As the world slowly seems to be recovering from one crisis, some countries seem to be heading for yet another precipice. Greece, the only EU country that was denied the right to enter the Eurozone at its birth, is wreaking havoc on the currency now. Though undoubtedly a mixture of poor budgeting and heavy government spending play their part in the Greek drama, a more palatable alternative explanation has been bandied around – that the economies of debt-laden member states are prey to speculators on Wall Street and in London.
The crisis unfurled quickly. Early this year, fears of a sovereign debt crisis developed concerning Eurozone countries such as Greece, Spain, Ireland, and Portugal. This led to a crisis of confidence as well as the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other Eurozone members, specifically Germany and France.
At the beginning of February, a Ä500m government bond auction in Portugal only successfully raised Ä300m, raising the cost of insuring against a Portuguese debt default. The failed Portuguese bond auction further intensified the fear that the emerging sovereign debt issues could become a global contagion. These fears led to a weakening of the euro and a widespread global stock and commodity sell off.
Since then, Greece has been the focal point of the crisis. The country’s government debt was estimated at Ä216bn in January and its budget gap, at 12.7 percent of GDP, is the EU’s biggest and is more than four times EU limits. A market frenzy has seen traders make bets worth billions of dollars against the euro and on the chances of Greece not repaying its massive debts. Those market worries have undermined the 16-country currency and spilled over to other vulnerable states such as Spain and hiked their borrowing costs. Eurozone leaders have blamed speculators in London and New York for worsening Europe’s government debt crisis.
At the beginning of March the Greek government outlined measures to save Ä4.8bn, including higher fuel, tobacco and sales taxes, as it seeks to lop four percentage points off the budget deficit. The EU has sought to restore stability by boldly announcing that the country is “on track” to achieve its deficit-cutting goals following the passage of extra austerity measures. The new measures put Greece “onto the path of fiscal adjustment for 2012 below three percent” of GDP, according to the EU’s Economic and Monetary Affairs Commissioner Olli Rehn.
Stepping in
José Manuel Barroso, European Commission president, has promised to examine whether legislative action is needed to limit trade in complex financial instruments such as credit default swaps amid concern that international speculators have made Greece’s financial problems worse.
Addressing the European Parliament in Strasbourg on March 9, Barroso said: “If it is true that the current problems in Greece were not caused by speculation on the financial markets, it is also true that this speculation was an aggravating factor.” He added that there was a need for “ad hoc reflection” on credit default swaps on sovereign debt.
Credit default swaps are a form of insurance for buyers to protect them against the risk that a seller or borrower would default on a security such as a government bond. In “naked” sales, the buyer does not hold the underlying asset and faces no such risk – but can make a profit on the swap itself.
The Greek government has blamed hedge funds for driving up its borrowing costs by speculating on such swaps on its government bonds. Prime Minister George Papandreou has compared the practice of selling naked credit default swaps to buying insurance on a neighbour’s house and then burning it down to collect.
At the time of Barroso’s announcement, he was in Washington to meet with President Obama. “Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” Papandreou said in a speech in Washington ahead of the meeting.
Barroso said the problem of “naked” practices “needs particular attention”. The Commission would therefore “examine closely” the relevance of banning purely speculative naked sales on credit default swaps of sovereign debt, Barroso said. He added that there must be co-ordination to ensure that member states take action together, as well as the need for international co-ordination.
“These markets are as mobile as they are opaque,” Barroso said, adding that the Commission would raise the issue with international partners in the G20 group later this year. He said there should be an “in-depth analysis” of the credit default swaps markets to see if “questionable practices” were taking place. If all else fails, he promised to put antitrust regulators on the case who could examine if dealers formed an illegal cartel in agreeing to place coordinated bets against the euro.
Barroso said that the Commission had started an action programme to ensure an “efficient, safe and solid” derivative market back in 2009. A lack of transparency on derivative markets is generally regarded to be one of the contributing factors to the financial crisis as many derivative contracts were not traded on authorised exchanges but among financial markets players. When problems occurred there was no central clearing house to resolve disputes and establish a fair value for investments.
Barroso said that Michel Barnier, European commissioner for the internal market, would present a proposal on derivatives before the summer. There would also be new proposals on market abuse by the end of the year, Barroso said, which would “increase market transparency and limit risks”.
