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.

How long can Spain fund itself at these levels?

Once again the crisis came roaring back this weekend, with a terrible Spanish debt auction last week and rumours that a raft of Spanish regions will need aid from the central government (as we predicted here) sending Spanish 10 year borrowing costs skyrocketing to a record 7.55%.

The questions now turn to how long the central government can fund itself and its regions at these levels.

By all accounts Spain has done well to ‘pre-fund’ a large amount of its debt this year (meaning its already borrowed most of the money it needs to), while the average interest rate on its debt remains fairly low (around 4%) while the average maturity of its debt is around six and a half years – in all not a bad debt profile considering everything. However, around 10% is soon to be added to the debt to GDP ratio while the mounting costs of bailing out the Spanish regions will only exacerbate this. All the while growth continues to stall – the Bank of Spain announced this morning that the Spanish economy contracted by 0.4% in the second quarter of this year, to add to the 0.3% decrease in the first quarter.

Those of you that read our recent report on the Spanish bank bailout will know that we pre-emptively tackled this issue in detail, but just in case here’s a refresher from the report:

 …looking at the Spanish state’s funding needs over the next few years, even with the recapitalisation of the banks taken care of, it faces a huge level of debt refinancing. Up to mid-2015 Spain faces funding needs of €547.5bn, over half its GDP and a large majority of its debt.

Spanish debt maturing
The Spanish central government will need to rollover €209bn in bonds and €75bn in bills, equal to almost 30% of GDP and close to half of its official debt. This will become increasingly difficult if Spanish borrowing costs remain at elevated levels.

Spanish deficit 
From mid-2012 to mid-2015 Spain will have to finance a deficit worth €179bn – that is assuming it manages to stick to the IMF projections and its deficit cutting plans.

Unpaid bills 
Spain also faces large stocks of unpaid bills at all levels of government, totalling around €105bn. These are due to be wound down over the next year or two despite having been at elevated levels for some time. Ultimately these funds are mostly owed to domestic creditors meaning withholding the money for longer will be counterproductive for the Spanish economy. (In light of this weekend's  rumours its interesting to note that the recent boom in arrears came nearly exclusively from regional governments).

…the amount to be rolled over in the next year or two is still particularly large…This will further increase the pressure on the banks to load up on Spanish sovereign debt, with potentially huge consequences if this loop ever breaks down. If the problems in the banking sector are not resolved their ability to continue funding the state will at some point come under huge pressure, if this falls apart Spain may find itself without any willing creditors.

Spain races against time

Things are looking sticky in Spain.

Firstly, the Spanish government announced a bail out of Bankia to the tune of €19bn in addition to the €4.5bn already put in - and is currently looking at the least painful way of getting cash to the bank. The plan is still up in the air. Yesterday there was talk about swopping government bonds for shares in the bank (Bankia could then use the bonds as collateral to get more cash from the ECB). This made a lot of people nervous, not least the Germans, who already worry that the link between states and ECB funding, via banks, is getting a bit too strong. Today's talk has instead focused on issuing bonds from Spain's specific bank bailout fund, FROB, to raise the cash Bankia needs.

Secondly, Catalonia - Spain’s wealthiest region - has asked the central government for financial assistance to repay its €13bn debt; bad news for the central government's debt and deficit. Thirdly, the the spread between Spain and Germany’s ten-year bonds reached its highest level since the introduction of the euro, with Spanish ten year bonds currently at around 6.4%.

There are a huge number of issues on the table here, but these events highlight three things that we pointed to in our April 3 briefing on Spain:

• Despite Spanish PM Rajoy's remarks to the contrary, it looks increasingly as if Spain is slowly realising that it may not be able to afford to directly fund Bankia or other banks that run out of cash. And the numbers could well go up. This, in combination with talks and leaks over recent days that European money will be needed to backstop the Spanish banking system (Rajoy is very keen on more from the ECB), indicates that Spain is now moving ever closer to bank bailout via the EFSF.

• A huge battle looms over the finances and economic autonomy of Spanish regions, that remain a massive liability for the central government's attempt to cut its debt and deficits.

• Spain is racing against the clock. Naturally it will take time for the structural reforms that Spain is pursuing to have an impact - time that markets just won't give it at the moment.

Instead, it looks as though that time may soon have to be bought by eurozone taxpayers.

Never fear, Barroso is here...

Commission President Jose Manuel Barroso issued a statement this afternoon in an attempt to assuage market fears over contagion to Italy and Spain. His ground-breaking approach at this possibly pivotal moment in the eurozone crisis – tell markets their wrong and remind them what’s already been done.

