That sinking feeling
May 20th 2010 BERLIN
From The Economist print edition
The bail-out has slowed but not stopped investor flight from Europe’s periphery
WHEN Europe’s finance ministers emerged in the early hours of May 10th to announce a €750 billion ($950 billion) rescue of the embattled euro zone, some joked that they had thrown everything at the problem “including the kitchen sink”. It turns out there are a few more implements left to hurl.
Germany this week announced a ban on the naked short-selling of euro-area government bonds and shares of some financial firms, and on the buying of sovereign credit-default swaps by investors who have not also bought the underlying bonds. Angela Merkel, Germany’s chancellor, gave warning that the euro is at risk as she defended the ban. If Germany hoped to calm markets, it failed. Shares slipped, as did the euro (see chart). Euro-zone solidarity fractured, too: Christine Lagarde, the French finance minister, said she regretted the decision.
The pipes of the world’s financial system are gumming up again. One concern is that American money-market funds, which Barclays Capital reckons have lent $300 billion-$500 billion to European banks, are cutting their exposure to Europe, making it hard for banks and companies to borrow. LIBOR, the interest rate that banks charge one another to borrow, has jumped to levels not seen since August. The pressure is growing on EU states to get a €500 billion stabilisation fund, the biggest chunk of the bail-out, up and running.
In the interim the European Central Bank (ECB) has been doing its bit. An initial €16.5 billion in government-bond purchases is thought to have focused on three of the smallest and most distressed euro-zone markets: Portugal, Ireland and Greece. That led to a quick thaw in these markets, where a week earlier trade had almost ground to a halt. On May 18th Ireland auctioned €1.5 billion in bonds and saw fairly robust demand for its debt. Two days later Spain attracted decent interest in a sale of ten-year bonds.
Yet the improvement is far from uniform. Spain had earlier struggled to sell all of a planned €8 billion issue of shorter-term notes, eventually scaling the amount back to €6.5 billion. And improving prices in the secondary markets may be deceptive because in the case of Greece and Portugal, at least, the only real buyer seems to be the ECB.
A significant change in European bond markets is under way. Europe’s decade-long “convergence play”, in which investors bet that over time bond yields across the euro zone would come together, is unravelling. Investors who had assumed an almost equal risk of default among euro-zone countries are now relying on emerging-markets desks to help them understand the credit risks they are taking. “Our emerging-markets traders were scratching their heads at some euro-zone government spreads,” says Andrew Balls of PIMCO, a bond investor. “What you have happening is an emerging-market crisis but it is happening with a country [Greece] that is a member of the euro zone.”
The laziest distinction that investors are now making between different markets is based on size. That is a particular worry for Portugal, which is less of a credit risk than Greece but is vulnerable because it is so small. Both countries’ bonds either are not in, or make up only a tiny portion of, the major indices that investors use as benchmarks. Investors are stealing away rather than bothering to discriminate between the two. “If you own them and they rally you really won’t make a lot of money but if things go wrong your reputation takes a hit,” says Paul Brain of Newton Investment Management. “For the smaller markets it is easier to just sell when the news gets bad.”
The exception is Ireland. Although small, it has attracted buying when the prices of government bonds have fallen. One reason may be a form of “home bias” because English-speaking investors in Britain may feel better able to assess its chances of cutting government deficits.
Bigger bond markets are less easy to abandon. Italy got away two auctions of five- and 15-year bonds fairly easily on May 13th. Many large investors such as insurance funds do not match assets and liabilities simply by currency but also by country. Yet investors in the debt of larger countries are looking more closely at whether they are being sufficiently rewarded for risk.
In a sense, this is welcome. The compression of bond yields over the past decade was another manifestation of the mispricing of risk as investors sought higher returns. “Many investors thought they were buying German bunds with a bit of free yield,” says one fund manager. “Now they realise they had bought a lot more of the lira and a lot less of the Deutschmark than they thought.” However, repricing is deeply destabilising. Most large holders of government debt are risk-averse. A fall in price is more likely to prompt a stampede than a calm appraisal of valuations.
That leaves the ECB in a quandary. In buying bonds of distressed countries it is, in effect, opening the emergency exits of a crowded theatre. Its hope is that in doing so it will make everyone feel safer and thus less likely to bolt at the first wisp of smoke. Yet the risk it faces is that in making an exit easier, more people will leave. That already appears to be happening in Greece, which received €14.5 billion from the European Commission on May 18th (in addition to €5.5 billion that the IMF had already released). Among the first uses of the money was repayment of an €8.5 billion bond that came due a day later.
A second dilemma is how far the ECB should allow interest rates to increase on the government bonds of countries such as Spain. Holding down borrowing costs will help make its fiscal adjustment easier, which should attract private capital. Yet unless yields widen there is little incentive for investors to hold its debt.
Germany’s bans on naked short-selling seem only to have heightened skittishness about owning European assets, as investors fret that hedging will get harder and rules tougher. The problem facing the euro zone is not speculative shorting of its countries’ bonds, but rather the reluctance of investors to buy them in the first place. Berating the markets that fund it is a very odd tack for any government to take.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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