Bloomberg News

Euro Fate Depends Whether Wyplosz or Kirkegaard Is Right

March 12, 2012

Charles Wyplosz, director of the International Center for Money and Banking Studies in Geneva. Photographer: Jerome Chatin/ EXPANSION-REA/Redux

Charles Wyplosz, director of the International Center for Money and Banking Studies in Geneva. Photographer: Jerome Chatin/ EXPANSION-REA/Redux

Charles Wyplosz is betting Greece isn’t “unique.”

After the Greek government successfully inflicted losses on its private creditors, the director of the International Center for Money and Banking Studies in Geneva predicts it’s the first domino to fall in a series that might culminate with Italy, the euro-area’s third-largest economy, reneging on its debts.

“The day Greece’s private sector involvement happened, people were saying ‘one down and next is Portugal,’” Wyplosz, who as long ago as May 2010 was saying Greece needed to restructure its debt, said in a telephone interview. “When Portugal is done, markets will look elsewhere. We’ve seen the contagion process over and over again.”

That stance, at odds with a vow by European leaders that such restructurings will stop at Greece, underscores the mixed feelings investors are signaling on the next phase of the debt crisis. While yields on 10-year bonds for Italy and Spain have dropped below 5 percent, Portugal faces a 13 percent interest rate and the cost of credit-default swaps on Italian debt imply a 27 percent chance of default within five years.

“In neither Ireland nor Portugal do I think that PSI will be implemented,” said Jacob Kirkegaard, research fellow at the Peterson Institute for International Economics in Washington. “Spain and Italy will muddle through.”

Fresh Doubts

Who is right will determine whether European leaders are right to declare a turning point in the sovereign debt turmoil now in its third year, or if they will be forced to take additional crisis-fighting steps after already putting up 386 billion euros ($506 billion) of aid. A wave of defaults would also raise fresh doubts over the longevity of the euro area 13 years after it came into being.

“It is doubtful whether the euro-zone monetary system can withstand an Italian default,” said Jens Nordvig, a managing director of currency research at Nomura Holdings Inc. in New York.

Greece wrapped up eight months of talks on March 9 by pushing through the biggest sovereign restructuring in history, cajoling investors to forgive more than 100 billion euros of debt. Bondholders with 95.7 percent of Greece’s privately held bonds will participate after so-called collective action clauses were triggered, opening the way for the country to tap a second international bailout.

While the debt swap was the first such operation since the single currency began in 1999, Europe’s finance chiefs say it’s a one-off. Greece is a “completely unique” case, German Finance Minister Wolfgang Schaeuble said yesterday.

Debt to GDP

Wyplosz, 64, is unconvinced, arguing other cash-strapped nations will have to follow as their economies prove unable to stomach the austerity required to deliver sustainable debts. Portugal’s debt will equal 111 percent of gross domestic product in 2012, compared with Ireland’s 117.5 percent and Italy’s 120.5 percent, according to European Commission estimates in November.

“We don’t have a solution for Greece, so there will be a harder default to come,” said Wyplosz, who has advised the International Monetary Fund and French government. “Then we’ll look to the next country in trouble.”

The rot may extend to Italy, whose economy hasn’t grown more than 3 percent in a year since 2000 and where debt has topped 100 percent of GDP since 1991, he said.

“They’ve never been able to bring their debt down and even if they do now, they won’t be able to grow,” Wyplosz said.

Portugal Travails

Portugal, which followed Greece and Ireland in requiring a bailout of 78 billion euros last May, is next in the firing line as speculators question whether it can resume bond sales in 2013. With unemployment at 14 percent and the economy shrinking for a fifth quarter, its benchmark yield reached a euro-era high of 18.29 percent on Jan. 31. It was still paying more than 13 percent yesterday.

Ireland, the recipient of 67.5 billion euros of aid, has said it won’t force losses on debt holders and is seeking a return to the credit markets next year as its economy already returns to growth.

