Miracles and mirages in the eurozone wonderland

Published in Business Spectator (Melbourne), 10 April 2014

In that faraway wonderland that it is the eurozone, nothing is quite what it seems. It is a strange place where half-bankrupt governments can plan a return to capital markets at moderate yields, and a central bank is able to impress analysts by talking about things it cannot do. Both instances are patently absurd, but just because something is absurd has never stopped it from happening in Europe.

The country planning a return to the market is, of course, Greece. On Monday, Greek Finance Minister Yannis Stournaras said that he was planning to issue new government bonds by June. There was no hurry, he said, but his country would manage to do so in the first half of 2014.

Looking at the yields on 10-year Greek government bonds, Stournaras’ optimism looks almost appropriate. They are currently trading at just over 6 per cent, which is much lower than at the peak of the Greek crisis when yields had skyrocketed to more than 40 per cent.

However, just looking at yields is highly misleading in the Greek case.

At the same time that Greece’s yields have fallen, practically all other economic indicators have deteriorated. As a percentage of GDP, Greek government debt is now slightly higher than it was three years ago when yields peaked. At the same time that Stournaras is trying to spread optimism about Greece’s recovery, it still looks likely that the country will receive its third bailout package.

How does all of this go together?

It only really makes sense under the assumption that Greece will forever be able to rely on its European neighbours for help. Let’s put it this way: If Greece was on its own, with no support, and it had close to 180 per cent debt to GDP, would its bonds yield just over 6 per cent? Certainly not. Investors would run a mile rather than leave a cent in the vicinity of Athens.

With the core eurozone countries on standby to stabilise Greece as needed, it is obviously a different story. Markets seem to have concluded after the past five years that Greece is somehow unsinkable thanks to Europe’s unwavering support. This significantly reduces the risk of investing in Greek bonds, which explains the falling yields.

As Greece is now planning to return to capital markets, it does not do so based on its own strength. It is therefore highly ironic when a spokesperson for the German treasury declared that Greece’s planned bond issue was a result of the country’s successful reform process and a sign of the return of market confidence.

In reality, it is only a sign for the market’s confidence in Germany remaining willing to help out as needed. But that would not have been a message the German government would have liked to send out.

So Greece’s planned return to normality is anything but. It actually underlines that the support mechanisms in the eurozone have become so entrenched and reliable that even bankrupt governments can now expect to refinance at low interest rates.

Needless to say, under such circumstances, the willingness to undertake tough economic reforms will be greatly diminished. Why bother with reforms when you can easily borrow anyway?

The other rather bizarre story coming out of the euro wonderland last week was the European Central Bank’s musings on the possibility of quantitative easing. Triggered by fears of deflation, ECB President Mario Draghi publicly thought about unorthodox policy responses. This alone had a significant impact on markets (including driving down periphery government yields, such as Greece’s, even lower).

Yet again, the reality is quite different than the first impression one might derive from Mario Draghi’s words – that is not only because he did not follow up on his words immediately. In fact, the ECB did nothing at all last week, not even the final cut of interest rates to zero that it could still take before entering unconventional territory.

What makes the power of Draghi’s statement so hard to understand is something else. Even if the ECB wished to engage in quantitative easing policies of the kind employed by the Federal Reserve or the Bank of England, it would struggle to do so. The difficulties of implementing QE in the eurozone are both legal and practical. Draghi knows this; it’s why he prefers talking over doing anything.

The legal complications for the ECB are well known. According to its mandate under European Treaty Law, it cannot engage in financing governments.

This is what it would be doing under a QE program, at least indirectly. Especially now that the European Court of Justice has been tasked by the German Constitutional Court with vetting the legality of the ECB’s Outright Monetary Transactions program (Will the euro die in the courts?, February 13), the bank’s actions in this space will be under close legal scrutiny. It is not entirely impossible but certainly very difficult for the ECB to engage in QE without overstepping the narrow confines of its mandate.

Draghi will therefore have to be careful in the way in which he deploys QE, if at all. One way to do so would be to avoid buying up government bonds and focus on corporate bonds instead. From a monetary policy perspective, this would almost have the same effect while avoiding the legal pitfalls described above.

But here comes the rub. The eurozone market for corporate bonds is not large enough for such policies. The majority of corporate financing in Europe is done through bank loans, not corporate bonds. In order to create a bond market large enough to let the ECB do what it wants to do, some mechanism would be required to securitise the corporate loans first. Good luck with that.

For the time being, all Draghi can do is talk. Or, as the German daily Die Welt put it, Draghi is the “master in the art of doing nothing”. Indeed.

So here we have the absurdity of the eurozone crisis on display in two separate stories: A nearly bankrupt country able to borrow regardless, and a central bank impressing markets despite its own limitations.

Nothing is quite as it seems, though. Greece’s return to markets is almost a sign of its weakness, and Draghi’s tough talk is symptom of his bank’s impotence. To understand what is really going on in the eurozone, you should never trust first impressions.

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