Sunday, 6 November 2011

Eurozone countries sovereign bonds are not sovereign

A sovereign bond is one that is risk free and one that can always be repaid in any circumstances. This is because for a nation state issuing a bond in its own currency it can always repay the bond by printing more of its currency. This may of course have huge inflationary consequences but there can never be a default. For this reason such bonds are given zero risk weighting in BIS bank capital adequacy calculations.

So called Eurozone sovereign bonds are thus not sovereign because they are denominated in a currency which is not controlled and thus cannot be printed by  the country issuing the bond, even Germany. This means that there can be a default and the probability of a default reflects the market's perception  of the ability of the issuing country to repay its bond debt. Thus the price, interest rate, that different countries have to pay to raise money by issuing bonds, IOUs in everyday parlance, varies from Germany at around 2% to Greece at around 20% currently.

The root of the financial malaise currently gripping the Eurozone lies in the refusal of the EU political elite for their own political agenda to acknowledge these simple facts. All Eurobonds are not equal and some are decidedly less equal than others.

Because banks, driven by BIS capital adequacy rules, are huge holders of Eurozone bonds they are highly susceptible to problems generated by this lack of sovereignty. Thus we might well soon see runs on banks known to be large holders of Greek and Italian bonds extending even to all banks in particular countries eg France. For these reasons as I write corporates are transferring funds to banks in countries like Germany and out of countries like Italy. Bankers unlike politicians are rational people who generally have to pay for their errors with their jobs. Ask Fred the shred!

I have doubts about the current Merkel panzer approach. exemplifed by the latest pronouncement designed to frighten the Italians reported by Reuters.

ECB Governing Council Member Yves Mersch said.
"If we observe that our interventions are undermined by a lack of efforts by national governments then we have to pose ourselves the problem of the incentive effect," Mersch said according to extracts of an interview with Italian daily La Stampa to be published on Sunday.
Asked if this meant the ECB would stop buying Italy's bonds if it did not adopt reforms it has promised to the European Union, Mersch, who heads Luxembourg's central bank, replied:
"If the ECB board reaches the conclusion that the conditions that led it to take a decision no longer exist, it is free to change that decision at any moment. We discuss this all the time."

Wow! Just the thing to terrify Bunga Bunga man into submission? More likely to make him a national hero standing up against the jack booted Huns!

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