The Daily Telegraph

Eurozone’s deflation woes risk insolvency crisis

Sliding prices and rising debt burdens heighten fears of a looming economic storm for the ECB, writes Ambrose Evans-pritchard

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The eurozone is sliding further into a debt-deflation trap, risking a protracted economic depression in the southern countries and a slow-motion insolvency crisis. Headline HICP inflation dropped to minus 0.3pc in September, reaching minus 2.3pc in Greece, minus 1.1pc in Ireland, minus 0.9pc in Italy and minus 0.6pc in Spain. The core rate fell to an all-time low of 0.2pc.

“The European Central Bank has completely lost control of the inflation process. It is very serious,” said Prof Ashoka Mody, the Internatio­nal Monetary Fund’s former deputy director in Europe.

The downward lurch comes as a second wave of Covid-19 threatens to truncate the fragile recovery before it has reached “escape velocity”.

Madrid is back in quarantine. Paris is on “maximum alert” after the ratio of coronaviru­s patients in intensive care reached the danger threshold of 30pc.

The north-south divergence is toxic for the eurozone’s one-size-fits-all monetary regime. By a twist of fate, those countries with the highest debt ratios have suffered the greater economic shock from Covid-19, pushing debt dynamics towards the point of no return.

“Our concern is that Italy and Spain will be left behind,” said David Owen from Jefferies.

Large areas of the eurozone are at risk of debt-deflation, a term used by Irving Fisher for when the contractio­n in nominal GDP causes real debt burdens to deteriorat­e in a vicious circle.

The OECD’S worst-case scenario sketches debt-to-gdp ratios next year reaching 229pc in Greece, 192pc in Italy, 158pc in Portugal, 152pc in France and 150pc in Spain. “Unfortunat­ely, this is becoming plausible,” said Owen.

“We’re seeing a storm building up that may come to a head over the next six months,” said Mody. “Debts have to be repaid and a lot of new debt has been guaranteed by government­s that can’t pay.

“The ECB has already bought 25pc of Italy’s debt and they will have bought half by next year. They will own Italy and they will own Spain. There may be no technical limit but the ECB is not a normal central bank; it is a bank for a confederat­ion of states so there is a political limit.”

He said lenders had been pushed into buying government bonds and were now enmeshed in an even more dangerous doom-loop than in 2012.

“They are highly stressed. Their value-to-book ratio – the best gauge – tells you the market thinks debts on their books are worth just 20 or 30 cents on the dollar. The ECB is trapped into having to buy up everything to stop the banks blowing up. How is this story going to end?”

Bank of America said the eurozone would soon be flirting with core inflation rates of zero.

“There is no reflation. Markets seemed to be waking up to a weak recovery. A reality check is probably in the pipeline for year-end,” it said, predicting that the ECB will be forced to double down on its stimulus plans in December.

Robert Sierra, from Fitch Ratings, said the pandemic had left a “negative output gap” roughly four times the shock from the Lehman crisis, leading to permanent scarring in the labour markets and holding down prices whatever the ECB does. “We expect headline inflation to fall to minus 0.6pc by the end of this year,” he said.

The ECB has played down the slide in inflation as a temporary distortion from falling commodity prices at the outset of the pandemic, but its narrative is rapidly being overtaken by events. Copper and iron ore prices have been slipping for weeks. Brent crude has fallen 15pc since late August and is back below $40.

Christine Lagarde, the central bank’s president, told the ECB Watchers forum this week that the organisati­on would follow the US Federal Reserve and allow inflation to overshoot the 2pc target, effectivel­y letting the economy run hot for a while.

Such rhetoric is academic at this juncture since the ECB has no means of achieving it. The key policy rate is already minus 0.5pc.

Lagarde insisted that it could go as low as minus 2pc before hitting the “reversal rate”, where it does more harm than good.

Her claim has raised eyebrows since the Bank of Japan’s foray into negative rates is widely viewed as a failure, and deeply negative rates would in any case be viewed by Washington as an attempt to drive down the euro.

A further €500bn (£453bn) of pandemic bond purchases in 2021 is now almost certain. This may lift asset prices and keep indebted corporatio­ns afloat but such QE no longer has traction on the real economy. Markets have invested much faith in fiscal stimulus from the EU’S €750bn Recovery Fund. However, leaked plans from the Italian treasury show how disappoint­ing this is likely to prove – once the money is spread across 27 countries and stretched to 2026.

Italy is the biggest recipient, yet net grants will be just €10bn in 2021 and €15bn in 2022. It will eschew loans from the fund because they come with Troika-like conditions. Portugal has rejected loans as well.

Nor is it clear when the Recovery Fund will see the light of day since Poland and Hungary have threatened to block approval over a “good behaviour” clause, and Finland and the Netherland­s may be heading for referendum­s.

In the meantime, rating agencies warn that there could be a wave of defaults when furlough schemes and debt holidays expire. Most cliff-edges hit in December. Banks are already tightening credit terms pre-emptively.

Paul Watters from Standard & Poor’s said blue-chip companies increased net debt by 8pc in the first half of 2020, mostly to build cash safety buffers, not for capex investment. These precaution­ary savings have flattered the money supply but they may contract again as firms repay loans.

The worry is the surge in “fallen angels”, companies degraded to junk status rated B- or lower. Numbers have doubled since early 2019 and reached a record 32.6pc at the end of August.

A disturbing number entered the pandemic with both poor cash flow and a debt-to-earnings ratio (Ebitda) of five or six times.

Watters said negative rates could no longer protect these walking dead once their revenues shrank.

Deflation will push them to the wall even sooner.

 ??  ?? Christine Lagarde, president of the ECB, has a job on her hands to revive inflation in the single currency area
Christine Lagarde, president of the ECB, has a job on her hands to revive inflation in the single currency area

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