Unsurprisingly, it doesn’t seem to have worked.

Barroso suggested that the market attacks on Italy and Spain are “unwarranted”, adding that

“In fact, the tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis.”

Erm, we’re pretty sure that’s exactly why the fears are warranted.

Clearly, markets (along with plenty of commentators) have to spell it out for eurozone leaders – until a long term solution to the crisis is found and until countries such as Italy and Spain demonstrate the political and economic capacity to return to sustainable economic growth (and therefore debt management), markets are going to remain concerned over the spread of the crisis.

Barroso also pointed out that

"Agreement was also reached on ground-breaking measures that will reinforce the euro area’s systemic response to the crisis by enhancing the effectiveness of the European Financial Stability Facility (EFSF)"

He also stressed the need to address “the sovereign debt crisis with the means commensurate with the gravity of the situation”.

However, the EFSF reforms could now well turn into part of the problem not part of the solution, as the EFSF clearly cannot be classified as 'commensurate means' - even in its expanded role. Why? Well, as we mentioned during our panel discussion on the ECB last week (and echoed by Citigroup’s Willem Buiter recently), the deal struck that eurozone leaders the other week means that the Single Currency has effectively been left without a lender of last resort.

This role should be performed by the ECB, but due to fiscal decentralisation it cannot do so without massively engaging in fiscal policy (and therefore politics) something everyone wants to avoid. The EFSF should fill this role but cannot currently for a few reasons.

First, the expanded role of the EFSF still needs to be ratified, which will take a couple of months at least (and the ratification may still run into problems in some countries such as Finland, Netherlands and even Germany). In the meantime, it will remain unclear who the actual lender of last resort is in the eurozone (no wonder markets are jittery). Given the short term nature of this crisis, it could all be over before this issue gets settled. The ECB is loath to intervene anymore and there are already serious questions surrounding its credibility, transparency, balance sheet and the conditionality of its lending (hint: its non-existent).

Secondly, and possibly more importantly, the size of the EFSF is far from being enough to cover Spain and/or Italy (which has a bond market of €1.6tr). Increasing it to the necessary size to cover these countries, around €2tr at least, is politically impossible and undesirable as well.

Add to these issues, the persistent lack of growth and competitiveness which plague the Spanish and Italian economies and its clear why markets are worried. Unfortunately, yet again, Barroso seems to have missed the point.

A Portuguese bail-out won't be enough

Over on Europe’s World we have a post on the future of Portugal. We argue that a bailout now looks inevitable but that it will do little to solve Portugal’s problems due to:

- Funding requirements topping €39.4bn this year alone, equal to 25% of GDP.
- Unsustainable borrowing costs both in the short term and the long term, as we have already noted.
- Over reliance on ECB funding - both the state and the banking sector
- Massive lack of competitiveness as well as few policy options to facilitate economic reforms and foster growth

Given the mountain of issues facing Portugal, a bailout might give the appearance of providing help in the short term, but restructuring debt and tackling the problem at its source - high debt to GDP ratio and massive amounts of private debt - will provide a much better long term solution for both the country and the eurozone. However, even so, in the absence of some serious reforms to boost the country's competitiveness, going far beyond those that we're seeing at the moment, Portugal may find itself in this position again before too long.

You can check out the full article here.

The cost of dignity

Yesterday, Portuguese Prime Minister Jose Socrates said:

"[Portugal] would lose its prestige and (its) dignity of being able to present itself to the world as a country that succeeds in solving its problems [if it asks for a bailout]."

Today, Portugal auctioned off €1 billion in 2 year government bonds, but the Portuguese really had to pay this time. The interest rate was 5.99% which, for 2 year borrowing, is an exorbitantly high cost. Keep in mind that even with the punitive interest rates of 6% for 3 years, the current bailout loans now look relatively good value for the Portuguese.

Oh, and just in case you thought things looked better down the line: 5 year rates reached 7.82% and 10 year hit 7.70%.

The 10 year rate has been above 7%, the threshold widely accepted as being unsustainable, for 24 consecutive days; Greece and Ireland lasted 13 and 15 days respectively before asking for a bailout. The real question now is not if Portugal needs a bailout but when, and will it be enough? Surely a restructuring would do more for its long term economic stability at this point.

In any case it looks like prestige and dignity are going to hit the pockets of Portuguese taxpayers hard until a decision is made.