Options Dwindle for Euro Crisis

By STEPHEN FIDLER

The biggest question in Europe isn't what it was a few weeks ago. It is no longer just whether any of the 17 governments in the euro zone will default on its debts; increasingly it is whether the euro zone will survive in its current form at all.

On Thursday, it emerged that the European Central Bank is considering a dramatic extension of its longest loans to commercial banks, to stave off a potential collapse of the bloc's banking system.

Meanwhile, leaders of the Continent's three largest economies met and pledged to work toward closer political and economic integration most analysts say is needed--but with no specifics, meaning the pace for such efforts still lags behind the market's demand.

Germany's failure to sell almost 40% of a 6 billion euros ($8 billion) bond issue at an auction Wednesday is, many analysts say, symptomatic of this new phase of the crisis, with investors beginning to question even the bloc's safest harbors.

But on Thursday, concern over German bonds drove their yields up to near-convergence with the U.K.'s sovereign debt, which has no clear advantage beyond not being in euros. In recent weeks, borrowing costs for financially strong euro-zone governments such as the Netherlands and Finland have increased. Other high-rated European bonds—such as those for the European Financial Stability Facility—have struggled to find buyers.

If the first phase of the crisis saw investors fleeing from the periphery of the currency union to its core, the second has them fleeing the euro area altogether.

"This looks like an issue that is wider than just Germany. We think it is about the market attempting to price a breakup of the euro," wrote analysts Stephane Deo and Matteo Cominetta of UBS Investment Research Thursday. Investors they visited this week in Asia are questioning the willingness of governments to keep the euro zone together, they report: "As a result investors may seek to disinvest from Europe."

Less than a month ago euro-zone leaders, with German Chancellor Angela Merkel in the vanguard, were forced to openly speculate on the exit of Greece from the euro zone—when Greece threatened a surprise referendum on it bailout terms. That opened up in public the possibility that the currency union might not be forever. But difficult and costly as the exit of Greece would be, market fears about a breakup have gone beyond that.

"This is not a function of whether Greece may leave. It's whether Germany, France, Italy and Spain are going to have the same currency," says Andrew Balls, head of European portfolio management at Pimco, the investment management firm.

Bond investors bought French government bonds knowing they would face interest-rate risk: Unless they hedged, they would lose money if interest rates rose. But it's only recently that it has dawned that French bonds expose them to another type of risk that conservative investors try to avoid: credit risk, the prospect that they may not be paid back in full and on time.

The reason this emerges with France, and not the equally indebted U.K., is because of uncertainty about the role of the ECB.

The central bank is resisting taking on the explicit role of lender of last resort for euro zone governments. Ms. Merkel, accompanied by the leaders of France and Italy, reiterated her support for its stance Thursday.

The ECB says it isn't a choice—it and many legal experts believe it would go beyond its charter to routinely buy national debt. It justifies its limited bond-buying as necessary for smooth workings of its monetary policy. Its consideration Thursday of longer-term loans to banks comes under a similar heading.

But without the promise of a central bank stepping in as a last resort, a government liquidity crisis is always at risk of turning into a solvency crisis. In the U.K., the Bank of England would step in as a buyer of government bonds.

Most investors have been assuming that the ECB has been, as Mr. Balls says, playing a "chicken strategy," waiting until the last minute to intervene decisively. First, the bank is presumed to want a cast-iron commitment on strict budgetary discipline by governments and the true integration of fiscal policies, including perhaps a common euro bond proposal as put forward by the European Commission this week.

Many governments of the euro zone are heading at full speed in the opposite direction. "It's doubtful whether the intrusive fiscal and economic regime proposed by Germany and the European Commission is a price which Italy, and many other euro zone countries for that matter, is willing to pay to rescue the bloc," said Nicholas Spiro, a London-based sovereign debt consultant.

Many are hoping that the ECB will swerve first, allowing them to avoid commitments that would be seriously unpopular among their electorates. The events of the past week have shown that time isn't on the ECB's side. It may be unable to stem the crisis if there is a permanent shift of investors away from the euro zone.

In a game of chicken, one or both drivers can swerve to avoid catastrophe. It is the possibility that neither swerves that investors are now building into the prices of euro-zone government bonds.

Write to Stephen Fidler at stephen.fidler@wsj.com

Source: http://online.wsj.com/article/SB10001424052970204452104577058370049616582.html?mod=WSJASIA_hpp_LEFTTopWhatNews