This may spell catastrophe for the international financial market

We’ve discussed in the past (most recently last month) how governments are mandating “bail-in” provisions for banks in difficulty.  Instead of a government bail-out, holders of bank bonds and securities (including depositors) are now to be forced to “bail-in” the bank:  i.e. surrender part of their money in exchange for shareholdings or other investments in the bank, in order to save it from bankruptcy.

The German Council has just set the cat among the pigeons, financially speaking, by advocating a similar “bail-in” requirement for sovereign debt – i.e. government bonds.

A new German plan to impose “haircuts” on holders of eurozone sovereign debt risks igniting an unstoppable European bond crisis and could force Italy and Spain to restore their own currencies, a top adviser to the German government has warned.

“It is the fastest way to break up the eurozone,” said Professor Peter Bofinger, one of the five “Wise Men” on the German Council of Economic Advisers.

“A speculative attack could come very fast. If I were a politician in Italy and I was confronted by this sort of insolvency risk I would want to go back to my own currency as fast as possible, because that is the only way to avoid going bankrupt,” he told The Telegraph.

The German Council has called for a “sovereign insolvency mechanism” even though this overturns the financial principles of the post-war order in Europe, deeming such a move necessary to restore the credibility of the “no-bailout” clause in the Maastricht Treaty. Prof Bofinger issued a vehement dissent.

The plan has the backing of the Bundesbank and most recently the German finance minister, Wolfgang Schauble, who usually succeeds in imposing his will in the eurozone. Sensitive talks are under way in key European capitals, causing shudders in Rome, Madrid and Lisbon.

Under the scheme, bondholders would suffer losses in any future sovereign debt crisis before there can be any rescue by the eurozone bail-out fund (ESM). “It is asking for trouble,” said Lorenzo Codogno, former chief economist for the Italian Treasury and now at LC Macro Advisors.

This sovereign “bail-in” matches the contentious “bail-in” rule for bank bondholders, which came into force in January and has contributed to the drastic sell-off in eurozone bank assets this year.

There’s more at the link.

This has the potential to be catastrophic in its effect on sovereign debt markets.  Such securities are bought by national governments, major banks and corporate investors because they’re regarded as ‘Grade-A’ investments – secure because they’re backed by the full faith and credit of national governments.  If that’s no longer the case . . . if there is no longer a guarantee that they’ll be repaid, but instead that investors may have to surrender some (perhaps a substantial part) of their investment in economic hard times . . . then there’ll be the devil to pay, and no pitch hot.

Keep a careful eye on this.  It’s only a proposal at present, but if it becomes policy or law, it might be the last straw that breaks the camel’s back in terms of international financial transactions.

Peter