MacroScope

Japan-style deflation in Europe getting harder to dismiss

To most people, the idea of falling prices sounds like a good thing. But it poses serious economic and financial risks – just ask the Japanese, who only now finally have the upper hand in a 20-year battle to drag their economy out of deflation.

That front is shifting westward, to the euro zone.

Deflation tempts consumers to postpone spending and businesses to delay investment because they expect prices to be lower in the future. This slows growth and puts upward pressure on unemployment. It also increases the real debt burden of debtors, from consumers to companies to governments.

In many ways, policymakers fear deflation more than inflation as it’s a more difficult spiral to exit. After all, interest rates can only go as low as zero and if that doesn’t kickstart spending, they’re in trouble. Again, just ask the Japanese.

European leaders and financial markets insist the threat of deflation in the euro zone is low. Outside experts surveyed by the European Central Bank said this week they saw a “very low” probability of deflation. And this is what European Central Bank president Mario Draghi said last week:

“We have to dispense once more with the question: Is there deflation? and the answer is ‘No’.”

Ireland: bailout poster child, but hardly textbook

Amid the euphoria surrounding Ireland’s removal from junk credit rating status, it’s easy to get swept along by the consensus tide of opinion that the Emerald Isle is the “poster child” for euro zone austerity.

But were another country to find itself in Ireland’s unfortunate financial predicament now, few would suggest it follow the path Dublin took.

The Irish government assumed the entire nation’s private banking sector debt in 2008 after then finance minister Brian Lenihan explicitly guaranteed all bank debt in the country. It was hailed as a masterstroke at the time, but in an instant Ireland’s hands were tied and its options all but evaporated. Even the stuff that posed no systemic risk was put on the government’s – the taxpayers’ – books. This prevented the collapse of the financial system, but at a price: the country’s sovereign debt load almost doubled to around 100% of annual economic output, and in order to do that it was forced to take an €85 billion bailout from international creditors two years later.

In euro bond markets, world still upside down

Corporate bonds normally yield more than sovereign debt since companies are seen as more likely than states to go bust. But during the euro zone debt crisis, when various governments had to be bailed out, that relationship broke down in Spain and Italy.

Click here for graphic by Vincent Flasseur.

Madrid and Rome are paying more to borrow in the market than similarly-rated companies generally. Ten-year Spanish and Italian sovereign bonds offer a comfortable premium of more than 60 basis points over a basket of BBB-rated corporate debt, even though that gap has more than halved from this year’s highs.

Spain and Italy are also paying more to borrow in the market than BBB-rated companies in their own countries. Calculations by Fathom Consulting using Thomson Reuters data show the average yield for 10-year Italian corporate debt within the euro zone basket is 2.4 percent versus 4.06 percent in the equivalent sovereign. For Spain, the average BBB corporate yield is 2.00 percent – also below a sovereign yield of 4.03 percent.

ECB rate cut takes markets by surprise – time to crack Draghi’s code


After today’s surprise ECB move it is safe to forget the code words former ECB President Jean-Claude Trichet never grew tired of using – monitoring closely, monitoring very closely, strong vigilance, rate hike. (No real code language ever emerged for rate cuts, probably because there were only a few and that was towards the end of Trichet’s term.)

His successor, Mario Draghi, has a different style, one he showcased already at his very first policy meeting, but no one believed to be the norm: He is pro-active and cuts without warning. Or at least that’s what it seems.

Today’s quarter-percentage point cut took markets and economists by surprise.

Will bank lending finally start to rise?

Big news over the weekend was the world’s banks being given an extra four years to build up their cash piles, and given more flexibility about what assets they can throw into the pot. This is a serious loosening of the previously planned regime and could have a significant effect on banks’ willingness to lend and therefore the wider economy.

For over two years, banks have complained that they can’t oil the wheels of business investment and consumer spending while being forced to build up much larger capital reserves to ward off future financial crises. That contradiction has now been broken (a big win for the bank lobbyists) and the impact on economic recovery could be profound.

However, there are no guarantees. Banks, in Europe at least, have also insisted that lending has remained low because there isn’t the demand for credit from business and households. If that’s true, increased willingness to lend might not be snapped up.

Mario and Angela — the euro zone’s pivotal pair

European Central Bank chief Mario Draghi and Germany’s Angela Merkel – the two most important people in the euro zone debt crisis response – take to the stage today, the former giving lengthy testimony in the European Parliament, the latter holding a news conference with foreign journalists.

With Greece sorted out for now, Spain and Italy fully funded for the year and markets simmering down, the crisis is in abeyance, in no small part thanks to these two. Draghi provided the game changer with the ECB’s bond-buying plan late in the summer but Merkel has shifted profoundly too during the course of the year – most crucially from considering a Greek euro exit might be a good thing “pour encourager les autres” to realizing it would be a disaster and acting to rule it out and also in backing Draghi’s bold move and ignoring a large measure of German disquiet.

