October 31, 2013 6:46 pm

Hollande holds the key to Merkel’s euro plan
Germany believes the long-term future of the single currency rests with France link
ingram pinn illustration
Join a conversation about Germany and the talk is soon about France. The present dynamics of Europe are shaped by German hesitation and French weakness. These postures are connected. The Franco-German motor ran out of steam a while ago but, seen from Berlin, nothing much can happen unless the two nations are travelling in the same direction.
Berlin wants to deepen other relationships. A few years ago, Angela Merkel thought Britain might be drawn into a troika. The German chancellor gave up on the idea when Britain’s government decided to detach itself from EU affairs. Poland has taken Britain’s place in German diplomacy. But the partnership with Paris remains an indispensable if insufficient condition for progress.
Europe and the euro have not loomed large in the post-election negotiations between Ms Merkel’s Christian Democrats and the centre-left Social Democrats. The future of the single currency has been parcelled off to a subcommittee of one of a dozen groups discussing the terms of a grand coalition. This does not imply the euro has been pushed to the margins; rather that the big arguments between the two parties lie elsewhere.

As I understand it, the chancellor’s office has submitted to the coalition negotiators four possible paths for the eurozone. All presume that the EU is an essential anchor for German prosperity and security and that the union would not survive the demise of the euro; and all depend on good working relations between Ms Merkel and François Hollande, the French president.
The first of the options might be described as “muddle through”. The eurozone’s drive towards banking union and mutual economic oversight would remain within the existing legal framework. The EU treaties, the argument runs, have proved remarkably flexible in allowing deeper euro integration.
The second is at the other end of the spectrum. Echoing the views of Wolfgang Schäuble, the finance minister, it calls for a comprehensive set of measures, underpinned by treaty change, to secure the euro’s future. It would finish the work left undone when France blocked German calls for political union at the time of the Maastricht treaty.
The third option acknowledges that banking union, implicit or explicit debt mutualisation and shared responsibility for national fiscal policies will indeed require changes to the treaties, but prefers a rifle to a shotgun. Treaty amendments would be narrowly drawn to avoid a need for national referendums. The European Stability Mechanism provides a precedent.
Finally, there is what I call the “if Britain plays silly buggersoption. Were Britain to seek to block changes, the eurozone would make new arrangements outside of the treaties. This is what happened when David Cameron tried and failed to veto a new fiscal pact. One would hope that Britain’s prime minister learnt something from that mistake.

Ms Merkel’s cautious pragmatism argues for the third as her preferred option. A big bang approach would be the more convincing show of confidence in the euro’s future but, one or more national electorates would probably shoot it down – even assuming that Mr Hollande, for one, was prepared to take such a risk.

Whatever the choice, Berlin believes that the long-term future of the euro depends on France. As I heard many times at a conference hosted by the Ditchley Foundation, Ms Merkel has put a new understanding with Mr Hollande at the top of her list of priorities.

Berlin knows two sides will always take a different view of, say, the respective responsibilities of surplus and deficit nations within the eurozone, but they need to stake out common ground. Far from exulting in French weakness, Ms Merkel sees it as an obstacle to bilateral co-operation.
The maddening thing is that Mr Hollande knows what must be done. Visitors to the Elysée Palace find a president clear-sighted about the imperatives of rebuilding competitiveness and shifting the burden of fiscal adjustment from higher taxes to lower spending.

The problem lies in the gulf between the analysis and the willingness to act. Mr Hollande worries that if he moves too fast, the French will take to the streets. Yet by moving too slowly he is driving them toward the xenophobic extreme represented Marine Le Pen’s National Front.

Returning growth is nurturing a belief that the euro crisis is over. Recent weeks have seen US hedge funds scrambling to buy the once toxic debt of the eurozone’s weakest economies. Some will take this as a bad signmany of the same funds were not so long ago losing large amounts of their clients’ money by betting against the survival of the single currency. I have never understood how people so supposedly smart about markets can be so expensively dumb about politics.
On this occasion, the hedgies are probably right about the short term. There are squalls ahead, perhaps one or two rough ones, but eurozone governments have not gone through the agonies of the past few years to throw in the towel now. Ms Merkel, though, is right about the long term: the euro has a future only if over time member states achieve a rough parity of competitiveness. And that has to start with France.

Politics saved the monetary union. The hedge funds missed the sheer force of political will behind the project. Rising populism across the continent, however, threatens an opposing dynamic; a public mood that comes to blame the euro for the wrenching economic and social adjustments demanded of Europe by globalisation. The single currency is safe for the time being. It would be a mistake to say the game is over.

Copyright The Financial Times Limited 2013.

Europe moves nearer Japan-style deflation trap with shock price falls

ECB warned it must take immediate and pre-emptive action to head off the risk of full-blown deflation by next year.

