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There is method in Merkel’s madness

Naked short-selling ban | There is method in Merkel’s madness Ian Fraser

The decision by German chancellor Angela Merkel to unilaterally impose a ban on “naked short-selling” last week was derided by many market commentators as an act of sheer folly.

The move was dubbed “an act of desperation” (by Brian Yelvington of Knight Libertas), “moralistic hysteria” (Charles Dumas of Lombard Street Research), “simply unfathomable” (Uwe Parpart of Cantor Fitzgerald), and “a distraction from the major issues” (former UK finance minister Alistair Darling).

Many market practitioners were left scratching their heads. Anthony Peters, a strategist at Swissinvest, told the Telegraph:

“Nobody has a clue what is going to happen next. Politicians have shown they have no understanding of markets. They are firing the wrong calibre gun, at the wrong target, and they are missing."

The German regulater BaFin imposed its ban on “naked short-selling”—when fixed-interest investors enter forward contracts to sell government bonds they neither possess or own—at midnight on Tuesday May 18th. The ban, which also applies to the use of credit-default swaps to speculate on European sovereign defaults, is to remain in place until March 31, 2011.

The move—which echoed a similar naked short-selling ban in financial institutions by governments in the US and UK in September 2008—came only eight days after the announcement of the EU and IMF’s monster €750bn bailout to sustain the euro and patch up Europe’s sovereign debt crisis.

As a mechanism for reining in febrile markets, the short-selling ban has so far been a spectacular failure.

It only seemed to cause traders to fret further about further possible negative revelations about profligacy and false accounting from southern European states. It was also ineffectual because it only applies in Germany, and most of the trading in EU sovereign debt is performed in London, New York, and Tokyo.

The euro and share prices are continuing to sink in value in the days following the announcement. And according to Barclays Capital, the ban exacerbated, rather than calmed, extreme credit market volatility.

Overall, the naked short-selling ban was widely portrayed as an example of a politician eager to teach the markets a lesson shooting themselves in the foot.

However what the market practitioners failed to grasp are the political imperatives behind Merkel’s move. The day after the ban, Merkel talked gloomily of the euro’s "existential" crisis and the destructive power of financial markets.

She called for a financial transactions tax to be imposed in Europe—even if the G20 fails to agree on one—and for the launch of a European ratings agency (a call that reflects suspicion that Standard & Poor’s and Moody’s are biassed against European debt owing to their American ownership).

She also called on Europe to "develop a process for an orderly state insolvency"—a methodology by which troubled states such as Greece, Spain, and Portugal could politely renege on their debts. This is what Dan Roberts called Merkel's "scorched earth" policy in his Guardian blog.

Many Germans have a deep-seated mistrust of the “locusts” and “wolfpack” of financial markets. Merkel is therefore being politically expedient in thinking that, if voters in Germany are to accept the burden for the €750bn eurozone bailout, the "wolfpack" that is seen as having precipitated, and profited from, the crisis should not be allowed to get off Scott-free.

Merkel has no desire to become the German leader who caved in to "the markets" and who allowed the single currency, and hence the EU to disintegrate on her watch. Longer term, however, attacking the short-sellers can only be a short-term palliative. If the euro is going to have a long-term future, deeper-seated, political reforms, are going to be required. And countries such as Greece, Portugal, and Spain must realise that borrowing from international investors can never be a one way street.

It remains to be seen what exact form these reforms will take (though if Merkel gets her way, a full political and economic union is on the cards). But whichever solution ends up being adopted, the eurozone will never be the same again.

Further reading on European sovereign debt and market regulation

Tags: credit rating agencies , EU , European Monetary Union , Germany , Greece , international differences , sovereign debt
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