Why the markets got it wrong on Europe
Published in Business Spectator (Melbourne), 27 February 2014
There are a few relationships in economics that are almost set in stone, with the odd exception to the rule. If supply increases, prices fall. If you consume more, you can save less. And if you want to achieve higher returns on your investment, you must be prepared to accept higher risks.
Looking at the development of the European economy, it appears as if the last of these propositions no longer matters with regards to European bond yields. As government debt in the European periphery becomes a riskier investment, the yields on periphery government yields are not going up as one might expect. On the contrary: they are falling.
Over the past two years, the yields on 10-year bonds peaked at 36 per cent for Greece, 15 per cent for Portugal, and just above 7 percent for both Spain and Italy. Today the respective yields are down to around 7.5 per cent for Greece, 5 per cent for Portugal, and around 3.5 per cent for both Spain and Italy. As a comparison, over the same three-year period, German yields have fluctuated within the relatively narrow band of 1.2 to 2.1 per cent.
This development of yields for eurozone periphery bonds is astonishing on two fronts. First, at the same time that yields have collapsed, public debt levels of the countries in question have increased. For example, in Italy the public debt to GDP ratio has increased form 120 per cent in 2012 to more than 130 per cent today. All other things being equal, this should have made their bonds look riskier not safer.
Second, the reduction in periphery yields of course also means an equal reduction in spreads to German bonds. Put simply, markets are now viewing investments in, say, Italian or Spanish bonds only as a little riskier than investments in German government debt.
The only way to make sense of these developments is to believe the announcement by Mario Draghi, the head of the European Central Bank, to do whatever it takes to save the euro. But Draghi’s ability to deliver on his word is now seriously in question given the legal uncertainty over the ECB’s mandate (Will the euro die in the courts?, 13 February 2014).
While the ECB might have been powerful enough to finance and save a small economy like Greece, the dimensions of Spain or Italy would certainly be too large even for the ECB to stem without triggering a revolt of other eurozone countries. Even if the ECB was technically and legally able to bail out a country like Italy, this would be an entirely different story politically.
Without the support of the ECB, the yields on eurozone periphery debt should have gone up, not down. This week, the Centre for European Policy published its new Default Index, assessing the likelihood of a sovereign default in eurozone member states. This index does not only look at narrow measures of public debt, but also at the general health of an economy and its businesses, its ability to generate growth and its dependence on foreign funds.
Based on the CEP’s index, the European periphery economies remain in the intensive care ward, showing no signs of improvement. On the contrary, these economies are on a negative downward trajectory even where they managed to reduce their capital imports.
Greece is a case in point. Though the country required fewer capital imports from its European neighbours, this reduction was only the result of negative net investment within the Greek economy. Instead of reducing its consumptive expenditure, Greece was shrinking its capital stock. This in turn reduces Greece’s ability to generate economic growth in the future. Therefore, even with a reduced dependence on capital imports, Greece’s overall position deteriorates further. The CEP report comes to the sobering conclusion that there are no signs that Greece will regain its creditworthiness anytime soon.
The situations in Italy and Portugal are marginally better but still serious. In both countries, the economies’ capital stocks are also eroding due to negative net investment. Since 2009, Italy has been consuming more than it produced. The consumption ratio currently stands at 101.6 per cent. Needless to say, this is neither healthy nor sustainable.
In conclusion, the CEP report sees Italy, Greece and Portugal as countries with severe and deteriorating creditworthiness issues. It is a bit more optimistic about Spain but points out that the Spanish, too, still have a lot of economic reform work ahead of them if they want to reduce their debt burden and their unemployment.
There is a paradox. Looking at the state of euro periphery economies, their debt burdens are increasing and their economies far away from creating the conditions for a sustainable recovery. At the same time, markets are seemingly coming to the conclusion that their default risk is not as high as was thought a couple of years ago.
It would not be the first time that markets are wrong in their assessment of the periphery’s default risk. After the introduction of the euro, yields across the Eurozone converged towards German levels. The mere fact that these countries shared the same currency led markets to believe that their default risks were identical. This was a mistake, as markets discovered in the euro crisis.
It now looks as if this lesson has already been forgotten. The same yields convergence process is underway once again. Now, just as then, there are no good reasons to share this optimism.
As George Soros said in an interview with Der Spiegel news magazine this week, the euro crisis is not over; it has only been put on hold. He is right. But if he is, then periphery yields are too low. They will shoot up once it is understood that the periphery countries have not recovered from their economic crisis, the ECB will not be able to save them, and the euro core is not strong enough to bail out larger countries like Italy.
Some relationships in economics are indeed set in stone, and in the long run you cannot neatly separate risk from return.
Here is another economic truism: If something cannot go on forever, it will stop.