Guest Blog: Domino Theory Risk Stays With Us

The market appears to have given a cautious thumbs up to the latest euro zone bailout solution. In the end, if Greece isn’t going to leave the euro, it will need large cash transfers from the other member countries for some years to come, and the political leadership appears to have accepted that.

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Coupled with the European Central Bank’s ongoing liquidity support and its latest 3-year funding offering this week, right now we have a marketplace that is not necessarily still thinking the worst.

At the same time, we had the ECB’s announcement on Tuesday that, temporarily, it will stop accepting Greek sovereign debt as collateralin its lending operations. Greek banks will, the statement notes, have to obtain liquidity support from their national central bank.

This is more significant than one might at first think. It suspends, perhaps forever, a key principle established at the euro’s founding that all sovereign debt was, for ECB purposes, equal.

If one remembers, it was this thinking that was partly behind the “convergence” behavior of sovereign bond yields both before and after the euro’s inception, and which led to Irish and southern euro zone debt trading as little as 10 basis points above Germany’s at one time. The market had priced euro zone risk as pretty much uniform.

That seems a long time ago. What is the likely impact of the ECB statement? Well just that, all bonds are not created equal (not that anyone who entered into a long-term convergence trade should have ever thought otherwise), but more significantly that contagion risk is going to remain firmly on the table.

If the ECB is making distinctions between different sovereign paper, then non-domestic investors will think a bit longer on whether the bonds of other heavily indebted euro members are worth investing in. Previously, there was always the “out” of the ECB for euro sovereign bonds, but no longer. Domino theory riskstays with us, and will not help southern euro zone debt spreads.

The latest bailout solutionfrom EU governments seems to have bought time for them to carry on the status quo for now, but it’s only that, a bit more time. The structural reforms needed by many euro members remain to be carried out of course, but currently in an atmosphere of slightly lower volatility.

This helps greatly. But the ECB announcement reminds investors that, in the worst possible scenario, nothing can be ruled out, and any arrangement can be changed at short notice. The possibility of a country leaving the euro, which would precipitate severe economic crisis in the EU and worldwide, can't be ruled out completely. Let's hope it doesn’t come to that.

Thanks to Stuart Turner at Newedge Group Treasury for data assistance with this article.

The author is Professor Moorad Choudhry, Treasurer, Corporate Banking Division, Royal Bank of Scotland.

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