The Eurocrisis is once again dominating the headlines. Renewed talk of a Greek exit, record yields for Spanish bonds and rising Italian borrowing costs have been splashed all over newspaper headlines. On the 25th of July, the yield on two year bonds for Spain hit more than 7% with the borrowing cost for five years and ten years exceeding 7.5%. For Italy the numbers were 5.2%, 6.5% and 6.7% respectively. Then, on the 26th of July, as Mario Draghi, the ECB president spoke of doing “whatever it takes” to save the Euro and making a reference to tackling problems of transmission of monetary policy being within the ECB’s mandate, the yields fell sharply. In this policy commentary we discuss 1) the relevance of high yields and 2) how they may be brought down and 3) the relevance, if any, of Draghi’s remarks.
No matter what the headlines say, the short-term impact of the rising yields on Spain’s actual borrowing cost is very limited. Spain is currently paying just 4.1% on the stock of its outstanding debt which has an average maturity of 6.4 years. This means that if Spain can now borrow at an average rate of say 7.1% (a full 3% points above current costs) it would take more than six years for this to reflect in its average borrowing costs. We have also analysed Italian borrowing costs in this piece here. This means that in any one year its actual borrowing costs are likely to rise only by about a sixth of that amount, around 0.5%. If the panic in the markets does not worsen (which is a big if) Spain’s actual borrowing cost will only rise to a bit more than 4.6% by July 2013 -a cause for concern yes, but not a cause for panic. What then is the problem? Why the near panic?
Why rising yields are a problem
The situation in Spain is very bad, but much more important is the fact that it is likely to get significantly worse unless current policies are changed dramatically. As the political space in the Eurozone shrinks this looks unlikely so not only does tomorrow look worse than today but day after tomorrow looks worse than tomorrow and there is no light at the end of the tunnel. Under such a negative overhang, few people expect bond yields not to go higher still as the credit risk in the economy rises. This gets us into a circular logic where expectations of the economy getting worse drives both current yields and future expectations of yields high – these are a cause for concern and every time a new level, say 7.5% is breached expectations set in that the next psychological threshold may be next. The absence of any Eurozone policy maker response every time a new level is breached further reinforces the belief that the situation will get worse. (An ECB response has been expected as yields reached new highs, but did not come. This is one of the reasons why Draghi’s remarks yesterday were interpreted positively by markets as he did address the issue albeit indirectly and the markets hope that this is a precursor to action)
The renewed discussion of a Greek exit from the Eurozone poses what is perhaps the biggest threat to Spain and Italy. As long as the Euro is considered to be permanent, the mains risks in Spanish and Italian bonds are credit risks. The minute one seriously starts considering the possibility of a break-up of the Eurozone, the additional risk of redenomination creeps in. Most Spanish and Italian bonds were issued under domestic law so in the event of a break-up of the Euro, could be redenominated into the peseta and the lira respectively. These are rightly expected to depreciate sharply, perhaps by as much as 50%, thereby inflicting a very large loss on bondholders. This means that foreign investors, in particular, have a strong incentive to flee and the uncertainty overhang surrounding the integrity of the Eurozone has been a big driver of capital flight from and rising yields in both the public and private sectors of Spain and Italy.
Rising yields have an immediate impact on the real economy as well as the financial sector beyond the market logic and dynamics we just discussed. First, rising yields depress the market price of the large amounts of Spanish government bonds held by Spanish banks that weakens what is already a very fragile financial sector. This in turn casts a negative shadow on the Spanish sovereign given that Spain will need to backstop most of any losses that may accrue in the banking sector. Second, rising yields and higher volatility increases the collateral haircuts that counterparties demand making life harder still for banks. Third, sovereign yields remain critical for the transmission of credit to the real economy. Beyond the immediate negative impact that further fragility in the financial sector has on the ability and willingness of banks to lend to the real economy, sovereign yields continue to provide a de-facto floor for borrowing costs for large segment of the real economy. The fact of the matter is that the transmission channel for monetary policy in the Eurozone has been broken – no one in the troubled Eurozone economies can borrow anywhere close to the ECB policy rate. Credit is too expensive in the troubled economies and too cheap in economies such as Germany which the crisis has not hit yet. This pro-cyclicality is hugely damaging. In countries such as Spain and Italy the price of credit is rising and its availability shrinking weighing negatively on asset prices as well as real economic activity. Both of these further reinforce the downward economic spiral weighing negatively on the financial sector.
