Friday, August 31, 2012

How seriously can investors take Draghi’s assurances?

ECB president, Mario Draghi, has repeatedly claimed that the central bank will do everything necessary to save the euro. Nothing has been formally agreed yet, but the ECB is expected to announce a new government bond-buying programme following next week’s meeting of its Governing Council. To have a significant impact on Italian and Spanish borrowing costs, the latest effort must be big enough to dispel the convertibility risk that lies behind the extreme polarisation of government bond yields across the eurozone: investors are loath to hold Spanish and Italian debt because they fear that the two countries’ membership of the currency union might be unsustainable. Unfortunately, the ECB is highly unlikely to do enough to convince investors that membership is unequivocally forever, not least because the Bundesbank opposes any open-ended commitment to cap borrowing costs.

Spain, Italy and the periphery of the eurozone face unprecedentedly high real borrowing costs, which are preventing a recovery in investment and hence economic growth. Without a return to growth, they will fail to dispel investor fears over the sustainability of their public finances and the solvency of their banking sectors. The Italian and Spanish governments argue that their high borrowing costs largely reflect convertibility risks and that the ECB should do as much as necessary to address these fears. The eurozone’s members that currently benefit from exceptionally low borrowing costs – Germany, Austria, Finland, the Netherlands and to a lesser extent France – maintain that very high Italian and Spanish borrowing costs largely reflect these countries’ failure to reform their economies and strengthen their public finances. There is merit in both these positions, but much more to the Spanish and Italian argument than the opposing one.

Opponents of open-ended ECB action argue that Italian and Spanish borrowing costs are not actually that high. Interest rates have just returned to levels seen in the run-up to the introduction of the euro, when investors distinguished properly between the countries that now share the euro. High borrowing costs are needed to focus minds and instil discipline. Were the ECB to take aggressive action to bring down borrowing costs, it would create so-called moral hazard; countries would be free to delay reforms in the knowledge that they will not be punished for it by having to pay high borrowing costs. According to this argument, it is a positive development that investors are now differentiating so strongly between the risks of lending to various governments. After all, the failure to do so in the run-up to the crisis contributed to the under-pricing of risk across the eurozone and reduced pressure on governments to reform their economies.

In nominal terms Italian and Spanish borrowing are indeed comparable to the levels of the late 1990s. But it is real cost of capital (that is, adjusted for inflation), that is crucial, and not the nominal cost. Both countries face much higher real borrowing costs than they did in the run-up to their adoption of the euro. Moreover, it is erroneous to compare the present with the late 1990s. Italy and Spain are at very different points of the economic cycle now than they were then. In the late 1990s both economies were growing, in the Spanish case rapidly, whereas now they face slump and mounting risk of deflation. Countries facing depressions and rapidly weakening inflation typically face very low borrowing costs: investors invest in government bonds for a want of profitable alternatives. This is what we see in the UK and US; borrowing costs remain at all-times low despite the extreme weakness of both countries’ public finances and poor growth prospects. Investors certainly need to differentiate between eurozone governments, in order to ensure that risk is correctly priced. The Italian and Spanish authorities acknowledge this. But the current spread between the yield on German government debt and that of the Italian and Spanish governments wildly exceeds what is required to make sure investors differentiate appropriately.

The polarisation of borrowing costs has politically explosive distributional effects: Germany is borrowing and refinancing its existing debt at artificially low interest rates. According to the German Institute for the World Economy, investor flight from the government debt markets of the eurozone’s struggling members to Germany has already saved the German government almost €70bn. Other countries face ruinously high borrowing costs, which are simultaneously increasing the scale of their reform challenges and narrowing their political scope to make the necessary reforms. The longer Italian and Spanish borrowing costs remain at such elevated levels, the greater the economic damage to those economies will be and the harder it will become for the two countries’ governments to shore up the necessary political support for further reforms.

Why have government borrowing costs across the eurozone diverged so much? The principal reason for the size of the spread between the periphery and Germany is convertibility risk. Investors believe that there is a chance that Italy and Spain will ultimately be forced out of the currency union and are thus demanding a hefty premium to insure against this eventuality. This feeds the convertibility risk by weakening countries’ fiscal positions and raising private sector borrowing costs (government bond yields set the cost of capital for the private sector). With private and public consumption in both Italy and Spain set to remain depressed for years to come, economic recovery requires stronger investment and exports. But borrowing costs are crippling and credit scarce. In a vicious cycle, the steep fall in the value of Italian and Spanish banks’ holding of government debt, combined with mounting bad debts as a result of recessions made worse by punitive borrowing costs, are forcing the banks to further rein in business lending. 

The ECB’s latest programme of bond purchases will be big enough to ensure that Mario Draghi does not lose face. But it will not be big enough to dispel convertibility risk and hence demonstrate its credibility as a lender of last resort. And it is this credibility problem, rather than the relative ‘credibility’ or otherwise of member-states policies, that is the principal reason for the unsustainably high borrowing costs faced by Italy and Spain.

Simon Tilford is chief economist at the Centre for European Reform.

1 comment:

Martin Wolf said...

Excellent post.