The eurozone seems to have a new saviour – China.
This morning, one central bank official declared that “the euro and the European financial markets… are and will be one of the most important investment areas for China’s foreign-exchange reserves.” And earlier this week, the country pledged to buy more Spanish government debt.
And yet, European debt has suddenly started worrying the markets again. The euro slid sharply against the dollar yesterday. And government bond yields were heading higher too.
So what’s got investors fretting again all of a sudden?
The reason Europe’s worrying the markets now
It may seem odd that Europe is back in the headlines so early in the New Year. After all, it’s not as if no one was aware of the various problems afflicting the region. Investors spent much of last year fretting about them, and they’ll remain a problem for the rest of this year too.
As usual, it seems the latest bout of panic was down to yet another hint that in the future, bondholders in bankrupt banks might have to share the pain with taxpayers. The European Commission published proposals from internal market commissioner Michel Barnier yesterday.
The idea is that in future, banks’ senior bondholders (their lenders) should act as a “last line of defence,” as the FT puts it. They would have to write down the value of their investments (giving the bank breathing room, in other words) before taxpayers were called on to fund a bail-out.
“Banks will fail in the future and must be able to do so without bringing down the whole financial system,” argues Barnier. “We must put in place a system that is well prepared to deal with bank failures in an orderly manner – without taxpayers being called on again to pay the costs.”
Life is going to get more expensive for banks
It seems reasonable enough. And it won’t apply to any bonds issued before 2013. Trouble is, it’s complicated to put into place. And regardless of how it’s done, it will make life more expensive for banks.
Think about it. If you, as a depositor, realised that you would stand to lose some or all of your money if a bank went bust, what would you do? You’d either avoid putting money in the bank, or you’d expect a higher interest rate. In fact, we pretty much saw this in action with the great deals Icelandic banks were offering just before they went to the wall.
The same goes for senior bondholders. If they’re going to be taking more risk, then they’ll demand a higher return. Now, just because it’s uncomfortable or difficult doesn’t mean that nothing should be done. And as Sony Kapoor of the thinktank Re-define points out to Reuters, a rising cost of funding for banks “would be no bad thing because they have enjoyed subsidised funding backed by the government.” But of course, trying to push all this through now just adds to the overall jitters in Europe.
We’ve also got another European country starting to appear on investors’ radar – Belgium. It currently has a hefty budget deficit to tackle, but no full-time government to tackle the problem. We covered Belgium’s problems in MoneyWeek magazine last year: Is Belgium about to split?
Why Germany’s recovery is a problem for the eurozone
But there’s another big problem facing the eurozone this year that could be more serious than either Belgian in-fighting or bank regulation. It’s Germany’s strong recovery. Why’s this a problem? Because a recovering economy becomes more vulnerable to inflationary pressures. Like almost everywhere else, inflation is rising to uncomfortable levels in the eurozone.
The most recent survey, for December, showed that the consumer price index is rising at an annual rate of 2.2%. That’s nowhere near as bad as the UK, but it’s above the European Central Bank’s (ECB) target for the first time in two years.
In Germany in particular, prices rose at the fastest monthly pace in eight years. Germany is notoriously, and understandably, inflation-phobic. It’s also the most important and influential economy in the eurozone when it comes to setting monetary policy. That all adds up to the potential for heavy pressure on the ECB to raise interest rates this year, regardless of how the rest of the region is performing.
As Ken Wattret of BNP Paribas told The Times earlier this week, higher rates “are the last thing the peripheral countries need. [These] countries are, in their service sectors, now showing recessionary conditions”.
It’s somewhat ironic. When the euro was launched, interest rates were set at a level to suit Germany’s sclerotic economy, which was still hobbled by reunification. But the flood of cheap money turned the strongly-expanding periphery countries, such as Ireland, Spain and Greece, into bubble economies. Low rates set them up for a fall. Now that Germany is rallying strongly, demand for higher rates could finish the periphery off.
What does all this mean for investors? It means we can expect a lot more turbulence for the euro this year, particularly against the dollar. There are certainly some trading opportunities here. And on that subject, we’ve just launched a new free email, MoneyWeek Trader.
Now, trading currencies isn’t for everyone. It’s pure speculation, not long-term investment, and you need to understand what you’re doing. On top of that, the easiest way for retail investors to trade currencies is through spread betting, which is high-risk in itself. However, if you like the idea of trading and spread betting, then the MoneyWeek Trader email is for you. It’s written by our new colleague, John Burford, who has been a trader for years, and is now sharing his tips and tactics. Like any good trader, John doesn’t just cover forex, but it is one of his stamping grounds. If you’re interested in learning more about trading, timing, how to get started, how to manage the risks, and the keys to successful spread betting, then do sign up here for his free MoneyWeek Trader email.
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