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Posts Tagged ‘Euro Crisis’

Euro crisis in a nutshell

In Uncategorized on 16/11/2011 at 5:55 am

Best concise explanation I’ve read.

What changed is not … political or economic fundamentals but how investors perceive … debt. For most of the euro era, investors considered euro-zone sovereign bonds to be risk free. Prices and yields would fluctuate but anyone who held an Italian bond to maturity assumed they would get back 100 cents on the dollar (or euro), as they would for a US Treasury or British gilt. This was always something of an illusion. Risk-free can only apply to the debt of country that controls the currency in which it borrows. A holder of its bond knows he can always sell it to someone else, in the last resort the central bank. As Chris Sims of Princeton points out, such bonds may have inflation risk but not counterparty risk.

That has never been true of a euro-zone member country, but investors happily ignored the fact, thanks in part to the European Central Bank which treated all sovereign bonds equally in its refinancing operations. (See our analysis here.) It no longer can. Investors who once classified their sovereign bonds as risk free must now treat them the way they might a bond issued by a railway company or an electric utility (i.e. as “credit”) and have concluded they own too much.

A staggering amount of debt must now migrate from the portfolios of investors who want only risk-free debt to those of investors comfortable treating it as credit. That is why yields on Greek, Portuguese and now Italian bonds have shown only fleeting responses to multiple bail-outs, austerity programmes and rounds of buying by the European Central Bank. Investors have treated the dip in yields that follow each announcement as an opportunity to lighten up.

http://www.economist.com/blogs/freeexchange/2011/11/understanding-euro-crisis

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