Will the market force Germany into making a decision?

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November 24th, 2011 Rajiv Shastri

In yesterday’s post, I explained why it would be difficult for Germany to support any euro rescue effort that transfers risk from the peripheral nations to itself. Eurobonds are one such solution. And while eurobonds allow the peripheral nations to access cheaper funds, they will increase financing cost for Germany and France. Till yesterday, Germany was unwilling to commit itself to a position on Eurobonds. Today, the markets signalled that Germany needs to decide.

Germany was able to sell just over 60% of a scheduled government bond issue of €6 billion at an average yield of 1.98%. Secondary market yields on German sovereign debt rose in the aftermath of this issue to 2.09%. This reduced attraction to German sovereign debt could well be fuelled by the possibility that if Germany were to agree to the eurobond solution, it would borrow at higher rates as explained yesterday. While the credit quality of Eurobonds will be inferior to Germany’s due to contamination by other Euro nations, they would be treated in a similar manner for risk weight and other risk management purposes. In this scenario, buying German Bunds now would deprive market participants of additional yield that may be available in the coming days.

Logically, participants would wait for a German decision either way, resulting in reduced demand for existing and fresh German sovereign debt. Yesterday’s failed sale of German Bunds seems to suggest that this has come to pass. For Germany, this is a grim reminder that even though it believes the decision deserves serious deliberations and time, time is a luxury it may not have.

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