more aggressive programme to reduce deficits and improve competitiveness. Neither, however, look very likely.

And the failure to do so could result in all kinds of messy scenarios — the most likely of which, they say, is that investors simply lose patience and flee the eurozone, pushing even Germany’s borrowing costs up sharply.

This in turn would create havoc in the euro swap market:

The euro swap market is based, in part, on interest rates charged by 44 banks in a range of countries; about half of these banks may be considered to be located in troubled or potentially troubled countries. If the euro swap market comes under pressure or ceases to function, this would have major implications for the funding of all European sovereigns—including those that are a relatively good credit risk.

And in that case, the commitment of European political leaders to keep the euro together may not be enough:

At the least, we expect several more sovereign defaults and multiple further crises to plague Europe in the next several years. There is simply too much debt, and adjustment programs are too slow to prevent it. But this prediction implies that the long-term social costs, including unemployment and recessions rather than growth, attributable to this currency union are serious. Sometimes it is easier to make these adjustments through flexible exchange rates, and we certainly would have seen more rapid recovery if peripheral nations had the leeway to use exchange rates.

Related links:
IMF Seeks $500bn More to Lend as It Plans to Cut Growth Forecasts – NYT
The catastrophe of failure does not ensure success – FT Alphaville
Disorderly default, almost as bad as civil war – FT Alphaville

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