Confusion over governments' intentions, and poor communications between officials and markets, are causing eurozone bond investors to assume the worst as weak countries grapple with their debts. The bond yields of Ireland, Portugal and Greece have soared since the European Union agreed in late October to discuss creating a crisis mechanism under which eurozone governments could restructure their debts in an orderly way.
Because of the time needed to agree on details of the mechanism and revise the EU treaty to include it, the reform will most probably not take place before 2013. Until then, current systems to handle eurozone debt crises will stay in place; these focus on keeping countries afloat while they repair their finances, and do not envision debt restructuring.
But bond spreads have jumped to levels where markets are pricing in a significant chance of a restructuring well before 2013. Eurozone officials and analysts say the opaque way in which the debate on the crisis mechanism has been launched, and distrust of governments' intentions, are fuelling the panic.
"Markets have misunderstood. They seem to be worrying about some form of restructuring or haircut or prolongation of maturities pertaining to current loans, to currently outstanding sovereign bonds, which is not the case," one frustrated eurozone official told Reuters on condition of anonymity.
"It is really a discussion of what will happen after 2013. Markets have interpreted this as meaning a sovereign restructuring could be imminent, and that is absolutely not what is being discussed."
The situation resembles the weeks before the EU agreed in May to provide a 110 billion euro bailout to Greece; though the EU tried to calm markets by declaring it would support Greece if needed, uncertainty over the EU's intentions caused yields to soar and ultimately made a bailout vital to avert disaster.
The October deal to discuss a new crisis mechanism was reached between President Nicolas Sarkozy and German Chancellor Angela Merkel, who then pressed the idea on the rest of the EU.
Since the deal was controversial, details of how restructuring would work were not spelt out. EU diplomats talked vaguely of a range of options such as writedowns (known as "haircuts"), debt rollovers and deferred payments of interest, depending on individual cases.
Since October, various concrete proposals have emerged. Finland has suggested that new eurozone bond issues include a Collective Action Clause letting a majority of holders impose restructuring on the others. The influential Bruegel think tank in Brussels proposed that the European Court of Justice act as a sovereign bankruptcy court.
But much discussion of these proposals has gone on behind closed doors, leaving investors unable to judge the likelihood of them being adopted. So markets have acted defensively by pricing in the possibility of huge mark-downs on bond holdings.
Investors have also been alarmed by repeated statements by German officials, including Finance Minister Wolfgang Schaeuble, that the private sector should share the pain of future debt crises. This has caused some investors to price in a risk of a country defaulting considerably before 2013.
The yield on two-year Greek government bonds, for example, has jumped above 12 percent from 9.6 percent at the end of October, even though those bonds will mature before the end of Greece's three-year bailout programme.
Senior eurozone official sources said many officials in the bloc had expected markets would be worried by the debate over the crisis mechanism, and had opposed starting the discussion now, preferring to wait until investors were calmer. But Germany ignored the warnings, they said.
Markets have come to believe that the orderly restructuring mechanism is being created specifically to handle defaults by Greece, Ireland and Portugal, even though this is not the case, the official said.
ECB Executive Board member Lorenzo Bini Smaghi denounced the mechanism this week, saying a default system where private investors were forced to take penalties would destabilise markets and encourage speculation.
Nevertheless, Germany appears determined to press on with the debate, partly because it does not want to pay the lion's share of the cost of future debt crises as it did with Greece, and partly because of domestic political imperatives.
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