The calm before the eurozone storm

Published in Business Spectator (Melbourne), 14 August 2014

Last week, after the bailout of Portuguese bank Espirito Santo, euro optimists celebrated this quick action by the Portuguese central bank as a good sign. “The systemic euro crisis is over,” wrote Berenberg Bank’s chief economist Holger Schmieding. He added that “while the eurozone still has issues, it now has a well-oiled machine to deal with them. The vicious contagion risks, which were the hallmark of the euro crisis, can be kept at bay.”

If only.

Though one could well argue that Europe has become better at dealing with acute crises of individual financial institutions like Espirito Santo, this does not mean that the euro crisis is over. In fact, one does not have to do much with the other. The systemic risks of Europe’s monetary and financial system still persist, having only been masked by the interventions of the European Central Bank. One could even make the case that by putting the euro crisis on hold, the ECB has made the problem worse.

ECB President Mario Draghi and his famous “whatever it takes” speech two years ago made it clear to markets that the ECB was willing to defend the euro against speculative attacks. This was also interpreted as an implicit guarantee that the ECB would be prepared to bail out struggling governments and financial institutions if required.

Draghi’s intervention had the desired effect of calming the euro crisis. However, it also had some nasty side effects, which are only becoming more visible as time passes.

The first effect of the ECB’s intervention was that it reduced the need for any eurozone government to implement economic reforms. When yields on government debt were still high, governments needed to convince their creditors of their creditworthiness. Under such pressure, even countries that were notoriously slow to reform such as Italy or Spain started administering some tough medicines such as spending restraint or labour market reforms. They really had no other choice.

As we can see now, the declining yields on government debt were not seen as a great opportunity to get the euro periphery’s house in order but mainly as an invitation to reduce reform efforts.

Perhaps the best example of this development is Italy. At the peak of the euro crisis, Italy’s situation was so serious that even a technocrat caretaker government could be installed by removing elected prime minister Silvio Berlusconi from office.

In comparison, Italy’s situation today looks much like business-as-usual. New Prime Minister Matteo Renzi took office in February of this year and started with the promise of turning his country around. After his first half a year, however, he has hardly achieved anything. The self-styled reformer is facing the same systemic political roadblocks endured by his predecessors.

While the youthful Renzi is fighting for political and administrative reforms, Italy’s economy has fallen back into recession. For the past two consecutive quarters, Italy recorded negative growth: ‑0.1 per cent in Q1 and ‑0.2 per cent in Q2. Youth unemployment is above 40 per cent; industrial production is stagnating; and Italy’s government debt is rising. Yet the Italian crisis is not visible in its government bonds, where yield on 10-year bonds are currently trading under 3 per cent.

Without the ECB’s intervention, Italy would look very different today. It would have either undertaken more serious reforms, or it could have concluded to leave the eurozone and in order to kickstart its economy through a devaluation of the new lira.

The second nasty side effect of Draghi’s intervention, apart from lifting the reform pressure off Europe, is that is has arguably created a bubble in European government bonds.

In a global environment of ultra-low interest rates, and with central banks in the US and Japan actively trying to devalue their currencies, the effective ECB guarantee for eurozone governments has made investments in higher-yielding periphery bonds all the more attractive.

Combined with a strengthening euro exchange rate, this created the perfect condition for carry trades from the US dollar and the Japanese yen into the eurozone. No wonder, then, that yields in the eurozone went into freefall. The only question is: will this bubble eventually burst?

Though it is hard to predict with certainty what will happen, it is quite likely that one or two things will eventually materialise.

The first is that interest rates in the US will rise, which would see capital flows into the euro periphery reverse. If (or rather when) this happens, we could see a rather rapid increase in eurozone yields once again. The second possibility is a weakening of the euro exchange rate as a result of an economic slowdown in the eurozone. A fall in the euro exchange rate would also undermine the profitability of carry trades — and it would have the same effect of spiking yields on periphery debt.

Since May, we have already witnessed a sharp decline in the euro exchange rate vis-à-vis the US dollar and the yen. With the eurozone economy looking shakier, with even Germany edging closer to recession, and with the full impact of Europe’s trade war with Russia still to be felt, there is every reason to believe that the euro’s exchange rate will come under pressure. If the ECB also moves towards full-blown quantitative easing, this would only compound the risk of a euro devaluation.

In summary, the ECB may have succeeded in temporarily driving down yields on periphery government debt. It was obviously helped by an international monetary environment of very low interest rates, which made investment in higher-yielding euro periphery debt more attractive. However, these conditions have arguably reduced the pace of economic reform across Europe while creating risks that the ECB will not be able to control fully.

Though many analysts may wish to believe that the euro crisis was over, it has only been put on hold. It will flare up again when markets once again turn their attention to the fundamentals of the eurozone. They now look worse than before with spiralling debt levels, high unemployment and no economic growth.

The next stages of the euro crisis are already programmed into the system. It is just a matter of time until the current period of calm ends. And though it is impossible to when we can expect the next euro storm, one thing we can say with certainty: The euro crisis is not over. Far from it.

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