Wasn’t the eurozone crisis supposed to have been solved by now?
It seems not. Markets were hammered yesterday, as fresh fears over the state of Spain and Italy erupted.
The Spanish stock market fell by 3%, while Italian stocks plunged 5% on the day. But the real worry is what happened to their cost of borrowing.
Spanish ten-year government bond yields rose above 6% for the first time since December (which is when the European Central Bank started doling out cheap money to eurozone banks).
Meanwhile, Italy’s cost of borrowing saw a similar rise, hitting close to 5.7%.
So why the sudden panic?
The trouble with the European Central Bank’s version of QE
At the end of last year, the European Central Bank (ECB) embarked on its first bout of LTRO – the Long-Term Refinancing Operation.
This is the closest the ECB has come to doing quantitative easing (QE). And at first it seemed to have worked.
The move was a response to last year’s big eurozone panic. Spanish and Italian government bond yields were climbing back then too. Rather than intervene in the markets outright (which the Germans aren’t happy about), the ECB came up with a cunning plan.
The idea was that the ECB would allow banks across Europe to borrow as much as they wanted over a three-year period at a knock-down rate of 1%. This was the LTRO. The unspoken deal was that they would re-invest this money in the bonds of troubled countries: Spain and Italy in particular.
If you can borrow money at 1% and re-invest it at 5%, that’s a pretty attractive deal. Particularly if the sovereign you are investing in is realistically ‘too big to fail’.
So here’s how it works. Investors see the state of Spanish banks and the property market. They realise that these banks have got to be sitting on unrealised losses of catastrophic proportions.
They also realise that, like almost every other government except Iceland, the Spanish government will probably be stupid enough to step in and guarantee these banking sector losses. So naturally, they stop lending to the Spanish government. Bond yields soar. People panic.
So the ECB – which can’t be seen to be printing money out of thin air – lends money to Spanish banks at rock bottom levels. Spanish banks use that money to buy Spanish government debt. That brings down the yields on Spanish government borrowing.
As John Plender puts it in the FT, “undercapitalised eurozone banks propped up overstretched sovereign borrowers who stood behind those same fragile banks”.
Now we have a much bigger problem than Greece to deal with
The trouble is, while Spanish banks might be buying Spanish government debt, no one else in their right mind is. Spain’s bond auction failure last week saw this in action. Spanish banks just don’t have the firepower to plug the gap left by vanishing foreign investors.
The other problem, as Plender points out, is that the loans from the ECB don’t come for free. Banks need to pledge assets to get access to this liquidity. In other words, it’s like a pawn shop. The banks don’t actually hand their assets over at the counter and get a ticket for them, but the ECB has a claim over the assets, just like a pawnbroker.
Trouble is, if all your assets are pledged to the ECB, then that doesn’t leave much for other creditors if your bank goes to the wall. So that’s going to make raising money from other sources more expensive.
It also means that if banks want to improve the state of their balance sheets (‘de-risking’ is the particularly ugly piece of jargon used to describe this), then they’re more likely to do so by cutting back on lending and trying to get rid of loans they’ve already written. In other words, you get a credit crunch.
That’s all bad news for the Spanish economy, which is already in the doldrums – it’s expected to shrink by 1.7% this year. The big worry is that Spain will need access to the eurozone’s bail-out fund, which has already been used to dish out loans to Greece, Ireland and Portugal.
But of course, it was troublesome enough getting everyone in Europe to agree bail-outs for those three countries. If Spain has to get the begging bowl out, we’re talking a serious lump of cash here. The bail-out fund probably isn’t big enough as it stands.
So we’re basically back to square one. Only this time, the problem is much bigger.
Investors are heading for disappointment
What’s the likely outcome? Well, as James Ferguson pointed out at a recent MoneyWeek roundtable: The 12 investments our experts would buy into now, chances are that the rest of Europe will have to accept that the only way out is for the ECB to start genuine quantitative easing (QE) rather than the LTRO variety.
But it might take a while to get to that point. The Germans really, really won’t like it. And lots of people have invested a lot of pride in avoiding the Anglo-Saxon route out of this disaster.
Don’t get me wrong. I can see the objections to QE. I agree with most of them. But if you’re not prepared to let the banks go to the wall, or fully nationalise them, then QE is what you’re left with. Or a break-up of the eurozone.
Whatever happens, it seems pretty certain that most parts of Europe are going to suffer a nasty recession (though Germany might be just fine). That doesn’t mean there aren’t any opportunities out there – my colleague Matthew Partridge reckons Italian stocks are worth a look.
However, it does mean that over-optimistic investors now seem likely to face a few months at least where their hopes are regularly slapped down. As I said yesterday, we could be entering a tough period for stock markets: so get your shopping list out in readiness for buying opportunities.
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