With the weekend full of on-again-off-again comments from various European, Asian, and US politicians and central bankers with regard the chances of various incarnations of the EFSF solving all of our ills (or not), Nomura's Fixed Income Research team has what we feel is one of the most definitive analyses of the various options. We have discussed the self-exciting strange attractor nature of the endgame that will be a leveraged EFSF many times recently. The Nomura team, however, does a great job of breaking down various scenarios, such as Structural Weaknesses of EFSF 2.0, Proposals for an EFSF 3.0 (and their variants), Leverage-based options, and EFSF 2.0 as TARP and how these will result in one of three final outcomes: fiscal union, monetization, or major restructurings risking the end of the euro, as everyone searches for a steady state solution to the 'problem' of the eurozone.
While the most elegant solutions have no official sanction, we think the necessary political resolve is yet to be forthcoming, and the technical issues are challenging if not insurmountable for many of the legal workarounds, resulting in the need for yet another round of parliamentary approvals. Consequently, we see a significant risk that the market, looking for large headlines and enhanced flexibility, will be disappointed at least in the short run.
The search for a steady state solution
In analyzing the eurozone debt crisis, the key challenge is to assess the likely path towards a steady state solution, defined as the market no longer being concerned about future default risks on government debt – at least over a time-frame that is meaningful to immediate asset allocation decisions. We have highlighted three broad alternative steady state solutions:
1. Full fiscal union and the issuance of Eurobonds with a joint and several liability structure or at least unconditional credit risk transfers to stronger countries for a extensive period of time (for sustainability to be reestablished).
2. Aggressive policy reflation, whereby the ECB significantly expands its balance sheet and its SMP program. (Given the requirement of EU governments to recapitalize the ECB, this option ultimately begins to blend into option 1.)
3. Default and debt restructuring in selected non-core countries and possible end of the euro area.
Option 1 is not under consideration at this juncture since all forms of recent fiscal or credit transfer appear to come with strict conditionality. As for the possibility of Eurobonds, it has been dismissed by the AAA countries and the German Constitutional Court?s ruling that uncapped liabilities accruing to the German state from its participation in the EU is unconstitutional. Option 2 may be a possible solution to the crisis, albeit with drawbacks, but our economics research team does not believe that the ECB is close to accepting the significant increase in credit risk on its balance sheet and the distorting influence on its monetary policy that this option would entail. The ECB is not programmed for full-blown monetization and the bar is extremely high for any major steps in this direction. For these reasons, the possibility of further debt restructuring in selected countries has become increasingly likely and in recent weeks has underpinned investor risk allocation decisions. The consequences would depend on the ability of EU politicians to isolate other periphery countries and European banks. This may prove virtually impossible without significant credit risk transfers, so ultimately European politicians will need to pick one of the three outcomes: fiscal union, monetization or major restructurings risking the end of the euro area.