Danske Research Endgame

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Investment ResearchGeneral Market Conditions

The debt crisis is heading towards the end game. Mistrust has spread to Italy, Spain

and beyond. In the absence of further policy action, interest rates spreads would

probably continue to widen and the whole euro project could come to an end.

A number of feasible backstops are available, but face resistance. The German

government as well as the Bundesbank is rejecting the use of the ECB as the lender of

last resorts. It is also rejecting the idea that the ECB lends money to the IMF, which

could then provide a temporary credit line for Italy. An increase in IMF quotas is an

alternative approach, but this also faces resistance from, e.g. the US.

The two models for leveraging the EFSF presented at the euro summit a few weeks

ago were designed to alleviate the debt crisis, but have attracted very little investor

interest and seem unlikely to work unless they are made more attractive to investors.

Eurobonds that would allow government to raise funds up to a ceiling with collective

guarantees could provide a much needed pause for governments. However,

Eurobonds also face German resistance and would probably not be deployable as

quickly as needed to combat the current debt crisis.

The ECB could provide a backstop by formally announcing a cap on individual

countries yield spreads and saying that it stands ready to buy unlimited quantities of

government bonds to defend this cap. However, the ECB and not least the

Bundesbank, fear that this will remove incentives for structural reform. Therefore, in

our opinion, the ECB is not going to make such a formal announcement unless the

situation deteriorates significantly.

So, with no backstops immediately available will the debt crisis spiral completely out

of control causing government defaults and possibly a euro break-up? We do not

expect this to be the case. The ECB will not provide any formal guarantees to the

market, but that does not mean that it will stop buying.

We believe that the ECB will defend an informal cap at possibly 7% interest rates on

10-year Italian and Spanish government bonds. The ECB will be averse to it, but do it

nonetheless. This is due to the fact that until austerity measures succeed in restoring

confidence in Italy and Spain there are not many viable alternatives if the ECB wants

the euro to survive.

The ECB has so far used its Securities Market Programme (SMP) to buy peripheral

government bonds to the tune of as much as EUR200 bn. We would not be surprised

to see them spend half a trillion or more before confidence is restored. It takes a lot of

money to defend an informal cap.

22 November 2011

Important certifications and disclosures are contained from page 4.

Senior Economist

Frank land Hansen

+45 45 12 85 26

[email protected]

ResearchEuro area: ECB to defend an informal cap on rates

Debt crisis is spreading

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2 | 22 November 2011www.danskeresearch.com

Research

Potential backstops

Formal cap on interest rates

The German government as well as the Bundesbank is rejecting the use of the ECB as the

lender of last resorts, see e.g.Spiegel. As late as last Friday, the Bundesbank governor,

Jens Wiedmann, stated that, The economic costs of any form of monetary financing of

public debts and deficits outweigh its benefits so clearly that it will not help to stabilize

the current situation in any sustainable way. The ECB could provide a backstop by

formally announcing a cap on individual countries yield spread s and saying that it stands

ready to buy unlimited quantities of government bonds to defend this cap, seeWhat the

ECB could do to alleviate market stress.However, the ECB and not least the Bundesbank

fear that this will remove incentives for structural reform and for governments to provide

alternative instruments to combat the crisis. Therefore, in our opinion, the ECB is not

going to make such a formal announcement.

Yesterday, ECB Governing Council member Ewald Nowotny (Austria) said that the ECBprinting money is not an option in its simple form. It could be argued that such

statements indicate that the ECB is looking for bolder instruments. If the situation

deteriorates significantly we think that the ECB could deliver a 50 basis point emergency

rate cut and present a 24 month, long-term refinancing operation as well as stepping up its

Securities Market Programme, stopping short of announcing a formal cap.

EFSF

An alternative backstop is the European Financial Stability Facility (EFSF). At the Euro

Summit on 26 October it was agreed to leverage the EFSF, which is likely to increase its

actual lending capacity four or fivefold to around 1-1.2 trillion. However, details for the

two models for leveraging the EFSF are lacking and so far they havent attracted muchinvestor interest. In the current market the incentives provided to investors are likely to

prove too small for the models to work. Recently, we have even witnessed the EFSFs

own bond auctions themselves becoming less successful and EFSF bond spreads

widening.

