Have borrowing costs in the eurozone periphery come down too far, too fast?

Over on his Forbes blog, Open Europe’s Raoul Ruparel asks: is there a bond bubble in peripheral Europe? The thurst of his answer is that, while there are good explanations for why costs have come down so far and so fast, they could certaintly have side effects, not least because people misinterpret the reasons for the move. The full post is here, but below are the key points:

What is driving this and is it a bubble?
There are three key factors at work here:

1. ECB President Mario Draghi’s promise to do “whatever it takes” to protect the euro combined with the unlimited bond buying policy of Outright Monetary Transactions (OMT) has driven borrowing costs down since mid-2012. This effect has been amplified by the expectations of further ECB easing, particularly some form of Quantitative Easing (QE), which would bring yields down even more.
2. There has been some success in terms of eurozone reform, particularly with the successful end to the Irish and Portuguese bailouts as well as these countries’ return to the markets, along with Greece. The eventual agreement on banking union and other aspects of trying to correct the structural flaws in the euro (although I believe it is far short of what is needed) has also contributed to the positive sentiment.
3. Possibly the most important factor though is the very low inflation in the eurozone (and even deflation in some countries). Over the past six months this has pulled the borrowing costs across the eurozone down.

This final point is driven home by looking at the rough and ready version of the ‘real yield’ on ten year debt in Europe (10yr yield minus HICP inflation). As the graph below highlights*, when this is done the UK actually borrows at a real rate which is 2% below Ireland’s.

Could this present a problem? (Hint: Yes)
While the process of collapsing bond yields in peripheral Europe is explainable it does still present some serious causes for concern.

• The huge demand for peripheral bonds does seem to have gone too far with respect to the economic fundamentals of these countries. Debt levels have continued to rise – exacerbated by low inflation – while many countries are barely posting any economic growth.
• More concerning though is that this creates very perverse incentives. Many governments can already be seen professing the success of their policies, citing falling borrowing costs and buoyant financial markets. In reality, these are much more down to the ECB and inflation effects mentioned above.
• The risk is that complacency seeps in (some of which can already be seen) and that the reform process in these countries stalls. Italy and France are prime examples of this. While the European Commission does have additional powers now to encourage further reform, when push comes to shove there is little it can do to force reform on an unwilling political class and population, particularly one with low borrowing costs.
• As detailed here, the banking union looks insufficient to break the sovereign banking loop in the eurozone. The efforts to improve the structure of the eurozone have slowed, the risk is they will grind to a halt until the threat of a crisis returns.
• The performance also looks strange relative to countries such as the US and UK which have always borrowed in their own currency for which they are solely responsible and have clear fiscal and central bank backing. Even with the changes to the euro structure and the ECB promises it’s hard to say that, in another crisis, the same issue wouldn’t arise with regards to a comprehensive lender of last resort (let’s not forget, the OMT comes with plenty of conditions and is limited in scope). Even though accounting for the inflation impact, the difference in risk between peripheral eurozone countries and the likes of the US and UK does seem to be being underestimated.

Ultimately, the crisis highlighted that too much price convergence without economic convergence and reform in the eurozone can actually be a bad thing, with resulting perverse incentives and negative outcomes. While the price action in peripheral bonds might not yet count as a ‘bubble’, investors and politicians would do well to remember these lessons when interpreting the record low borrowing costs.

What keeps the folks in Brussels and Berlin awake at night?

Possibly this graph - from our new report on the internal devaluation needed in the PIIGS for the euro to remain intact.

Source: Eurobarometer

It shows how trust in the EU amongst voters in the PIIGS has on average fallen from 55%  in 2001 to 25% in 2012, in the wake of EU-mandated cuts. On average, 66% of voters in these countries now mistrust the EU (up from 26% in 2001). And Spain still has half of its internal devaluation ahead of it (not to mention Greece). This won't be easy.

The ECB loads up on PIIGS exposure

Reuters MacroScope blog covers some of our updated figures on the exposure of the ECB to the struggling peripheral countries. Following the ECB’s Long Term Refinancing Operations (LTRO) the ECB’s exposure to these countries has increased significantly, without their situations showing any sign of improvement – in fact many of them are now in a worse position.

Last year we showed that the ECB exposure to the PIIGS totalled €444bn. Just a year later this has increased by a whopping 106%, to €918bn. The exposures are detailed below:

Total exposure - €917.61bn 

Exposure through lending programmes - €703.61bn 

Greece - €73.4bn
Ireland - €85.07bn 
Italy - €270bn 
Portugal - €47.54bn 
Spain - €227.6bn 

Exposure through the Securities Markets Programme - €214bn 

This gives the ECB a massive leverage ratio 38.4:1. This in itself is not the issue, more concerning is the fact that a third of the ECB’s balance sheet now resides in the PIIGS.

On top of this, while the ECB’s exposure has been rising the quality of collateral supporting this exposure has been deteriorating quickly. There are a few factors underlying this:

 - The value of the huge amount of PIIGS sovereign bonds which PIIGS banks hold has fallen while the default risk involved with them has risen quickly.
- The sovereign guarantee which backs up many of these banks (both explicit and implicit) has also become less solid as the states’ finances worsen and public outrage against bank bailouts increases.
- The risks and losses held on the balance sheets of these banks is yet to be fully acknowledged or fully realised in many cases. (For example, see our recent briefing on the massive problems in Spanish banks relating to their exposure to the bust real estate and construction sectors).
- The ECB has widened its collateral scope allowing even more opaque and harder to value collateral to be used to bank up its unlimited liquidity provision. 

