Europe defuses the risk of a financial implosion

by Michael Collins, Investment Commentator at Fidelity

February 2012

The eurozone debt crisis is unresolved. Many European countries are in recessions, if not depressions, as austerity packages bite. Greece is close to bankruptcy even if brinkmanship talks allowed for a second bailout. Indebted governments must roll over billions of euros worth of bonds at reasonable rates to stay viable. The interbank market is spluttering. Countries such as France have lost their triple-A credit status. Eurozone leaders dither at more summits. Yet global stocks have rallied since December and the Reserve Bank of Australia sees enough progress in Europe since its rate cuts in November and December to hold rates steady in February. Why?

Better news from the US on jobs and economic growth has buoyed investors, as have lower inflation and stronger output numbers from China. The main reason, though, is that among all the bad news pouring out of Europe lies a major comfort for investors; the European Central Bank has found an inventive way to stave off a catastrophe. Hence the 4.4% rally in the US S&P 500 in January, a 5.1% jump in the S&P/ASX 200 Accumulation Index, its best January in 18 years, and a 7.4% gain in MSCI Emerging Markets Index in US dollars.

Stock markets fell for much of 2011 (though the S&P 500 was flat last year thanks to better data on the US economy) because investors fretted that Europe’s debt crisis would trigger a Lehman Brothers-style crisis circa September 2008. Investors saw that the ECB was unwilling to break free of its legal constraint to implement the one credible, medium-term solution for the crisis that is politically feasible. This was for it to buy unlimited amounts of government debt to, in effect, act as lender of last resort to eurozone governments.

Guaranteeing that cash will always be available to pay out government bond holders is a role the central banks such as the Federal Reserve and the RBA play for their governments, even at the risk of complications such as inflation. (The most comprehensive solution to the eurozone crisis would be a political union to match the monetary one – fat chance politically, though.)

Repo man Mario

The ECB under Jean-Claude Trichet, through German pressure, refused to undertake unlimited purchases of government bonds last year, citing the EU treaty clause that prevents the ECB financing eurozone debt. Small purchases of government bonds (in terms of the problem to solve – not necessarily in the amount spent) were largely offset by the sales of short-term securities so there was no increase in the ECB’s balance sheet or the eurozone monetary base.

But Mario Draghi, who took over the role as president of the ECB on November 1, has skirted around these legal impediments to enable the central bank to mimic how the Fed has expanded the US monetary base through its asset-purchase programs to avert a financial and economic crash.

The way the ECB did this was in December to offer banks, via three-year repurchase agreements, unlimited amounts of money at such low interest rates that it was virtually free. Much of this money naturally ended up buying higher-yielding government bonds, which is an indirect way for the ECB to help keep down yields on public debt. To encourage use of the facility, banks can provide loans as collateral under the agreement, which transfers the bad-loan risk to the ECB.

To the relief of investors, more than 500 European banks used the facility in December to borrow 489 billion euros (A$612 billion). That’s equal to about 5% of the eurozone’s GDP and more than the US$600 billion (A$556 billion) the Fed spent over eight months when it conducted its second asset-buying program over 2010 and 2011. The ECB’s facility is open again this month, as planned.

In years to come, the repo move by Draghi may be seen as the turning point in the eurozone crisis because it appears to be a way of preventing an implosion that rocks the world’s financial system. That’s a far lesser achievement than solving the eurozone’s debt crisis but it explains the recent surge in stocks, the decline in credit-default swaps on downgraded European government debt and the narrowing in yields on shaky sovereigns such as Italy and Spain over German debt.

The Stoxx Europe 600 Index, for instance, rose 7% from December 8 when the facility was announced to the end of January. Two-year yields on Spanish and Italian government debt fell more than 200 basis points over that time.
Great difficulties remain unresolved in Europe and a catastrophic moment is still possible. How the euro survives as the currency of such indebted countries with vast current-account imbalances (either surplus or deficit) appears insolvable without fiscal transfers (read political union).

So far, through flapping around and pursuing austerity programs, European policy-makers have aggravated the eurozone debt crisis and its social cost. But if they can come up with inventive ways to buy time as effective as Draghi’s repo deal so they can address the competitiveness differences among European countries, maybe Europe’s elite can give investors more reasons to be optimistic that the eurozone can pull through its debt crisis without triggering a global financial upheaval.

Financial information comes from Bloomberg unless otherwise stated.