The only real solution to the European debt crisis is credit writedowns

By Global Macro Monitor

Very unfortunate timing of today’s ECB meeting as Mario Draghi poured cold water on providing a backstop for the distressed Eurozone countries. It’s kind of like holding a press conference before playing a hand in a high stakes poker game. At stake? The future of the global economy and President Obama’s re-election.

Christopher Wood, over at CLSA, had some great nuggets in his latest Greed and Fear piece:

The reason why the character of Draghi has become all important is that it is clear that the compromise agreed by Nicolas Sarkozy and Angela Merkel in Paris earlier this week does not establish the groundwork for a credible fiscal union. For this reason a conservative ECB boss would not view it as a reason to pursue debt monetisation. But if the ECB boss is a politician, looking for an excuse to monetise, then the central bank’s reaction to the new agreement will be different….

The other major development this week again involves a concession from Frau Merkel. She has reportedly agreed that private sector bondholders, most notably Eurozone banks, will in future not be compelled to take losses on their sovereign lending in the Eurozone, as they have been in the case of Greece. This marks in GREED & fear’s view a massive retreat from the German leader’s previous stance driven by moral hazard concerns, and also by demands from the left wing of German politics that banks should take losses. Again, concern about financial sector systemic risk appears to have driven this Merkel backdown. But it is, of course, much easier asserting the principle that there will be no sovereign defaults than deciding who is ultimately responsible for all the sovereign borrowings. And here the likes of Mr Sarkozy, and his friends in the periphery, will be looking to Mr Draghi’s printing press to relieve them of the burden. Does Frau Merkel really agree to that? GREED & fear doubts it…

The bottom line from the above is that risk assets will rally further out of this week’s summit if Draghi proves to be a politician. If not, and debt monetisation is not forthcoming for now, then the best hope to trigger a further rally is the likely announcement sooner rather than later of a G20 central bank financed lending facility at the IMF of several hundred billion dollars to supplement the existing euro bailout fund, with Italy the most likely initial recipient. This news was leaked in a report in today’s Nikkei and also complements what GREED & fear has been hearing on the grapevine in recent days (see Nikkei article “G-20 mulls IMF lending program for Europe”, 8 December 2011).

Like many, we at the Global Macro Monitor believe the only solution to the European debt crisis is to write down bad debts, but we’re also realistic that it will take time because of the weak and highly levered balance sheets of many of the European banks holding the sovereign debt. Bridge solutions will have to do for now as banks bolster their capital. Germany seems to understand this as the sovereign debt crisis has created systemic problems in their own banking system.

After today’s ugly reaction, the Eurocrats now know what the markets want. Will they deliver the fig leaf to give the ECB cover to provide the backstop? We still believe so.