That is to name but a few of the issues in play (we'll have a fuller discussion of the implications of this next week).

The real question which should be asked in all this is: how has the eurozone crisis continued to worsen despite the ECB more than doubling the money it has poured into these states?

Patently, the current approach to the eurozone crisis has failed. Even the ECB’s massive interventions only bought a short amount of time (and a lot less than many may have expected). The eurozone continues to fiddle at the edges of the crisis. All the talk of ECB lending, eurozone firewalls, IMF resources and austerity programmes fails to accept some of the fundamental flaws which underpin this crisis.

The eurozone needs to accept that there are a few structural flaws underpinning the eurozone crisis and move to correct them, not least: an endemic lack of competitiveness in the peripheral states, a structural bias towards low growth, a massively undercapitalised banking sector, mismatched monetary policy and a currency which remains grossly overvalued for many of its members. Until these issues are tackled, with both widespread political and economic will even further sprays of ECB liquidity will do little more than buy time, while further raising the cost of the potential break-up.

Update

The figures on exposure through lending programmes were obtained from the websites of the national central banks of:

Greece
Ireland
Italy
Portugal
Spain

Closer together or further apart?

EU leaders meet today in a bid to patch up the eurozone (while also dealing with other pretty complicated challenges such as Egypt and energy security).

Dutch daily De Volkskrant yesterday had a feature ("Leer eerst eens je broek op te houden") looking at how the atmosphere in the EU's diplomatic circles is becoming increasingly abrasive and more tense. The paper claims to have obtained various statements from diplomats, making clear the eurozone crisis and ongoing bailouts are complicating relations within Europe.

And it ain't pretty. Here goes:

A diplomat from a "small and rich country" finds it difficult to stay calm, and has to express his anger at what he explicitly refers to as the "the PIGS", Portugal, Ireland, Greece and Spain. He says:

it is incredible: these countries are still posturing. Then I think to myself: well, well, perhaps you should learn how to stand on your own two feet first.

When asked if he is not now insulting them by using such harsh language he snaps back:

it's their own fault [why should] hard working Dutch and saving Germans [pay the bill] for the Greeks, who strike continuously, even now when they have received €110 billion in emergency support from us.

A German diplomat gets more and more heated as he talks about Commission President Barroso's calls for propping up the eurozone bailout fund with more cash. Frustrated, he exclaims:

whose money is Barroso actually talking about? Is it his own? No! It's the money of the Germans, the Dutch, the French, the Finns. Is it so crazy that we get frustrated?

A high ranking Commission official complains about the "roughening of the mood":

the word PIGS alone. The image it conjures of responsible Northerners having to pay for a bunch of lazy people sitting under a palm tree by the Mediterranean. That leaves scars. Most citizens in Southern European countries are not to blame for the economic situation in their country. But they are being depicted as the trash of Europe.

A Portuguese diplomat adds that

I see my German and Dutch colleagues getting more and more authoritarian, as if they are in charge. Even the Finnish, who normally don't open their mouths, make interventions. (...) At the same time I get less and less involved in the discussion.

A diplomat from Ireland, which just received a €85 billion EU/IMF emergency loan, concurs:

I watch my words, it's like that. Our banks are down, not the German ones. Our economy is floored, not the Dutch one. We lost, then you better keep quiet.

Spain, which likes to see itself as one of the big powers of the EU, has a harder time accepting the new balance of power. Spanish Europe Minister Diego Lopéz Garrido privately tells journalists:

It's one thing to accept that Germany and France are important for the EU. But it's a whole different thing to accept that they impose an ultimatum.

Frustration is growing with the Franco-German motor, which is increasingly looking more like a tank. "If the other 25 member states would please sign here", is how a Commission official summarises the mood.



Germany, in particular, is causing a lot of anger. France is being taken less seriously. A diplomat from an Eastern European country notes,

The country is after all a bit of an open air museum. That you can keep up such grandeur with a mummy state and a couple of car factories is causing jealousy, but no annoyance or fear.

A German diplomat comments that the Deauville summit, at which Merkel and Sarkozy agreed on the thrust of a new economic order for the eurozone,

was a communication disaster (...) It looked like a diktat. But without Deauville we would still just be talking.

An Irish diplomat remarks that "the dynamics within the EU has completely changed", adding that Germany has evolved from a "mediator" in 2007, when the country held the EU Presidency, to a

role model, but one which imposes itself in a binding way. I understand it, though: we receive, they pay

The Commission official adds that the Commission hears plenty of complaints from Southern European leaders:

they say they are being belittled, or put to the side. The whole Commission is concerned. We should really watch out. This leaves marks. The blood is sticking to the walls.

He notes, however, that there won't be a revolt because of the upcoming discussions on the EU's long-term budget: "they won't bite the hand that feeds them."

Pew! Some people claimed that European Monetary Union was a “dream”. If so, Europe is now waking up to a nightmare.

Is this simply normal bickering in what are tense circumstances or something more? We're not entirely sure, but as Milton Friedman predicted in 1997:

The euro will aggravate the political tensions to the extent that economic shocks, which beat countries in different degrees but which could until now be facilitated through exchange rate adjustments, will change into political controversies.