In an earlier piece we discussed the emergence of what we have called ‘a dumbbell trap’ in the Eurozone wherein the divergence of yields between weaker and stronger economies has a self-fulfilling dynamic so can entrap the Eurozone in a bad equilibrium. The possibility of a break-up of the Eurozone feeds this dynamic further since the currencies of weaker countries are expected to depreciate and those of stronger countries are expected to appreciate fuelling incentives to move money from the former to the latter.
In our discussion, we have also highlighted how the economics of the dumbbell trap goes beyond actually make the politics of any solution to the Eurocrisis much more difficult. The more the divergence between economies, the more any solution would be seen to be redistributive making the already poisonous politics in the Eurozone even worse. The capital that is fleeing Spain and Italy driving the yields there to record highs is fleeing to safe havens such as Germany depressing yields there to record lows. This rising yield divergence is yet another reason why current levels of Spanish and Italian yields are very damaging.
Another thing of note is both the reason behind the spike in short term Spanish yields in particular and the possible impact of such a spike. Spain faces large near-term uncertainty as the Eurozone leaders are unable to come up with a coherent response to the crisis. Renewed talks of a Greek exit further add to this uncertainty. The logic is that the biggest dangers to the Spanish economy lie just ahead. It is clear that without a change in the dynamic of the Eurocrisis these dangers are very real and rising. The corollary to this is that for Spain to make it through the next years successfully, a stemming of the Eurocrisis is essential. That is why the borrowing costs for Spain for 2 years, 5 years and 10 years are very close to each other (the yield curve has flattened) as the assumption is that Spain will only be able to navigate the two years with a successful resolution of the Eurocrisis. Most default risk for Spain or the risk of a break-up of the Euro is thus concentrated in the near term. However the spike in short-term yields, no matter how logical, could create some serious problems of their own. Not least amongst them is the fact that governments use short-term borrowing for liquidity management in the same way that companies use current accounts. Losing access to this market creates a serious danger of the government accidently running out of cash and missing payments to domestic or international creditors which would be disastrous.
While the discussion above applies most directly to Spain, the logic therein also applies to Italy with the key differences being that Italy does not have banking problems that are anywhere nearly as serious as Spain, that it has a primary surplus not a large deficit and that it has significant net private wealth unlike Spain. For more on what we think of Italy, check out our recent piece “The Italian Conundrum”.
What can be done to bring yields down?
Now that we have discussed the problem(s) in Spain (please also read our recent more detailed piece on the state of the Spanish economy “The Spanish Donkey”) what can be done about these? The main question we address here is that of rising yields – how can these be brought down for Spain (and Italy) in the near term.
A reactivation of the ECB’s SMP
Around this time last year, as Spanish and Italian were spiking, the European Central Bank reactivated its Securities Markets Program (SMP) and started buying significant quantities of Spanish and Italian bonds in the secondary market. This immediately brought the yields down for two reasons – first it introduced a large new buyer in the market thereby changing the supply-demand dynamics and second it created an expectation that the ECB was on the lookout and would intervene when necessary to create a ceiling for how high bond yields would be allowed to go. However, as it became increasingly clear that the ECB intervention was limited and not open-ended, the impact of the second effect dissipated. The ECB itself was very insistent that the program was limited in time and size. The ECB cut down its purchases to zero and has now not bought any bonds in the secondary market since March. In total, it bought about Euro 220 billion of bonds under the SMP. Hence the impact of its intervention was only temporary. Such ECB Intervention, through a reactivation of the SMP remains a likely possibility but there are good reasons to think that it would be even less effective this time round, unless there is change to the way it’s done.
