Why The ECB And The Rescue Funds Cannot Prevent A EMU Breakup

by: Colin Lokey

It is worth noting, for those who believe that Europe will continue to 'muddle through' its crisis and the world will escape this debacle without experiencing a systemic shock, that there simply is not enough water out there in terms of loss absorbing capacity to put out the fire. For instance, a new report from Credit Suisse (NYSE:CS) reminds investors that while the official number for the European Stability Mechanism's (ESM) capacity is 500 billion euros, that number must be reduced by a fifth to account for amounts already earmarked for existing bailouts. Note the irony here: the bailout fund is borrowing from the future just like the indebted nations and citizens it is meant to rescue. Once it reaches full capacity (all contributors have paid all installments) the fund will have just around 400 billion euros which Credit Suisse figures is enough to bailout Spain (and only Spain) for just one year.

Of course in reality, Spain isn't the only country in trouble. Italy too has come close to losing access to bond markets several times over the course of the last year and could require an amount larger than Spain to stabilize it. Additionally, Citi (NYSE:C) recently forecast Portugal will need another restructuring and Greece's contention that it only needs 'more time' ignores the well-known fact reiterated last week by Germany's economy and finance ministers "that time is always money".

Interestingly enough, Ray Dalio's Bridgewater Associates estimated the combined cost of these problems last month. They determined that the total would be around 1.5 trillion euros, or, 650 billion more than the ESM, the EFSF, and a hypothetical 150 billion euros from the IMF combined.

As such, the only way to make all of this work, is for the ECB to provide most of the firepower by buying short-end bonds in the secondary market. The bailout funds, on the other hand, will make purchases in the primary market. Supposedly, this will kill two birds with one stone: it will allow the ECB to dodge accusations that it is engaging in the financing of governments and, because the primary market purchases by the rescue funds must be accompanied by a Memorandum of Understanding (MOU), it will ensure that the beneficiaries are implementing the necessary reforms to return their countries to fiscal sustainability.

In short then, the ECB's role in this operation is essentially to ensure that the whole thing doesn't fall apart by using its balance sheet to intimidate the market. The rescue funds' role on the other hand, is to ensure that the participating countries' keep their commitments by virtue of the MOUs (the rescue funds cannot effectively ensure that yields remain subdued because the market knows that their purchasing power is limited to their treaty-established capacity). The problem here is that neither the ECB nor the rescue funds can guarantee that they can hold up their end of the bargain.

As for the ECB, the notion seems to be that simply by announcing a rate cap or a target range for rates, market participants will not test its resolve. The first problem with this is that, as Daiwa Capital Markets notes, unless the ECB intends to assert that periphery debt is no more risky than core debt, it will have to

"...give its view on what risk premia should be priced into government bonds - effectively telling the market what the "correct" level of risk (and hence default probability) is for each country."

Furthermore, should a country fail -- in the ECB's eyes -- to implement the necessary measures to lower its deficit, debt-to-GDP ratio, etc, the ECB would be forced to either admit that the risk premia it estimated to be appropriate for that country are in fact set, not subject to revision, and thus not in anyway anchored in reality, or else reset the target range for that country's risk premia based on economic realities which could indicate to the market when and to what extent the ECB is losing confidence in that country. Clearly, neither of these are desirable options.

In reality however, even if the ECB could communicate what the appropriate risk premia are for each eurozone country, the market will of course test the central bank's resolve. In this event, the ECB will have to defend the caps and this would require that the central bank admit of no limit to its willingness to expand its balance sheet. This, as I have argued before, is moral hazard at its worst.

The odds then, seem stacked against the ECB's ability to control where yields on periphery debt go. It is equally unlikely that the MOUs countries sign in order to activate the rescue funds will be incentive enough to ensure that economic reforms are implemented in a timely fashion and to the agreed upon extent. Indeed, reality may make compliance impossible. If data out of Spain on Tuesday is any indication, any attempts to predict the extent to which the periphery can meet targets are doomed to failure: Spain saw private sector deposits fall by nearly 5% in July alone while a forecasted 1% annual decline in GDP was revised up by 30% to 1.3% annually, and, to top it all off, Catalonia, which represents 20% of Spain's economy has requested a 5 billion euro government bailout.

Given this, it seems likely that beneficiaries of rescue fund bond purchases will likely not be able to guarantee that the conditions attached to such aid will be met. The failure of an aid-receiving country to meet its obligations would put the rescue funds and the ECB in an awkward position: either they can cut their noses off to spite their faces and cease to purchase that country's debt causing yields to spiral higher, or they can undercut their own credibility and admit that the conditions never mattered in the first place.

All in all, there simply is no version of this plan that is going to work. Eventually, someone is going to default and exit the euro as it will become impossible for the ECB to stay within its mandate and keep the currency union intact. Investors should now begin to consider that Greece may not be the first or the only country to exit. I have yet to hear a convincing argument for how this situation could possibly end without the system suffering a significant shock. I recommend staying very conservative with long puts or short positions on/in equity indices (SPY, FEZ, QQQ, EWI, EWP, EWG) and long positions in gold (NYSEARCA:GLD) and volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.