European Debt Crisis Morphs Into New Phase

Bloomberg Opinion – By Mohamed A. El-Erian

Portugal’s decision to follow Greece and Ireland in seeking a European Union-led bailout may mark a watershed in the region’s debt crisis. Instead of a falling domino that threatens to topple countries higher up the credit- quality ladder, the latest aid request will likely speed up the debt restructuring of the three countries in Europe’s intensive- care unit.

Portugal’s need for emergency assistance became inevitable last month once its parliament rejected the government’s plans for yet another round of austerity. Former Prime Minister Jose Socrates’s resistance to seek a bailout became untenable in the face of credit-rating downgrades, deterioration in market spreads and access, and the added balance-sheet strains on Portugese banks. With help coming from the European Central Bank, Portugal will now access emergency funds from other governmental sources to meet its debt obligations and to reduce the probability of a banking crisis. While Portugal is the third euro-zone country to go down this road in less than a year, the next phase will likely play out differently. Portugal is negotiating for a bailout in the run-up to its June elections. As such, it will find it hard to provide the policy commitments deemed critical for the type of EU and International Monetary Fund support keeping Greece and Ireland afloat. Transitional mechanisms will be needed to bridge to a new government that’s able and willing to commit to a credible multiyear reform program. Look for the ECB and EU to carry an even larger burden in the next few weeks, with the IMF getting involved at a later stage.

Restructuring Likely

Judging from market pricing of Portugal’s debt, it’s increasingly likely that this emergency lending will be accompanied by some type of debt restructuring after 2013. This would be enabled by the wider set of policy options favored by Germany. Whether this timeline materializes will depend not only on Portugal, but also on what happens elsewhere in Europe. Specifically, will Portugal’s bailout be followed by a further migration of the debt crisis in the euro zone? Or will Portugal mark the phase when truly differentiated outcomes are sustained ? The fear is that Portugal’s bailout is yet another indication that Europe’s peripheral debt crisis will ravage Italy and Spain next. This would be consequential for a lot more than just these two countries. Italy and Spain would overwhelm the euro zone’s rescue mechanisms, thus transforming a peripheral crisis into a region-wide debacle.

Shift in Focus

Fortunately, the probability of this happening is declining as more European banks — like Germany’s Commerzbank and Italy’s Intesa this week — succeed in raising additional private capital.

If this trend continues, as I expect it to, look for the EU, ECB and IMF to change their approach to helping the three countries being bailed out. The focus will shift away from liquidity and on to solvency well before 2013. With reduced concern about the contagion spreading up the credit-quality ladder, these three official lenders will be less willing to continue to pile new debt on top of old debt, and rightly so. The approach taken so far, while succeeding in retarding the day of reckoning for private creditors and banks, has involved significant costs. The strategy has shifted even more of the burden to already stressed taxpayers and users of public services. It has further undermined the outlook for sustainable economic growth and employment creation, aggravating social tensions. And it has contaminated the ECB’s balance sheet, eroding its hard-earned credibility and policy responsiveness. On the surface, Portugal’s bailout may look like a replay of Greece and Ireland. But don’t be fooled. Seemingly familiar developments in the next few weeks will likely be followed by a paradigm shift, especially if European banks continue to raise capital. This will accelerate the move from an unsustainable liquidity approach to a more durable solvency solution for the continent’s debt crisis.

(Mohamed A. El-Erian is chief executive officer and co- chief investment officer at Pacific Investment Management Co. The opinions expressed are his own.)


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