By Ambrose Evans-Pritchard

7:11PM GMT 31 Oct 2013

 People are silhouetted in front of a large euro coin during a ceremony outside the Frankfurt stock exchange to launch the euro coins in Frankfurt

All key measures of eurozone inflation fell dramatically in October, stunning the markets and leaving the region dangerously close to a Japan-style deflation trap.

Consumer price inflation (CPI) plunged from 1.1pc to 0.7pc, the lowest since the financial crash in 2008-2009. “This is a massive downward surprise,” said Gizem Kara from BNP Paribas.
A string of debt-crippled states are now sliding into deflation, with Italy buckling over the late summer. The underlying rate is even lower once austerity-linked tax rises are stripped out.
The shock data came as EMU-wide unemployment jumped to a record 12.2pc in September, with a further 74,000 people losing their jobs. Youth jobless rates reached 40.2pc in Italy, 57.6pc in Greece and 56.6pc in Spain.
“This is playing out in a very similar way to Japan in the early 1990s,” said Albert Edwards from Societe Generale. All it needs now is an unexpected recession and Europe will slide into outright deflation. The risk is a trade shock from Asia. That is when the markets will start to panic."

The euro tumbled a cent to below $1.36 against the dollar as investors began to price in a quarter-point rate cut by the European Central Bank as soon as December.

A former ECB governor said the bank’s passive stance over the past few months was a “disaster” for Italy and Spain. The time-lag effects mean that serious damage has already been done.

“It is incredible that they have missed their 2pc target by so much. This risks driving the periphery into protracted depression and could destroy the eurozone. Credit conditions are far too tight. The ECB should cut rates to zero, extend three-year financing for banks and relax collateral rules,” he told The Telegraph.

What scares me is that the ECB seems to be formulating policy for Germany without any regard for everybody else. It has been captured by Germany. What is so bizarre is that the old Bundesbank would not have let this happen,” he said.

Even German inflation is at a three-year low of 1.4pc. Prices fell 0.4pc in Bavaria and 0.3pc in Saxony in October. While the Bundesbank has been fretting about a local house price boom, the average rise in property has been less than 3pc over the past three years.

Julian Callow from Barclays said the fall in the eurozone’s core inflation rate (without energy and food) to 0.8pc is evidence of powerful forces at work in the world economy. China’s fixed capital investment reached $4 trillion last year. The sheer scale of this is leading to huge over-capacity in manufacturing and is transmitting a deflationary impulse through the global system,” he said.

“The ECB has to be very alive to the risks. Its treaty mandate is to support the 'general economic interests of the Union'. This means giving equal weight to jobs as the US Federal Reserve is doing.”

Mr Callow said the failure to act is allowing the euro to punch too high against the dollar, yuan and yen, exacerbating the deflationary effects and tightening the screw for struggling exporters in Southern Europe. The Bank of Japan has succeeded in driving down the yen with a blitz of monetary stimulus.

A report by the Bruegel think-tank in Brussels said the slide towards deflation may push Italy and Spain into a “runaway debt trajectory”. It lowers nominal GDP growth, causing debt costs to rise faster than the economic base, the “denominator effect”.

Bruegel said each one percentage point fall in inflation forces Italy to increase its primary budget surplus by an extra 1.3pc of GDP to stabilise debt. Italy is already targeting a sustained surplus of 5pc, a feat that no country except oil-rich Norway has pulled off in half a century.

The latest inflation data show Italy’s CPI rate fell by 0.3pc in both September and October, despite a rise in VAT taxes that should have pushed it higher.

Over the past three months, France, Italy, Spain, Portugal, Greece, Cyprus, Ireland, Slovakia, Slovenia, Estonia and Latvia have all seen price falls once extra taxes are stripped out. It is a similar pattern in Bulgaria, Romania, Hungary and the Czech Republic, with Poland and Denmark close behind. The entire region risks sliding into a deflation trap if recovery falters.

Hans Redeker from Morgan Stanley said the “Japanisation effect” in Europe is having perverse effects. The fall in inflation is automatically raising real interest rates, tightening the vice further in a vicious circle.

Deflation accidents usually happen when things seem cosy for while and central banks do nothing. Europe is now in a deflationary equilibrium but this could turn bad if there is any outside shock. We think this could come from Asia, probably a credit squeeze by China’s central bank,” he said.

Japan was able to cope with deflation in the 1990s because it had a positive global income flows of 3pc of GDP. Europe does not have that advantage. The flows are negative,” he said.

Morgan Stanley said the ECB must take immediate and pre-emptive action to head off he risk of full-blown deflation by next year. Japan’s travails over the past 20 years show that is very hard to shake off the virus once it becomes lodged in the system.

