Three Reasons Europe is Failing to Act (Koesterich)

by Russ Koesterich, Portfolio Manager, iShares

Despite recent progress toward necessary fiscal reforms in Greece, Italy and Spain, bond investors have been abandoning European markets and driving up yields.

These investors are essentially expressing their frustration with European politicians and policy makers. Like their US counterparts, European politicians and policy makers are failing to adequately address their region’s debt problems. Here are three reasons why.

1.) Reforms alone aren’t enough: In the past month, governments in Greece, Italy and Spain have fallen and been replaced by new governments with stronger mandates to pursue necessary fiscal and structural reforms. While this certainly represents some progress, bond investors recognize that reforms don’t happen overnight and aren’t enough to deter a worsening crisis.

2.) A lack of firepower: The European Financial Stability Fund (EFSF) was supposed to be able to halt slides in European sovereign debt markets by buying up bonds while reforms are being implemented. Although European politicians were successfully able to expand the EFSF to support such purchases, the current amount of the fund is not enough to solve Europe’s problems.

3.) The savior hasn’t stepped up: It’s now apparent that the only entity with sufficient purchasing power to halt slides in European bonds is the European Central Bank (ECB). Unfortunately, both the ECB and the German government have argued against expanding the ECB’s existing bond purchase program beyond its current limited parameters. The ECB has said governments are the ones who should solve the region’s problems. The president of Germany’s Bundesbank, meanwhile, recently said such stepping up by the ECB would be a violation of European law. Experts, however, have called that argument into question.

What does this mean for investors? If a politically acceptable solution is not found, Europe risks turning a liquidity problem for smaller peripheral countries into a solvency problem that infects most of the continent. As the European failure to act continues, volatility is likely to remain high in the near term.

Source: Bloomberg

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