The US does seem to be listening – and it also seems sympathetic. On March 9, Chicago Federal Reserve President Charles Evans said that “I am a little concerned that instruments like that found their way into the current financial distress and found a way to generate additional inter-connectedness of agents and financial institutions beyond what most people understood, I think, in securitisation markets.”
While Evans said that credit default swaps can be useful for hedging purposes, he said the potential for spill-over effects from the instruments needs to be explored. He expects additional discussions at the international level on the issue. “I think that the proposals to net them at some clearinghouse level are potentially very useful,” he said.
Unseen debt
Ben Bernanke said in February that the central bank is looking into derivatives transactions that Goldman Sachs and other US banks made with Greece amid concerns that they might have been used to help the government hide its debt. The SEC is doing its own probe.
Other European leaders are also campaigning for action to be taken. German Chancellor Angela Merkel and Luxembourg Prime Minister Jean-Claude Juncker have called for urgent regulation of credit-default swaps to shore up the euro area and prevent a rerun of the Greek financial crisis. Merkel has said that “quick action is needed,” calling on the US to “make a gesture” and curb the trades. She has complained that “institutions bailed out with public funds are exploiting the budget crisis in Greece and elsewhere”. French President Nicolas Sarkozy is also turning to regulatory efforts to help tame the surge in Greek financing costs.
Germany, which can borrow at the lowest interest rates in the EU and has the union’s largest economy, has been looked to as the source of a potential bailout for the Greek government should it fail to raise the necessary money to fill its budget gap through the credit markets. While Merkel has stated that Germany “would stand by Greece”, a potential Greek bailout has proven unpopular with the German public and the country’s politicians, particularly as an election looms ahead. German politicians called on Greece to sell some of its islands to pay off its debts. Papandreou has suggested that his country could seek relief from the IMF – an idea that was met negatively by the President of the European Central Bank, Jean-Claude Trichet.
While there is consensus that something needs to be done to regulate the derivatives markets and credit default swaps in particular, as well as establish some kind of mechanism which can help EU members that suffer at the hands of speculators, no one is quite sure what that mechanism should be, how it can work, and how quickly it could be brought into effect. The European Commission has said that it will produce plans for a European monetary fund to help Eurozone countries that get into financial difficulties.
While the plan has the backing of Wolfgang Schäuble, Germany’s finance minister, who said it would work as “a measure of last resort” and only after “a cascade of sanctions” against governments that break euro rules, his chancellor is less keen, arguing that the fund would require a change in the Lisbon Treaty, which defines the EU’s constitution, that would be very difficult to achieve. French Finance Minister Christine Lagarde said a European monetary fund may not be the best option. “Other ideas need to be studied and those that respect the Lisbon treaty are much preferable,” she said. Luxembourg’s Juncker says any such fund should not create an opening “for countries that don’t take budgetary discipline so seriously.”
Bundesbank President Axel Weber, an ECB governing-council member, also questioned the fund proposal. Jürgen Stark, a member of the European Central Bank’s executive board, has also expressed doubts about setting up such a fund. Instead, Weber sees the need for more transparency in the credit-default-swap market. “The credit default swap market has developed very strongly and drives prices in bond markets,” Weber told reporters in Frankfurt. “Not everybody who buys protection has an underlying exposure. It’s a very opaque market and we need to have a much more transparency.”
While European leaders seek ways to limit credit-default swaps, Germany’s BaFin financial regulator said market data lack evidence that the instruments were used to speculate against Greek bonds. Data provided by the US Depository Trust & Clearing Corporation did not show that new open positions were built up and also does not indicate “massive speculative action,” BaFin has recently stated.
London has also attacked the plans, calling them “misguided” and “unworkable”. Terry Smith, chief executive of broker Tullett Prebon, compared the plans to “someone suffering a major injury and then being supplied with a strip of Elastoplast”.
“Whether you reflect back on the Asian currency crisis of the nineties… or on 2008, when regulators banned short selling of financial stocks, the crises weren’t caused by speculators,” Smith added. Markus Allenspach, the head of fixed income research at Julius Baer, said credit default swaps may have accelerated market moves but did not cause any of the underlying imbalances. “This is shooting the messenger,” he said.
The crackdown on speculators has also got short shrift from bond market experts who say that it would be impossible in practice to unravel the complex interrelated web of credit default swap positions. “Unless policymakers make it absolutely clear what does and does not count, uncertainty will cause extreme volatility, and they run the risk of ending up with worse problems than they started with,” said Simon Thorp, head of fixed income at Liontrust Asset Management.
