New mar­ket storm could catch euro zone un­pre­pared

The Pak Banker - - MARKETS/SPORTS -

Dis­tracted by an un­re­solved mi­gra­tion cri­sis and ne­go­ti­a­tions on keep­ing Bri­tain in the Euro­pean Union, euro zone lead­ers could be caught un­pre­pared by a new storm on fi­nan­cial mar­kets.

Global mar­ket tur­moil since the start of the year has helped set warn­ing lights flash­ing in euro zone sov­er­eign bond mar­kets. In early Fe­bru­ary, the pre­mium that in­vestors charge to hold Por­tuguese, Span­ish and Ital­ian govern­ment debt rather than Ger­man bonds hit some of the high­est lev­els since the euro zone cri­sis that peaked in 2011-2012. Euro­pean bank shares have been badly hit by con­cerns over their high stock of non-per­form­ing loans, new reg­u­la­tory bur­dens and a squeeze on prof­its due to sub-zero of­fi­cial in­ter­est rates. New EU bank­ing reg­u­la­tions that force share­hold­ers and bond­hold­ers to take first losses if a bank needs res­cu­ing are fur­ther spook­ing the mar­ket, no­tably in Italy.

All this comes at a time when pub­lic re­sis­tance to fur­ther aus­ter­ity mea­sures has surged all over south­ern Europe, pro­duc­ing un­sta­ble re­sults at the bal­lot box.

Fur­ther­more, the storm clouds are gath­er­ing above a ten­u­ous and slow euro zone eco­nomic re­cov­ery - growth is of­fi­cially fore­cast to reach 1.9 per­cent this year ver­sus around 1.6 per­cent in 2015. South­ern pe­riph­ery coun­tries all face bud­get prob­lems that are fu­elling political ten­sion with Brus­sels.

In­fla­tion is also re­fus­ing to perk up de­spite the Euro­pean Cen­tral Bank's bond­buy­ing pro­gram and neg­a­tive in­ter­est rates, mak­ing it harder for heav­ily in­debted euro zone coun­tries to pay down debt.

Yet euro zone gov­ern­ments trans­fixed by dif­fer­ences over shar­ing out refugees, man­ag­ing Europe's por­ous bor­ders and ac­com­mo­dat­ing Bri­tish de­mands for con­ces­sions on EU mem­ber­ship terms have a huge amount on their hands al­ready. One French govern­ment ad­viser said the EU had never faced such an ac­cu­mu­la­tion of crises in the last 50 years.

At their most re­cent meet­ing, euro zone fi­nance min­is­ters said the lat­est mar­ket tur­moil was no rea­son for con­cern at this stage.

They in­sisted that the euro zone is very dif­fer­ent now from its sit­u­a­tion in 2010 in terms of in­sti­tu­tions and in­stru­ments avail­able to han­dle an­other out­break of the cri­sis.

Among them are the Euro­pean Sta­bil­ity Mech­a­nism (ESM) res­cue fund, bet­ter cap­i­tal­ized banks, a par­tial bank­ing union with a sin­gle su­per­vi­sory au­thor­ity un­der the ECB, a mech­a­nism for wind­ing down fail­ing banks, and an em­bry­onic bank res­o­lu­tion fund.

The ECB has also come a long way since 2010, widen­ing its pol­icy scope to so-called quan­ti­ta­tive eas­ing, cre­at­ing money to buy euro zone govern­ment bonds in a bid to re­vive in­fla­tion and boost re­cov­ery.

Mar­kets ex­pect the ECB to loosen mon­e­tary pol­icy still fur­ther next month, but it's not clear that such a move would bol­ster confi- dence in the banks.

And noth­ing that has hap­pened so far is close to the prob­lems seen in 2011-2012. The spread be­tween Por­tuguese and Ger­man 10 year bond yields hit more than 1550 ba­sis points then; the Fe­bru­ary 2016 high was just shy of 380 bps.

But wor­ries about banks have been spread­ing to sov­er­eign bonds in more vul­ner­a­ble coun­tries in a re­vival of the so-called "doom loop" that EU re­forms were meant to re­move. Pres­sure from euro zone hawks such as Ger­many and the Nether­lands to ei­ther limit the amount of home-coun­try debt that a bank may hold, or give na­tional sov­er­eign debt dif­fer­en­tial risk weight­ings on banks' books have added to un­cer­tainty.

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