South Europe Challenges Germany’s Revival Recipe

Italy, France and Spain are trying to take a united stand against Germany in finding new ways to fight the euro-zone debt crisis.

But the southern European trio’s latest salvo—to use Europe’s bailout funds to buy the sovereign debt of Spain and Italy—is likely to get an icy reception in Germany if it involves loosening rescue fund rules or tapping resources of the European Central Bank.

Italian government officials said on Wednesday that a still-vague proposal by Prime Minister Mario Monti this week to start bond purchases by Europe’s bailout funds would be a topic of discussion at a four-way European summit in Rome on Friday.

Europe’s rescue funds are allowed to buy government bonds, but they haven’t done so yet. Such a program was envisioned as a way to allow countries facing market pressure to get help without the attached strings of a full bailout program. Countries have so far instead relied on the ECB to do the job. As of last week, the ECB held €210.5 billion ($267 billion) of government bonds, but it has always been a reluctant buyer and made its last such purchases in mid-March.

Mr. Monti’s comments, which were backed by French President François Hollande and which a Spanish minister described as “intelligent,” seem to suggest that bond purchases by the funds could be automatically triggered with little in the way of a quid pro quo.

“The idea is that virtuous countries, like Italy, can have financing for their sovereign debt that isn’t at interest rates like those for countries that are seen as not having made efforts,” Mr. Hollande said.

Under one proposal, the rescue funds would insure bond purchases made by the ECB against losses, a European official said. The hope is that would convince the ECB, which has much more firepower, to restart its own bond-buying program, this official said. The loss insurance would effectively leverage the resources from the bailout funds.

Mr. Monti’s proposals appear designed to speed activation of bond buying by the bailout funds by reducing the political hurdles before they intervene, said Mujtaba Rahman, analyst for Eurasia Group in New York.

Any attempt to loosen bailout rules, however, would be staunchly rejected in Germany, which has also long opposed a bigger role for the ECB in resolving the debt problems of individual countries.

“There will never be any purchases without conditions,” a German government spokesman said on Wednesday.

Speculation that the euro zone could soon dispatch its bailout funds to buy up Italian and Spanish bonds pushed down the two countries’ funding costs Wednesday. In late-afternoon trading in Europe, the yield on Italian 10-year bonds was down 0.13 percentage point at 5.79%, while the yield of their Spanish equivalents fell 0.27 percentage point to 6.77%.

The new comments by Messrs. Monti and Hollande also highlight the shifting plates of European diplomacy since Mr. Hollande’s election in May. At European summits for most of the past three years, Ms. Merkel had usually relied on former French President Nicolas Sarkozy to support her. On Friday, Messrs Monti and Hollande—joined by Spanish Prime Minister Mariano Rajoy—are more likely to openly challenge the German leader.

“I think Merkel is now being asked to give a strong political signal, to show that she is willing to find a common ground,” said Franco Pavoncello, a professor of politics at John Cabot University in Rome.

One key possible advantage of the rescue funds’ buying bonds over a full-blown bailout, such as those received by Greece, Ireland and Portugal over the last two years, is that a government could in theory benefit from aid—without closing off access to private investors at the same time. The bailout funds’ guidelines already foresee that bond purchases could be made under conditions that would be much less onerous for the beneficiary governments than a full bailout.

Still, it couldn’t be done quickly or quietly: a country would need to request aid, agree to some economic conditions and the intervention would need to be approved by other euro-zone governments, including some parliaments.

The conditions attached to bond-market interventions are likely to be looser than those tied to the fully fledged bailouts, focusing mostly on bringing down deficits and economic imbalances such as high current-account deficits that are viewed as potentially dangerous.

Italy and Spain are already required to make the budget cuts and labor-market and pension reforms, but support from the bailout funds would force them to spell out specific steps and their timing in more detail. Trying financial support to fulfilled promises would also add extra pressure on both governments.

The bigger issue with relying on the bailout funds, rather than the ECB, to keep Italian and Spanish funding costs down may be their limited resources.

Even once the funds are in operation, they can only lend an extra €500 billion—of which as much as €100 billion have already been promised to spain’s wobbly banks. that is way less than the €2.6 trillion Spain and Italy carry in debt.

“For the [fund] to be useful in the secondary market, its commitment has to be ‘unlimited,'” analysts at Barclays said in a note Wednesday. “It has to be ready to buy as much as needed for as long as needed, even if in fact it may not need to use much firepower to stabilize very thin markets.”

One other question is whether the bailout funds would claim explicit seniority for the bonds they own over private investors in the event of an eventual debt restructuring. Explicit subordination of private investors would potentially make them more reluctant to buy bonds.

The question of the funds’ seniority is being examined by euro-zone finance ministers Thursday night, in the context of the Spanish bank bailout.

Officials said the European Commission, which lobbied hard to give the bailout funds the power to buy bonds, wouldn’t oppose their use in this way, but played down the likely impact.

“We are talking here about financial paracetamol,” said Commission spokesman Amadeu Altafaj Tardio. “It may actually alleviate the tension, the pain, the unease for a while, but it does not address the causes.”


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