Eurobonds

Another alternative is Eurobonds. The European Commission will present its proposals

for Eurobonds on Wednesday. The paper includes three options. The most ambitious is to

convert all euro area government bonds to Eurobonds with collective guarantees. The

second most ambitious would allow governments to raise funds up to a ceiling, e.g. up to

40% of GDP, using Eurobonds. Beyond that, countries would again have to issue theirown sovereign bonds. The least ambitious model is to have Eurobonds up to a ceiling

backed by limited guarantees from the 17 euro area member states. The European

Commission concludes that the least ambitious model will not demand treaty changes. If

guarantees are very limited the last option is unlikely to be a solution to the debt crisis.

According to the Wall Street Journal the European Commissions paper says that the

quality of the bonds issued under option three could be further improved by providing

collateral, such as cash or gold reserves, or earmarking tax revenues.

In our opinion, the second model has the most attractive features. It would create an

attractive Eurobond market and it would provide periphery countries with a window of a

couple of years to fix their public finances before they have to return to the market, but

incentives for reform would remain intact as they would eventually have to return to

issuing national government bonds. But for now, Eurobonds face German resistance and

will probably not be deployable as quickly as is needed to combat the current debt crisis.
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IMF

Finally, the idea that the ECB could lend money to the IMF so that it can provide a

Precautionary Lending Facility for Italy seems to be gaining some traction. The ECB is

not allowed to finance euro area governments, but it can conduct banking trans actions in

relations with third countries and international organisations, including borrowing and

lending operations. If all parties agree to this approach a deal could be presented at the

EU summit on 9 December. However, Germany and the ECB remain opposed to this idea

as well. IMF resources can also be scaled up via quota increases. This approach seems

more viable, but it also faces some resistance from the ECB and the US. Finally, the IMF

resources could be boosted by bilateral loans from countries like, e.g. China and Japan. At

the moment there is no imminent need for new IMF funds. The IMFs free resources are

currently estimated to be close to EUR400bn. However, if Italy and Spain need to be

bailed out additional IMF resources will be needed.

The ECB may defend an informal cap

So, with no new backstops immediately available, will the debt crisis spiral completelyout of control causing government defaults and possibly a euro break-up? We do not

think this will be the case. The ECB will not provide any formal guarantees to the market,

but that does not mean that it will stop buying. We believe that the ECB will defend an

informal cap at possibly 7% interest rates on 10-year Italian and Spanish government

bonds. The cap could also be set to secure rates below the 450bp margin requirement

threshold at the London Clearing House (LCH) Clearnet. This can be seen as an interim

stage until the debt crisis is solved by austerity and structural reforms and institutional

changes. The ECB may demand (at least informally) that these changes are expedited in

return for keeping an informal cap on interest rates.

Defending a formal cap would demand much smaller quantities of ECB government bond

purchases than defending an informal cap as confidence would be restored much morequickly (almost instantly) if a convincing cap is announced. If the market knows that a

formal cap is defended by the ECB, market forces would eventually help the ECB in

achieving its target, as has been the case for, e.g. Danmarks Nationalbanks fixed

exchange rate band and the Swiss National Banks announcement of a minimum

exchange rate for the CHF. But the ECB appears to be more focused on the moral hazard

problems attached to giving formal guarantees than whether this would be the cheapest

way to achieve the objective of stopping the debt crisis; so for now, we expect the ECB to

continue its purchases without announcing any formal targets. If the situation deteriorates

significantly and core countries are affected more heavily, a formal cap could eventually

be announced.

If the ECB sticks to the informal cap approach it could end up buying government bondsin very large quantities before the crisis has come to an end. The ECB has so far used its

Securities Market Programme to buy government bonds for almost EUR200bn, of which

probably as much as EUR100bn are Italian and Spanish. This is three times as much as

the covered bond programme and a bigger quantity than many observers expected that the

ECB would be willing to buy. We would not be surprised to see the ECB spend

EUR500bn or more before confidence is restored.

We expect that confidence will eventually be restored. Our debt projections show that as

long as interest rates are kept at a reasonable level Italy and Spain will remain solvent.

Thus, when confidence eventually returns the ECB could make a profit on its purchases

of Italian and Spanish government bonds. It is less clear whether the ECB will avoid a

haircut on its portfolio of Greek government bonds. The ECB is not included in thevoluntary private sector involvement (PSI), but in order to bring Greeces debt down to

sustainable levels an Official Sector involvement (OSI) programme might also be needed.


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Disclosure

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The author of the research report is Frank land Hansen, Senior Economist.

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