Saturday, 23 June 2018

Joint eurobonds, direct bank bailouts, super-EIB

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IFR editor-at-large Keith Mullin sees grounds for optimism in last week’s European summit

IFR Editor-at-large Keith Mullin

IFR Editor-at-large Keith Mullin

HAVE WE REACHED a eurozone breakthrough of sorts? While there may not have been any big decisions taken, there does seem to have been a fairly radical shift in the nuance of the conversations around how to salvage the euro, culminating in Mario Monti sticking his neck out and saying on TV on Thursday: “Europe can have eurobonds soon”.

“We do not expect it to be too far off,” he added. The clearly animated Italian prime minister implied that Angela Merkel, a hardline hold-out to the notion of common bonds, could be persuaded.

It appears that a majority of EU leaders are behind the eurobond idea in principle. Given how the economic fortunes of the eurozone break down, I’m sure this is statistically correct. But there’s no doubt that the northern European alliance remains opposed to the idea, and with good reason.

Elsewhere, the idea of a heavily recapitalised EIB to over €20bn (up to €180bn of lending capacity with co-financing and leverage) seems to have passed without too much opposition; ditto the concept of infrastructure bonds (up to €4.6bn of new investment, although short on detail at this point).

And allowing the eurozone bailout fund to directly recapitalise ailing banks – thereby breaking the negative feedback loop between sovereign and bank stress – is moving towards the next steps: the creation of a resolution regime (proposal due June 6) and the bête noire of conditionality, where most of the work will need to be done.

WHAT MAY HAVE softened Merkel’s implacable opposition to eurobonds is the other EU leaders stressing and re-stressing some basic truths, and some political realities.

First of all, it’s clear that the mechanics of the eurozone currency union saved Germany’s major banks from insolvency, and German taxpayers from the burden of a massive bailout, as they were able to repatriate their huge exposures to peripheral Europe – well in excess of their available capital – more or less intact in favour of ECB funding as the crisis deepened from around 2010.

Let’s be clear here: northern European bank exposure to the periphery wasn’t altruistic economic development funding – a lot of it was speculative financial arbitrage.

Second, Germany relies on the EU for exports, the engine of its economic growth. This is a point that’s been underplayed in this debate. About 71% of Germany’s exports of goods went to Europe in 2011, and 59% to member states of the European Union. Asia may be a target export market for Germany, but in 2011 Asia trade only accounted for 16% of the total, and the US for just 10%.

Northern European bank exposure to the periphery wasn’t altruistic economic development funding – a lot was speculative financial arbitrage

Germany’s export sector accounts for almost half of its economic output. A stable Europe works massively in Germany’s favour. Germany has been more than happy to export its capital wherever it’s been needed, in the form of buyer’s credits and other forms of tailored trade finance, to fund imports of German capital goods.

The lending volume of KfW IPEX Bank amounted to €61.1bn in 2011, for example. Of course, the benefits to Germany of its export finance are direct and transparent. But if Merkel were to shift her internal messaging to the effect that a stable Europe works to Germany’s advantage, which it does, the case for eurobonds becomes a lot more palatable.

On the political reality point, the recent North-Rhine Westphalia elections gave Merkel’s Christian Democrats their worst showing since 1949, with their share of the vote falling nine points to 26%. The centre-left SPD (39%) and its coalition Green Party (12%) now have a clear majority in the country’s most populous state.

With Francois Hollande hitting it off so well with Barack Obama with their shared growth-before-austerity vision, Merkel must be wondering what this all means for the outcome of German federal elections due in September 2013.

ON THE SPECIFICS of eurobonds, much remains to be done. Having Germany financially back the profligate periphery will undoubtedly bring down overall eurozone borrowing costs. But it will also bring up the cost of borrowing in the core; Germany certainly won’t get away with the negative yields seen in last week’s two-year note with no coupon.

But common bonds will have downward sovereign ratings implications for countries such as the Netherlands, Finland and Austria. It will result in a major shift in the burden of responsibility, without any accountability baked into the equation to bring deadbeats to book.

In the absence of more stringent and formal conditions that will have to accompany issuance of eurobonds, Merkel is right to push back, particularly at a time of high government deficits and debt levels in much of the eurozone, and when the impact of current austerity measures has yet to feed through into the numbers.

In the circumstances, it’s no accident that peripheral European government bond curves are so inflated. And even while the perhaps more positively inclined discussions continue at the level of eurozone leaders, stress continues to show up.

In the past few days, we’ve seen curve flattening in Spain with 2/10s breaking 200bp. For sure, we’re not yet at that deep stress point that led to curve inversion in Italy late last year, but inflated yields, curve flattening and the structurally short position the market has adopted are all correlated to market perceptions of impending doom.

Next stop: the EU summit at the end of June, where the market will be looking for some concrete proposals and specific timelines.

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