A German debt purchase is a bet on euro zone break-up

June 1, 2012

Wednesday’s panic in the bond markets drove yields down to unprecedented lows in U.S., UK and Germany. The stampede into British and American debt is no surprise, since both countries represent a rock-solid guarantee of repayment in their own currency (though heaven knows how much lenders will be able to buy with the money in ten or twenty years’ time), but why the rush into Bunds?

One possible interpretation, which can never be discounted, is pure panic, based on nothing more rational than faith in Germany’s sleek cars, orderly cities and conservative bankers. But that is unlikely to be the whole story, if only because the trend has been apparent for too long to be put down to knee-jerk reaction.

The only other plausible interpretation is that the market is now betting on a euro zone break-up.

Look at it this way. The one thing which seems to be unanimously agreed is that the euro zone can only survive if Germany shoulders a substantial share of the outstanding ClubMed debt burden. Nobody can invent a solution which does not amount to the same bottom line – Germany underwrites borrowing by member country governments, or lends directly to them, or underwrites loans by the firewall-type institutions with the confusing acronyms, or agrees to backstop German bank lending to the troubled countries, or borrowing by Spanish banks or…

Of course, many of the solutions being proposed involve so-called “joint responsibility” for loans, but who are they kidding? Only the very dimmest German taxpayer will be comforted by having Greece, Spain and co on board as joint guarantors of the massive loans needed to sort out the mess. In fact, the spectacle of ClubMed countries underwriting loans to themselves gives a new meaning to the expression “pulling yourself up by your bootstraps”!

As far as ECB-based solutions are concerned, the same thing applies. The ECB’s own credibility as a borrower depends on the support of member country governments – again, read Germany – ready to ensure it never runs out funds, so it is hard to see any comfort for Bund investors here either.

Some back-of-the-envelope computations may help to put all these Germany-pays solutions in perspective.

Roughly speaking, Germany’s national debt currently stands at just over 80% of its €3 trillion GDP. The debts of the Italian and Spanish Governments alone amount to some €2.25 trillion and €1 trillion respectively, so even a 20% write-off of their debt would raise Germany’s own debt level to over 100% of GDP – and then there is Greece, which has already defaulted on well over 50% of its debt, and Portugal and Greece, which are struggling bravely but may well ask themselves why they bother if they see other countries being more generously treated, not to mention France, which is unlikely to be much help, and could itself end up in need of support.

In the end, if you don’t trust Italian and Spanish debt, you can’t trust German debt either – at least, as long as it is in the euro zone.

Of course, the ECB could save the situation by simply printing euros, subject to getting the green light from its council, where the Bundesbank holds sway. But in this (quite plausible) scenario, you would expect the euro to weaken, maybe dramatically, so again it is hard to see the attraction of German debt. In fact, if you believe the Europeans are ultimately going to rescue ClubMed by printing euros in the vast quantities required to stave off default (and austerity), you may as well hold Spanish, Italian or even Greek debt and rely on the high yield to offset your currency losses!

No, the only scenario which can justify holding Bunds is a German exit from the euro zone – either alone (unlikely) or as part of a complete breakup — in which case investors may hope to find themselves holding claims denominated in Deutsche mark instead of euros. Unfortunately, if they are anticipating a nice juicy capital gain, they may end up being disappointed, because (albeit I am no lawyer) I can see no reason why Germany would feel forced to convert its debt to Deutsche mark at a rate favourable to investors. The most transparent way to do things would be to issue Deutsche mark alongside euros (if the euro zone had not totally disintegrated by this point) allowing the new and the old currencies to trade for a while so as to establish a market-based exchange rate as a basis for converting Bunds. However, in the more likely scenario of a total collapse of the euro zone, conversion would have to take place rate at some more or less arbitrary exchange rate, and even the Germans might be tempted to err on the low side, even if it meant short-changing Bundholders.

For example, suppose they chose to convert at €1.00 = DM0.50. Would investors have got a good deal from the conversion?

The fact that the newly-launched Deutsche mark might by this time be trading in the currency market at some rate or other against the dollar, the yen and the pound will do nothing to answer this question, and if the answer will not be obvious even after the fact, we certainly cannot know in advance. Indeed, even in the closed room somewhere deep in the bowels of the Bundesbank where the “contingency plan” for a Deutsche mark relaunch must be well advanced by now, even the economists working on it may not know whether the deal they are going to offer investors will turn out to be a fair reward for the near-free loan or a complete rip-off.

Either way, German debt is a risky business. Banks may have no choice, given that they are more or less forced by the regulators to hold Government debt, but when many blue chip stocks are yielding 6% or more, I cannot understand why any investor would choose to hold Bunds (or UK gilts or U.S. Treasuries) at current yields.

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