FRANKFURT (MNI) – Market reaction following the agreements reached
by Eurozone leaders on July 21 highlights the dangers of sovereign debt
restructuring, European Central Bank Executive Board member Lorenzo Bini
Smaghi said last week.

In the text of a speech given on October 17 and published on the
ECB’s website today, Bini Smaghi also warned that while the idea of debt
restructuring and bigger haircuts on Greek government paper may seem
politically attractive, such practices would not help promote fiscal
discipline and could end up costing more in the long run.

As Eurozone leaders prepare to meet tomorrow in Brussels, their
second summit in four days, there is talk of cutting the face value of
Greek debt by as much as 60%, compared to the previously-agreed 21%.

“This may actually create a disincentive, i.e. an incentive not to
adopt the corrective measures which are needed to reform the economy,”
Bini Smaghi said.

As a result of the far more limited 21% haircut agreed to over the
summer, “contagion has spread progressively to the core of the euro
area, as concerns about sovereign risk have risen to levels which are
hardly justified,” he said, thus implying that boosting the haircut to
the levels being discussed today could have serious and dire
repurcussions.

In August, contagion spread to Italy and Spain, driving up their
yields and forcing the ECB to resume and accelerate its sovereign bond
purchasing program.

Bini Smaghi reiterated that Greece would be solvent if it were
willing to sell its assets. “Its unwillingness to do so, for local
political reasons, and the inability of the European authorities to
induce the country to do so, aggravates the situation in the financial
markets and tests the political resilience of the creditor countries,”
he warned.

Bini Smaghi pressured leaders to ensure that they will find a
powerful enough leveraging solution for the Eurozone’s bailout fund, the
EFSF, when they gather in Brussels on Wednesday.

“It is important to realize that the size of the backstop has to be
proportional to the systemic risk we may face,” he stressed.

“The political authorities, and the taxpayers to whom they report,
have to understand that if this risk materialises, and the euro area
fails to provide a convincing answer, all parts of the union will be
severely affected, even those who currently seem safe,” Bini Smaghi
said.

He also noted that in the Eurozone monetary policy “cannot be used
to finance governments,” reflecting the ECB’s opposition to playing a
key role in any leveraging mechanism.

A strong bailout fund is one key element in breaking “rather
dangerous feedback loops” between the financial sector and sovereigns,
Bini Smaghi said. Other necessary measures include better Eurozone
governance and stronger capital buffers for the financial system, he
said.

“At the current juncture, higher capital in the banking sector
could help to reduce the negative feedback loop between the sovereigns
and the banks, through several channels, he said.

— Frankfurt bureau: +49 69 720 142; email: frankfurt@marketnews.com —

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