Germany continues to go-slow on future steps, at least in part largely for domestic political reasons, but look where we are now – with an ECB prepared to act in a way that horrifies the Bundesbank, a permanent euro zone rescue fund, a banking union in progress and multiple bailouts agreed and help for Spain likely to come soon – and it’s remarkable to see how far Berlin has moved.

Europe ends year on front foot

Credit where credit’s due, the EU has surprised on the upside over the last 24 hours or so, not only signing off on a revised Greek bailout plan to keep that show on the road and agreeing that the ECB will supervise 150 or more of the bloc’s biggest banks, but then pledging to set up a mechanism to wind down problem banks.

Now, there is many a slip twixt the cup and the lip as they say – not much more is going to be cemented until next autumn’s German elections are out of the way, the ECB only has direct oversight of 5 percent or so of euro zone banks (when we know from the financial crisis that smaller banks can be almost as lethal as the big boys) and there is no indication of how a bank resolution scheme would be funded (perhaps via a financial transaction tax although only 10 or so countries have so far committed to that). Also, direct recapitalization of banks by the ESM rescue fund, to take the burden of indebted states, is unlikely to happen before 2014.

Nonetheless, we shouldn’t be churlish. EU leaders are clearly using the window of calm created by the European Central Bank’s pledge to buy euro zone government bonds in whatever size is needed to shore up the currency area in order to press on with the permanent structures which will ensure the bloc’s future. So while Finnish Foreign Minister Alex Stubb’s assertion that the EU is in its best shape for years may be pushing it a little, his follow-up line that if you’d offered them this state of play at the start of the year they’d have snatched your hand off is hard to argue with.

Greek bailout deal tantalisingly close

The Greek bond buyback has fallen a little short, leaving Athens and its lenders to plug a 450 million euro hole. The euro zone and IMF had given Greece 10 billion euros to buy back enough debt at a sharp discount so that it could retire 20 billion euros worth of bonds and knock that amount off its debt pile. Without that, the deal to start bailout loans flowing to Athens again would fall through.

Due to the discount working out slightly more generously than expected, Greece fell slightly short but it’s impossible to believe the currency bloc will throw itself back into turmoil over a few hundred million euros. Athens will confirm the state of play this morning. One source said German “bad banks” had not tendered most of their holdings and could be tapped again. A solution will be found and probably in time for the EU leaders’ summit on Thursday and Friday. IMF chief Christine Lagarde came close to saying as much last night, welcoming the bond buyback and leaving the loose ends to the Europeans.

More preparatory work for the summit gets underway today with EU finance ministers meeting to try and bridge a gap over plans to regulate euro zone banks cross-border – part one of building a banking union. The European Central Bank is set to be the overarching regulator but Germany wants its scope severely constrained, while others want it to be able to intervene in any euro zone bank, at least in theory. This does not have the power of Greece or Italy to move markets but an inability to agree on the least contentious part of a banking union would not send a good signal.

Italy gives new bite to euro zone crisis

Don’t start putting out the tinsel yet. Just when we thought we had a smooth glide path into Christmas the euro zone has bitten back.

Over the weekend, Italy’s Mario Monti called Silvio Berlusconi’s bluff and said he was pulling the government down which will mean early elections in February. The budget bill will be passed and then the country will be in a potentially precarious state of limbo as parliament is dissolved. Italian bond futures have opened more than a point lower, which denotes a reasonable measure of alarm, although the safe haven Bund future has only edged up so we’re far from panic mode.

The big question is whether a government results that will stick to Monti’s agenda and whether he himself will have a prominent role to play in the administration. There are constitutional difficulties to keeping Monti as prime minister since he has said he would not stand at the election, though he has also said he would be prepared to step in again if no stable government is formed. Most likely, presuming a government is elected that supports his reforms, is that he will play a key role but not take the top job.

Calm after the storm

After months of bickering and struggle, the euro zone and IMF have agreed on a scheme which will notionally cut Greece’s mountainous debt to a level they view as sustainable in the long-term. Athens has now launched a buyback of its debt at a sharp discount from private creditors which should wipe 20 billion euros of its debt pile – a key plank of the plan.

Is the problem solved? Absolutely not. But has Germany achieved its goal of delaying any disasters, or really tough decisions, until after its elections in the Autumn of 2013? Almost certainly. So we could (famous last words) be in for a period of relative calm on the euro zone crisis front.

German Chancellor Angela Merkel and her finance minister have begun quietly hinting that euro zone government and the European Central Bank may eventually have to take a writedown on the Greek bonds they hold to make Athens’ debt controllable. That won’t happen for at least two years but in the meantime, bailout money will flow and Greece will survive.