October 27, 2013 7:55 pm
Debt: A deceptive calm
By Ralph Atkins in London
Investors are wary that the tranquility in eurozone bond markets could breed complacency
James Carville, an adviser to former US President Bill Clinton, wanted to be reincarnated as the bond market, complaining that it was more powerful than presidents or popes. “You can intimidate everybody,” he moaned.

He should have moved to Rome. This year, Italy has had an inconclusive election, a government often on the brink of collapse and an economy struggling to leave a deep recession. But the bond markets have been noticeably quiescent.
To enlarge graph click here

Rather than Rome’s borrowing costs rising as investors worried about the security of Italy’s public debt, the difference – or “spread” – between the yield on 10-year Italian and German government bonds has fallen to levels unseen since the eurozone crisis hit the country more than two years ago.
“I don’t recall [prime minister] Enrico Letta mentioning the wordspread’ in any of his official speeches,” says Alessandro Tentori, strategist at Citigroup in London.

It is a similar story in other stressed parts of Europe’s monetary union. Apart from a few weeks in May and June, when borrowing costs spiked globally, eurozone yields have followed a downward trend this year. Spain’s long-term borrowing costs are level pegging Italy’s; Irish government yields are even lower.
Whether this new phase in the eurozone crisis is sustainable or simply the calm before the next storm will help determine the eurozone’s future. The stability reflects market confidence in the eurozone’s prospects – and the fact that fickle international investors fled at an early stage of the crisis. But overreliance on domestic investors has thrown Europe’s economic integration into reverse and may prove dangerous. While the calm may provide breathing spacelower bond yields cut financing costs – it could breed complacency.

Eurozone leaders are in the midst of far-reaching reforms to strengthen the continent’s financial system. “The danger is that without market pressure, the whole process of eurozone reform slows – and these are the reforms that are required to secure the eurozone’s future,” says Myles Bradshaw, senior European portfolio manager at Pimco.

The euro’s launch in 1999 was the biggest achievement in Europe’s post second world war drive to bring together the region’s economies. The impact on sovereign bond markets was dramatic. During the late 1990s yields converged as investors began to think in terms of a single eurozone market. The risks of a country defaulting, or exiting the eurozone, were ignored.

The complacent mood was shattered in 2009 when the escalating debt problems of Greece erupted into a crisis. Soaringspreads” on the debt of governments in the eurozoneperiphery” – southern Europe and Irelandthreatened the sustainability of public finances. They prompted sweeping changes by policy makers, including the launch of an emergency government bailout fund.
Bond market pressures remained relentless, however, until July 2012, when the European Central Bank finally stepped in. Mario Draghi, ECB president, declared it would provide a backstop for sovereign debt markets. To back his pledge to dowhatever it takes” to save the euro, he unveiled an “outright monetary transactionsprogramme allowing unlimited ECB intervention if necessary in eurozone bond markets.
The OMT programme removed eurozonetail risk” – a low probability event that would have had catastrophic consequences. The ECB did not state, however, what yields it would deem appropriate in Europe’s monetary union. Its vagueness was deliberate: it did not want markets to test at what point it would intervene.

A danger now is that eurozone bond markets have been lulled into a false sense of security by Mr Draghi. The ECB president saw OMTs only being activated in a fresh emergencywhich has not yet happened. But Laurent Fransolet, head of fixed income research at Barclays, argues that markets are fully aware of the programme’s limitations.

“It was like central bank intervention in foreign exchange markets,” says Mr Fransolet. Everybody was betting one waybeing short Europe and extremely negative on everything. Draghi came in and saidthat’s it. But we haven’t had any details about OMTs and it is clear the ECB does not want to use them. Do you really think he wants to use them to help Italy?”

Instead, many bond market experts argue this year’s falls in eurozone periphery bond yields are consistent with the progress made towards ensuring the future financial stability of member states and the monetary union.

“The markets see Mr Draghi as a very strong and stabilising figure, and in the driving seat, but they are also looking at governments and seeing some good execution track recordsSpain is a good example,” says Spencer Lake, the global head of capital financing at HSBC.Markets are looking at all that and saying, ‘we’ve probably reached or are near the bottom’.”
The “real game changer”, argues Daniel Gros, director of the Centre for European Policy Studies, has been the ending of countries such as Spain’s dependence on foreign capital inflows. Before the eurozone crisis, Spain, Italy, Ireland, Portugal and Greece were importing heavily and running up large current account déficits.

The effect of the crisis was to slash demand for imports, while structural reforms and lower costs boosted exports, giving the peripheral economies current account surpluses. “That is fundamental because they no longer need capital from overseas,” says Mr Gros. “The OMT programme was the act that took tail risk out of bond markets when there was a real panic. What has made the stability more permanent have been changes in real economies.”

