BMI View: The eurozone crisis is fast reaching its Lehman moment. Despite the severity of the debt market storm and enormity of the figures involved, the eurozone has sufficient resources to overcome its biggest crisis. However, political paralysis, frozen capital transmission channels and 'flight to safety' pose formidable obstacles to unlocking the potential of the bloc's resources to overcome the debt market rout.
We have previously warned that fixing the eurozone would first require a crisis of epic proportions in order to provide the political cover for policymakers to take necessary but unpopular decisions needed to reform the beleaguered currency union. That 'epic crisis' is here. Turmoil in Greece and a botched attempt at an 'in or out' referendum brought the eurozone close to the brink, Italy's bond market has started to unravel as the economy dives into recession and debt sustainability is questioned, while the apparent spread of market contagion to France and insufficient demand for debt at the latest German government bond auction.
Up until recently we adopted a cautiously optimistic stance, expecting the eurozone to muddle through and find a solution to stop the rot. We reasoned that the costs of not doing so would be so great as to spur Europe's politicians into action. However, the anaemic policy response thus far - particularly the poorly equipped and poorly conceived European Financial Stability Facility - and political paralysis has severely dented our optimism. Time is fast running out. Without the announcement of a shock-and-awe strategy, such as the European Central Bank (ECB) being allowed to monetise sovereign debt or the EFSF being provided with several trillion euros of fire power, the likelihood of the currency union being pulled apart by the market increases by the day.
We would stress, however, that the eurozone has the resources at its disposable to tame the crisis. Indeed, this crisis is not a case of there being a lack of firepower or insufficient intellectual capital, but is instead the result of political paralysis, frozen capital distribution channels and 'flight to safety' which has sucked resources out of the periphery and flooded core debt markets. Below we consider a number of factors which we believe highlight the issue of sufficient resources but insufficient resolve.
Show Me The Money
It may be surprising to think that in the midst of an unprecedented crisis there is arguably not arguably a shortage of money. There are a number of ways to look at this. First, central bank policy rates in the West have been held at near zero since the height of the global financial crisis. Although the ECB had pre-emptively begun hiking earlier in the year, it has now started to cut rates and could end up converging towards the zero bound.
Real Policy Rates Have Turned Negative |
Central Bank Policy Rates - Headline Inflation, % |
Source: BMI, Bloomberg |
In addition to slashing policy rates, there have been various attempts across the world to directly inject money into the economy. The US Federal Reserve and Bank of England pursued quantitative easing, while the ECB continues to provide substantial liquidity through various emergency programmes despite vociferously denouncing QE. Indeed, the ECB provides funds through its marginal lending facility (having previously reduced collateral quality requirements to keep thinly capitalised banks afloat) and has forayed into the sovereign debt market by purchasing sovereign bonds on the secondary market through its securities market programme (SMP).
Full-Blown ECB Monetisation May Be The Only Way |
ECB Securities Market Programme, EURbn |
Source: BMI, ECB |
With nominal interest rates near zero and real rates deeply negative, the economy has been primed for credit expansion. However, traditional (and increasingly less traditional) monetary policy has lost traction as the private sector deleverages. There is not only a lack of demand from the end user of credit (i.e. households and firms), but even financially sound debtors seeking credit are being cut off by risk averse banks. Europe's banks have instead exploited the near zero cost of money to widen loan spreads and boost profitability, in a bid to gradually recapitalise. Banks have also started to pile up reserves at the ECB as the heightened uncertainty over the future of the eurozone has scared lenders away to the point that they are more than willing to accept negative real returns through the central bank's deposit facility.
Flocking To The ECB |
ECB Deposit Facility, EURmn |
Source: BMI, ECB |
The ECB itself is the eurozone's biggest trump card. We have recently argued that the central bank will have little choice but to intervene heavily in the debt market in light of the heavy refinancing load and deterioration in risk sentiment. In our view, only the ECB has the ability to stabilise the market. Indeed, it is the ECB, not the EFSF, which is the eurozone's financial bazooka.
Core Debt Markets Soaking Up Capital
Near-zero policy rates have similarly translated into record low sovereign bond yields for those governments that are fortunate enough to have 'safe haven' status bestowed upon them. Indeed, even while sovereign bonds at the periphery of the eurozone have been dumped, demand for US, UK, German (and other core eurozone) bonds has firmed since the onset of the 2008 financial crisis. Core Europe's debt markets are the biggest in the world behind the US and Japan.
The UK gilt and German bunds markets, in particular, continue to soak up capital to the detriment of governments elsewhere in the region that are struggling to refinance at sustainable rates. Again, with long-end bond yields collapsing in these markets, there is clearly plenty of liquidity around, it is just not being distributed widely, creating a massive schism in the debt markets. Ultimately a joint-liability bond market may be a vital component of a long-term solution to the crisis.
A Race To The Bottom? |
German & UK 10-Year Government Bond Yields, % |
Source: BMI, Bloomberg |
Even in the case of Germany and the UK, the flood of money seeking a safe haven could ultimately prove more of a curse than a blessing. Locking up capital in the bond market at negative real yields is a worrying sign for future growth. The longer that money is tied up in this way, the less funds are being put to more productive use. As such, the lack of investment in projects that generate return can lower productivity and broader economic growth over the longer term, potentially elevating the debt burden for Europe's safe havens.