Bondholders Desire Inflation as Austerity Antidote: Euro Credit

Dec. 7 (Bloomberg) -- The biggest investors in European sovereign debt say they will tolerate inflation over austerity, and that Greece's exit from the euro would spark a recession.

"I want growth," said Kathleen Gaffney, co-manager of the $19.3 billion Boston-based Loomis Sayles Bond Fund, the biggest non-bank holder of Greek debt. "Without Europe holding together, we're looking at, not just a severe recession, but a freezing up of the global financial system, which would be a depression."

Governments from Italy to Spain are cutting spending to reduce bond yields that reached euro-area records of more than 7 percent last month. The cost of insuring euro zone government bonds against default also rose to a record on Nov. 25 on concern a member of the single currency would default. The Markit Itraxx Sovx Western Europe index of credit-default swaps on 15 governments was at 326 basis points in London yesterday, down from its peak of 385, according to Markit prices.

While the austerity measures announced by governments in Italy and France have reduced 10-year yields to 5.80 percent and 3.21 percent, respectively, from as high as 7.48 percent and 3.82 percent in November, investors say that without growth the relief may only be temporary. The Organization for Economic Cooperation and Development on Nov. 28 slashed its euro zone growth forecast for 2012 to 0.2 percent from 2 percent, saying the region "represents the key risk to the world economy."

'Debt Mess'

German Chancellor Angela Merkel and French President Nicolas Sarkozy are pushing for new rules to tighten euro-area economic cooperation before a Dec. 8-9 summit of European Union leaders. Standard & Poor's said on Dec. 5 that it may downgrade the two countries' AAA credit ratings along with the grades of 13 of their neighbors.

"The danger in Europe is that austerity, feeding on itself, makes the economic environment worse and exacerbates the fiscal problem rather than solving it," said John Stopford, head of fixed income at Investec Plc in London, who helps manage $90 billion. "Ultimately, to get out of the debt mess, we need to see growth across Europe." Stopford holds French, Dutch and Finnish debt, and no peripheral bonds.

The only way for Europe to solve the crisis to allow inflation to accelerate, eroding the value of fixed-income securities, and for investors to write down some of their holdings of government debt, according to Komal Sri-kumar, chief global strategist at Los Angeles-based TCW Group Inc., which manages $120 billion.

"My examination of indebted countries for decades suggested the way they get out of debt in a big way is through inflation," he said in an interview, citing the Latin American defaults of the 1980s. "If you find austerity is not the way out, then you should do it through inflation and debt reduction through haircuts."

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