“It’s very clear that Ireland won’t seek any writedown,” Irish Prime Minister Enda Kenny said in a Feb. 8 interview on Bloomberg Television’s “InBusiness with Margaret Brennan.”

A Greek default nevertheless means a more than 60 percent chance of Portugal following, according to an analysis of credit default swaps by Fathom Financial Consulting. The risk then grows that Ireland, Spain and Italy declare bankruptcy, said Erik Britton, a London-based director of Fathom.

Italian Warning

The reason is budget retrenchment is harder to impose in a fixed exchange-rate bloc where nations are unable to compensate with lower interest rates or a cheaper currency, said Britton. In the case of Italy, the budget reductions required to pare the debt would only work if the nation’s economy and fiscal position were healthier, he said.

Italy’s jobless rate has risen to the highest in more than a decade at 9.2 percent in January and business confidence has dropped to a two-year low as Prime Minister Mario Monti seeks to balance the budget in 2013 via 81 billion euros of austerity measures imposed since last year. Monti has urged German Chancellor Angela Merkel to help him deliver more signs of progress to keep Italian voters on his side.

“Italy looks an awfully like it is on an unsustainable path,” said Britton, a former Bank of England economist. “Austerity doesn’t provide a way out in a currency union and default is the only way.”

Spanish Steps

Spain is finding it hard to couple cuts with growth. Prime Minister Mariano Rajoy said this month that its 2012 deficit will be higher than agreed at budget talks with the European Union. A deepening economic slump is hampering efforts to pare the euro-area’s fourth-largest budget gap and Rajoy now aims for a deficit of 5.8 percent of GDP, compared with the previously agreed 4.4 percent.

Kirkegaard, 38, is more sanguine, predicting Europe’s authorities will hand Portugal more money later this year to save them from re-entering markets in 2013 and noting Italy is already winning back the faith of investors. The European Central Bank’s infusion of three-year bank loans has helped stabilize the crisis, while governments will boost the capacity of their bailout funds to limit infection from Greece, he said.

“The austerity will still hurt, but at this point I can’t see another country” defaulting on its privately held debt, said Kirkegaard, who has worked for the Danish government and the United Nations.

Portuguese Measures

The IMF and European officials last month credited Portugal with delivering on its goal to trim its budget deficit to 4.5 percent of GDP this year, down from 9.8 percent in 2010. Prime Minister Pedro Passos Coelho’s majority government also means more political certainty than Greece.

Schaeuble was caught on camera last month telling his Portuguese counterpart that Germany, Europe’s biggest economy, is ready to adjust terms of Portugal’s rescue if needed.

Meantime, Italy’s budget deficit narrowed more than economists forecast last year to 3.9 percent of GDP and it is running a primary budget surplus which means it’s only borrowing to pay interest costs. Monti is also switching from austerity to rallying growth by targeting red-tape and making it easier to do business.

“Italy has shown if you have a sensibly managed fiscal situation that’s not in itself going to lead to default,” said Kirkegaard.

The risk is European leaders go back on their word and force a Greek-style restructuring elsewhere, then contagion spreads, Barclays Capital economists, including Antonio Garcia Pascual, wrote in a March 7 report to clients.

Italian Lessons

“Reneging on that commitment and launching a PSI in Portugal could raise questions first about Ireland, but potentially also about Spain and Italy,” they said. “Yet, PSI cannot be ruled out at a later stage. As time goes by, reform fatigue may become a problem and support for more radical political parties may emerge.”

At Pacific Investment Management Co., which manages the world’s largest bond fund, Co-Chief Investment Officer Bill Gross sees division among bondholders as to whether Wyplosz or Kirkegaard are correct.

“I’m not forecasting a second default, but the markets certainly are,” Gross said in a March 9 “Bloomberg Surveillance” radio interview with Tom Keene and Ken Prewitt. “The rules have been changed here.”

To contact the reporters on this story: Simon Kennedy in London at skennedy4@bloomberg.net.

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net.


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