Both countries have debt and deficit levels that are no worse, and in some cases better, than those of Britain, Japan and the United States. But because they cannot devalue their currencies and must instead impose growth-sapping economic measures to regain competitiveness, their bonds have traded as if their economies are near insolvent. Meanwhile, the securities of debt-racked Britain, for example, are snapped up with abandon.
It is a paradox that lies at the heart of the European debt crisis. On Friday at its most recent summit meeting, Brussels took a halting first step to addressing this issue on a permanent basis.
Eurozone leaders proposed that Europe's current and future rescue facilities might buy Italian and Spanish bonds as long as these countries fulfilled Germany's austerity demands and met debt and deficit targets. The market, expecting more waffling, jumped and the yields on 10-year Spanish and Italian bonds dropped sharply as investors celebrated the prospect that Europe might become a buyer of last resort of its beaten-down bonds.
Still, Friday's euphoria notwithstanding, economists and market participants remain doubtful that the bond market fears can be permanently assuaged until the European Central Bank intervenes with the force and conviction shown by its peers in the United States and Britain.
Paul De Grauwe, a Belgian economist at the London School of Economics, says he believes that the latest step will not be enough. De Grauwe has written extensively on how the cycle of fear and panic in the bond markets is pushing countries that may not need a bailout to ask for one.
The eurozone's temporary bailout fund, the European Financial Stability Facility, which has only 248 billion euros at its disposal and must first raise the money on the bond market, does not have the firepower to convince skittish investors that Europe is serious, he said. Italy and Spain alone have a total of nearly 2.5 trillion euros in sovereign bonds outstanding.
De Grauwe proposes instead, that the European Central Bank announce that it will be an aggressive buyer of Spanish or Italian bonds until the spread - or the difference between the yields on these bonds and benchmark German bonds - reaches a certain level, say 300 basis points, compared with the recent level of 500 basis points and above.
"You would then have a floor on bond prices and it would be attractive for investors to buy Spanish bonds again," said De Grauwe.
His most recent paper claims that the Spanish and Italian bond rout has been driven more bythe psychology of fear than hard and true economic numbers.
"The EFSF does not have the credibility given its resources," De Grauwe said. "What you need are the unlimited resources of a central bank."
Such a forceful approach has been resisted by Germany, the bank's largest shareholder, on the basis that countries would not proceed with necessary reforms. It is also true that the ECB has intervened in the markets before and is said to own close to 150 billion euros of weak eurozone country bonds.
(Source- http://economictimes.indiatimes.com)
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