Monday, 1 November 2010

Merkel ditches the PIIGS

Time to write on serious matters. Dr Frau Merkel has had enough of ill disciplined PIIGS. Her 'plan' is to revert to the tried and tested IMF recipe of default, haircuts and debt holidays so bond holders will not get all their money back and in the meantime will get no interest payments. This the Dr Frau argues will shift the risk from Germany to the bond holders. Clearly the Germans have had enough of underwriting Greek debt especially as the Greek economy seems to be going from bad to worse. Merkel is clearly driven by internal German politics but she is playing a dangerous game.

For years the market have included a significant risk premium on PIIGS debt as historically these countries have a long history of defaulting on their debt. In the last year this risk premium has blown out to over 8% for Greece. Merkel's solution institutionalises this risk premium and invites the market to only finance PIIGS debt at high rates of interest.  This undermines the whole Euro project as it leads to a two tier Euro debt market.

It is reported in the second quarter of this year foreign ownership of PIIGS debt has reduced by 5% ad by 14% for Greece. The main buyers of this debt are the national banks of the PIIGs who can use these bonds as collateral to borrow Euros from the ECB.

This is a very lucrative carry trade for these banks but leads to an increasing concentration of risk in these countries.  As always political convenient short term solutions have a long term down side. Eurozone states have to borrow €900 bn next year. Investors will be happy to buy German debt but after that not even strike torn France looks safe.

This is the real game that could destroy the EU.

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