At the time of the Greek restructuring, the ECB owned billions of Euros of Greek bonds that it had bought through the SMP. It insisted that its claims were senior to that of other holders of the same bonds and negotiated to get paid in full. This meant that for a given amount of debt reduction needed the non-ECB holders of Greek bonds had to face larger haircuts. Without any explicit change in policy, market actors will rightly assume that the more Spanish and Italian bonds the ECB buys, the larger the haircuts they may face if this debt is eventually restructured as the ECB would once again refuse to take any losses. This rational fear of larger potential losses combined with the evidence that when the ECB says limited intervention it means it implies that the positive impact of any ECB purchases is likely to be less than last time round and will dissipate more quickly. In fact, any ECB intervention can and will bring yields down in the short-term but may actually leave yields higher than before the intervention once the immediate effects dissipate as the residual risks that remaining private bondholders face would actually be higher in the event of a restructuring. On this issue of seniority our stance is more subtle than that of others who simply say that seniority is bad, but suffice to say that in this case it is a real problem. So the ECB could reactivate the SMP but it would only provide temporary relief.
The purported purpose of the SMP was to tackle “dysfunctional markets” which could really mean anything but the ECB implicitly made it clear that it was concerned about the transmission of monetary policy, which Draghi repeated in his recent remarks. However at the time the SMP was active, speculation was rife as to what criteria the ECB used to intervene – was it bid/ask spreads in the market? Was it bond yields? Was it phases of the moon? This ambiguity may have its benefits but the most efficient way to drive yields down is to say that this is your intent. And of course the stated intent has to be backed by credible firepower – notice the Swiss National Bank’s clear explicit target of not allowing the Swiss Fanc to appreciate beyond 1.20 against the Euro and a clear intent to do “whatever it takes” to stay on target. Last year, we suggested that the ECB similarly set up an explicit yield target for sovereign bonds somewhere between 4%-5% or that it could target limiting yields divergence between different member states given that both create problems in monetary policy. But then it would have to explicitly say that this is the target and that it would defend this and do “whatever it takes”.
This, no matter what Draghi said in his recent comments, is simply not on the cards, yet.
EFSF/ESM purchases of Spanish and Italian bonds
The current terms of the EFSF, the Eurozone’s crisis management fund and the soon to be launched ESM allow them to purchase Eurozone government bonds in the primary or secondary markets. The problem with this option, which could be activated if Eurozone governments agreed, is that while this would bring yields down immediately, the limited size of the funds, which simply do not have enough firepower to support Italy or Spain beyond a few months, means that this could at best serve as a stop gap measure. Unlike the ECB, which could be much more effective, if it chooses to, by making an open-ended intervention and saying it won’t claim seniority, there is little that the EFSF and the ESM could do by themselves to make their interventions more effective. In fact, the ESM’s interventions may have the same negative impact as the ECB’s future interventions unless it also explicitly rules out any claim of seniority. (For our opinion on the concept of seniority click here)
A fully-fledged bailout wherein Spain was taken off the market and the EFSF/ESM financed it through loans would once again confront the same issue of the funds simply not being large enough to credibly support Spain and Italy on which the markets would focus next.
EFSF/ESM first loss guarantees
The option for the EFSF to be able to provide first loss guarantees against sovereign bonds was discussed in earnest last year and adopted with some fanfare but has never been used. There is some renewed discussion about using this. If this option is used in a credible manner and sold as ‘Germany and other strong countries guaranteeing Spanish and Italian creditors against losses willingly because they believe that such losses will never materialize’, it would have some impact on bringing yields down. In particular, the crisis funds need to be credible that if the proverbial shit does hit the fan, Germany and other countries would indeed fulfil their obligations and repay creditors for the amounts of losses insured.
Microfinance, where collective liability can compensate for high individual credit risk may be a useful model to look at. The point about such an option is that it leads to behavioural changes. If Germany and other countries put their taxpayer money on the line as a junior claim in the event of a Spanish default, they won’t just sit still but would have a very strong incentive to make sure that Spain does not default.
