Monday 26 August 2019

Relative calm in eurozone comes at a cost and will not last forever

Europe's common currency has survived so far but has done little for political cohesion

EXIT: Italy faces a period of political uncertainty after prime minister Matteo Renzi announced his resignation following his defeat in a constitutional referendum
EXIT: Italy faces a period of political uncertainty after prime minister Matteo Renzi announced his resignation following his defeat in a constitutional referendum
Colm McCarthy

Colm McCarthy

Despite inadequate design and misguided management, Europe's common currency has survived eight years of severe economic downturn, and survived better than support for its designers, the traditional political parties in the EU's founding member states.

European political cohesion would be in better shape, and the United Kingdom still on board, had the common currency enthusiasts been ignored. But the common currency project will survive: it enjoys deep political commitment in Germany, sadly not extending to a willingness to remedy the design flaws so clearly in evidence since 2008.

The preferred German policy is to ignore system fragilities until crisis strikes, blame other European governments for inadequate 'reform' and thus to maximise economic cost and political damage through doing too little, too late.

There is no Article 50 for the euro - unilateral exit for any country suffering buyer's remorse is prohibitively costly, as advocates in France and Italy will discover in early course. The relative calm in the eurozone these past few years has been purchased at high political cost and is unlikely to last.

If there is another eurozone crisis in 2017 it will be a sovereign bond crash, a banking bust, or a combination of the two. The last sovereign bond crash was in 2012 and involved Italy and Spain, both too-big-to-fail countries: something had to be done so the European Central Bank announced its willingness to shore up the eurozone sovereign bond market.

No such alacrity was in evidence when smaller countries, including Ireland, faced borrowing difficulties during 2010 and 2011. The policy of supporting sovereign bond markets, the first major initiative under Mario Draghi's presidency, was a success and reassured markets without any actual ECB bond purchases.

The ECB has virtually unlimited firepower and the markets are loath to speculate against it. Since March last year, the ECB has pursued a new programme, called quantitative easing or QE, purchasing large quantities of mainly sovereign bonds every month, thus ensuring cheaper borrowing costs for the heavily-indebted members (except Greece, excluded from the ECB's munificence).

By the end of 2016 about one-sixth of all the sovereign bonds in issue in the common currency area will belong to the ECB and Draghi announced last Thursday that the scheme will continue until the end of 2017, although at a somewhat slower pace than the markets had expected. By definition, any programme of purchasing government bonds from existing holders in very large quantities must eventually end, since there will be no bonds left to buy.

Long before that point is reached, financial markets would seize up: they need some substantial portion of the bond stock to remain outside the central bank vaults. QE was initiated earlier in the USA and in the United Kingdom but has already been terminated. At some stage over the next few years QE in the eurozone will be scaled back, and then withdrawn.

This matters a lot to countries which would face higher borrowing costs without the ECB's intervention, a category which includes Ireland. Much of the measured improvement in the Irish budget numbers these past two years has been due to easier borrowing terms.

Interest rates on government borrowing have been rising from unprecedented lows (negative in some countries) since the Brexit vote in the UK and the Trump victory in the US. The most immediate threat is that one of the heavily indebted countries, with a large continuing need to re-borrow maturing debt, will see the cost of new debt begin to spiral upwards.

The first ECB intervention in 2012 occurred when Italy's spread for 10-year money (the penalty over German borrowing rates, the lowest) rose to 5pc. This was deemed unsustainable, not least because the Italian debt stock in absolute terms is Europe's largest. Cue urgent action to save the euro.

The Italian spread was down to just 1pc earlier this year but has drifted up towards 2pc in recent months, notwithstanding the ECB's continuing support for the Italian bond market. Only Portugal and Greece, both SETF (small enough to fail) countries, face higher spreads. But Italy cannot be allowed to fail. An Italian exit from the bond market would create a worldwide financial crisis and possibly the chaotic break-up of the common currency.

So the political uncertainty in Italy created by Matteo Renzi's heavy referendum defeat and resignation will not be permitted to see bond spreads inch back up to crisis levels.

Some way will be found to sanction market support and last Thursday's announcement from the ECB was the first instalment.

Mario Draghi announced that the bond market purchase programme will be extended to the end of 2017, although at a somewhat reduced (but still substantial) pace. It had been due to run out at the end of March.

At his press conference, Draghi managed to avoid answering the more searching questions but made clear that the decision to extend QE was not unanimous. Opposition to the QE extension apparently came, yet again, from German representatives on the ECB's governing council.

Everyone knows the hawks will fold if things go really badly for Italy: nobody has a mandate to collapse the Italian bond market and hence the common currency experiment. Draghi secured agreement from the hawks to restore a faster pace of support if needed.

He made no reference to the ongoing (after eight years) solvency shortfalls in the banking system. Numerous European banks have high levels of non-performing loans, poor profit prospects and weak balance sheets.

Some Italian banks and one Spanish lender are in need of early injections of capital and the share prices of the eurozone banking sector generally are weak.

The markets place a far lower value on the shares of many banks, including the two largest German banks, than the net asset value they show in their books, which means that the markets believe they have yet to make adequate provisions against dud loans.

New EU rules about restructuring banks in trouble make it difficult for governments (even ones which have the money) to subscribe extra capital, as was done in many countries in the early years after the crash of 2008. They are supposed to haircut bondholders first.

Unfortunately this policy, which would have spared much grief in Ireland had it been in place when the crisis struck, is now a hindrance to bank resolution in Italy. Some bank bonds have been sold to retail investors, as also was permitted to happen in Spain. The result is political reluctance to do the sensible thing within EU rules, which is to recapitalise the weaker Italian banks using public money.

The ECB is currently purchasing €80bn worth of bonds, mainly government issues, every month. It has taken substantial risk on to its balance sheet and has already lost money, since bond prices have fallen.

As early as October 2008 the US authorities engaged in a compulsory recapitalisation of the main American banks - they were forced to accept government capital, in some cases under protest.

If a fraction of what has already been spent buying government bonds at negative yields had been forced on the banks, the European banking crisis would be over.

But that would contravene the sacred 'too little, too late' principle.

Sunday Independent

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