A particular beneficiary of the improvement in global investor sentiment towards the eurozone has been Ireland, which is expected in December to become the first eurozone country to leave its bailout programme. Irish bond yields have dropped as foreign investors have sought to grab a share of its apparent success story.

But arguably a much bigger reason for the recent stability in eurozone bond markets across much of the rest of the region is that foreign investors have retreated. So far this year, domestic investors have accounted for almost 100 per cent of the net issuance of Italian and Spanish government debt, according to calculations by BNP Paribas. Of outstanding Spanish bonds, almost 70 per cent is currently held domestically. For Italy, the figure is almost 60 per cent.

The outbreak of the crisis spurred the initial outflows but the “re-domestication” of eurozone bond markets was encouraged by two other factors.

First has been the ECB’s policy of providing large volumes of cheap loans to eurozone banks as its contribution to fighting the global economic crises of recent years – the eurozone’s equivalent of “quantitative easing”. The glut of liquidity encouraged banks to buy government bonds, especially as they could use those bonds as collateral to obtain more funds from the ECB, “round tripping” their investments. Second, have been actions by regulators encouraging European banks to retrench behind national borders, reducing their exposure to riskier assets.

For eurozone governments, increased domestic bond ownership has offered a cheaper way of absorbing debt mountainsdomestic investors demand a lowerrisk premium” and can often be lent on to buy debt at favourable rates.

Eurozone policy makers think they have found a third way of dealing with high debt – a better alternative to debt restructurings or inflating it away,” argues Mr Tentori at Citigroup. “They are desperately trying to shape the eurozone in such a way as to make it self-financing.”

Japan has illustrated how a country, with strong domestic ownership, can operate with a level of public sector debt equivalent to more than 200 per cent of national output and still keep official borrowing costs down. Yields on 10-year Japanese government bonds are just 0.6 per cent.

Yet the stability created by “re-domestication” of eurozone bond markets could prove fragile. A mounting concern of eurozone policy makers is the increased mutual dependence between banks and governments in the eurozone periphery, which could quickly exacerbate financial instability if a fresh crisis erupted somewhere in the financial system.

The ECB has set breaking such links as an important objective as it takes responsibility for financial sector supervision. “The issue is how to reduce the fragmentation of the eurozone. The banking system has become Balkanised by national interests, non-trade barriers and investor pressure,” says Huw van Steenis, banking analyst at Morgan Stanley.

The links between banks and sovereignsbasically changes the nature of the eurozone. Banks are acting as the arms of the central bank to help governments avoid default,” argues Thomas Mayer, senior adviser to Deutsche Bank.

Judging the most appropriate level of international ownership of government bonds is hard too many short term foreign investors would run the risk again of sudden outflows at the first sign of the fresh trouble.

However, the departure of foreign investors has reversed the financial connections that the euro’s launch was meant to foster. The idea under the Maastricht treaty, which led to the euro’s launch in 1999, was for capital flows across the eurozone to spur economic growth and compensate for differences in borrowing costs between different member states.

Without outside investment, the struggling periphery economies could find it even harder to escape recession and produce the growth needed to reduce public-sector debt mountains.

One risk is that resentment grows, fuelling anti-euro political movements. “This is why in the end you need the ECB as a backstop,” says Mr Mayer. “Take away the ECB and the view over the abyss looks scary.”

. . .

There is another hitch on the more immediate horizon. The ECB’s OMT programme is being reviewed by Germany’s constitutional court – a judgment could come in coming months. While the Karlsruhe judges cannot overrule the central bank, it could throw obstacles in its path, reducing its effectiveness in removingtail risks” from eurozone bond markets.

Investors cannot entirely dismiss the possibility of a debt restructuring or a country exiting the eurozone. Greek government bond holders had losses imposed on them last year, setting a possible precedent despite eurozone policy makers insistence it was a one-off case. Angela Merkel, the German chancellor, and Nicolas Sarkozy, the former French president, at one stage floated the possibility of Greece leaving the monetary union.

Eurozone politicians may not be jolted by bond market pressures in the near future – the dangers are generally longer term, rather than immediate. But investors will remain wary of the current calm. As Mr Bradshaw of Pimco warns: “The existential risks are much lower but they are still there; they are still biased towards the downside.”


Bringing it all back home

Foreign ownership of Italian and Spanish government bonds was rising before the eurozone financial crisis erupted in late 2009 and 2010. It was a time when cross-border European financial ties were strengthening.

But the eurozone crisis sparked the region’s financial fragmentation. Governments and the private sector faced much higher borrowing costs in the eurozoneperipherycountries than in “corecountries such as Germany. But the “re-domestication” of government bond markets explains the more recent stability.

Copyright The Financial Times Limited 2013.