But such credibility is hard, if not well-nigh impossible to achieve, particularly at the same time that countries such as Finland are insisting on collateral from Greece and Spain for their share of EFSF lending. This is the exact opposite end of the spectrum from the kind of equity-like stake that a first loss guarantee would imply. ESM seniority is also obviously completely incompatible with any credible guarantees.
Another problem with such as guarantee would be that it would not work if it only protects investors against say the first 10% of loss. It would need to go much further – perhaps loss protection up 33% would be needed to make investors feel more comfortable given that the expectations of haircuts, if debt restructuring were indeed necessary, is substantial.
The problem of the limited size of funds would once again come to the fore as the size of residual support for the EFSF and ESM from the strong countries would need to be large enough to credibly cover losses in the event of a restructuring of debt.
Last but not the least is the problem that if such guaranteed bonds were issued, it would create a two-tier market. Investors may flee the market in non-guaranteed bonds towards that in guaranteed bonds. This would depress the market value of the stocks of existing bonds further putting pressure on the Spanish banking sector. It would also mean that there may be a problem of exit from the issuance of guaranteed bonds as the demand for the non-guaranteed bonds may have dried up by then.
In short, such an option, used sensibly, could help in the short-term but comes with several problems and limitations of its own.
Banking licence for the ESM
This sensible option, of providing a banking licence to the ESM thus giving it access to the ECB’s line of credit and making it an eligible counterparty for the ECB has been proposed and rejected outright but given how bad things look, there is a possibility that this may be put back on the table. Essentially, the ECB, which accepts sovereign bonds (amongst other assets) as collateral to provide funds to private banks, would then be able to provide such funds to the ESM which could essentially deploy these to buy even more sovereign bonds.
This could significantly increase the effective size of the ESM as in essence, the ESM’s own funds would be economically equivalent to equity and be used to absorb credit risk arising from its bond purchases and the ECB’s money would be debt that would be used to fund the purchases. The only theoretical limit to how far this can go will depend on the haircuts imposed on the collateral by the ECB.
Much less clear that the technicalities of this solution are the politics. First, Germany remains explicitly opposed to this idea as do Finland and the Netherlands. Without all members of the ESM agreeing this would never get a banking licence. Another issue is that even if such a licence is granted, the ECB has to agree to have the ESM as an eligible counterparty. That is not the end of the matter. The ECB uses a Risk Control Framework to manage the risks to its own balance sheet and has an enormous room for flexibility within this. It could at any point decide to limit its own exposure to any counterparty (say the ESM) or particular assets (Italian or Spanish government bonds).
Our point is that any decision on the use of the ESM as a bank to tackle the Eurocrisis will work only if it has the full and continuing support of all 17 member states as well as the ECB. It is exactly this which imposes very serious political obstacles on this option seeing the light of day despite the fact that this is otherwise a neat idea.
Credit risk indemnity for the ECB
As we discussed in the previous section, under the ESM as a bank model, the ESM takes on the credit risk and the ECB provides the funding to support troubled sovereigns. Under the SMP, the ECB takes on the credit risk and provides the funding.
Another idea, which we first floated last year, would be for the ESM to indemnify the ECB against any credit losses on its purchases of sovereign bonds. This could then free up the ECB’s hands to enact a much larger SMP. Economically, this is similar to the ESM bank model as the credit risk is taken on by the ESM and the funding comes from the ECB. However, unlike the ESM bank idea, which has explicitly been ruled out by key political actors not least Draghi himself, this idea has not been vetoed, yet. One could see how this may politically be more attractive than some of the other ideas that have been discussed but yet be economically workable.
The ECB is very clear that they will not ask for such an indemnity but if the ESM were to offer one…
The discussion in this policy brief has focussed on what can be done in the near-term. The fundamental problems we face are two-fold. First, whatever is economically workable does not seem politically feasible and second, that without a broader more comprehensive solution to the Eurocrisis any steps to address spiking yield would only have a temporary impact. For example, if the possibility of a break-up of the Euro is not credibly taken off the table, the logic of the dumbbell trap in which the Eurozone is presently struck, will continue to dominate.
Sony Kapoor
Managing Director