Eurozone Recovery Falters — What’s Next?

This opinion piece was written just prior to the outbreak of the coronavirus epidemic in the West. The authors believe that the pandemic will increase the necessity and therefore the probability of fiscal integration in the eurozone.

Based on the leading economic indicators, the eurozone economy may be heading for a prolonged slowdown or possibly a mild recession. A deeper or longer slump cannot be ruled out if weakness starts to feed upon itself. Surely, room for macroeconomic policy action to stem the downturn will be critical.

But how much room is left for policy stimulus? And how would an alternative policy mix other than monetary stimulus affect the eurozone and financial markets?

Monetary policy stimulus has met growing resistance inside the ECB’s Governing Council. President Christine Lagarde has very little leeway to step up quantitative easing (QE) or drive policy rates deeper into negative territory. Indeed, she called on EU member states to stimulate the economy through their budgets. However, the EU’s fiscal rules, along with looming market concerns over debt sustainability in some countries, make robust fiscal stimulus among the governments of the southern nations (or “periphery”) unlikely. What’s more, there is little appetite for counter-cyclical fiscal stimulus in the northern nations (the “core”), in particular the Netherlands and Germany.

Two Instruments

Therefore, we believe powerful new instruments will have to be created in case the downturn proves severe. The debate on what these tools might look like is ongoing and revolves around two kinds of instruments:

1. A “safe asset” that eurozone banks can invest in in lieu of national sovereign debt. A risk-off in financial markets can trigger another stampede from periphery sovereign to safe core debt, pushing the eurozone into another existential crisis, with little scope for ECB support. In the past decade, banks on the eurozone’s periphery have invested massively in national sovereign bonds since they yield lucrative returns at negligible funding cost — provided the ECB keeps rates low and acts as investor of last resort. Meanwhile, core sovereign bonds — especially bunds — serve as the de facto safe asset for the eurozone financial system. If periphery banks could invest in a safe asset guaranteed by the joint national sovereigns, the eurozone would be better protected against systemic crises.
2. A eurozone “budget,” essentially a supranational sovereign entity mandated to tax and spend, directly or indirectly, through transfers to and from national sovereigns, while occasionally running deficits funded by newly issued debt. This new instrument could achieve a more balanced fiscal-monetary policy mix while circumventing the EU’s fiscal rules and easing the pressure on monetary policy to step in.

While these two instruments tend to be seen as distinct, they can be combined into one. A newly created safe asset could be issued and swapped for national sovereigns on the balance sheets of the banks and the ECB. The ECB would commit to grant exclusive eligibility to the safe asset — assumed to be attributed a zero-risk weight on bank balance sheets while national sovereign debt would lose this designation — both as collateral for repos and for its asset purchases. In line with the prevailing convention, we’ll call this asset the “eurobond,” though other labels — such as E-bonds and Esbies — have been circulating as well, depending on the design specifics.

This would create a “risk-sharing” debt security.  Deficit spending by the eurozone “budget,” meanwhile, would be funded by the euro issuance of the eurobonds beyond the quantities needed for the aforementioned swap operations, thereby easing the aggregate fiscal stance. Ideally, this spending would be geared towards longer-term goals, such as climate policy and innovation, that transcend national interest.

This new set of instruments would be a first big step towards addressing some of the most pressing flaws of the euro project. It would acknowledge the impossible trinity by effectively giving up some fiscal sovereignty for the benefit of the greater good and create a situation where all countries stand to benefit in the long haul. As such, it will likely have profound and lasting effects on European and global financial markets, and European politics at large.

The likelihood that such proposals will be adopted looks minute at present, but that could change if the eurozone slumps. After all, alternatives are scant. Nevertheless, central to our financial markets outlook is the assumption that the eurozone — spurred by a further worsening of the business cycle — will indeed continue implementing structural reforms to transform the common currency area into an economic and political block that is less vulnerable to internal and external shocks, both from outside and within. As such, we believe the most likely impact of the new policy toolkit on financial markets will be a combination of euro appreciation, tighter spreads, and stronger equity markets, financials in particular.

1. Yield Spreads

Since the new eurobond would be underpinned by guarantees from the national sovereigns, we expect yields of the core to rise, reducing the amount of sub-zero yielding government paper. Conversely, we believe that risk perception in financial markets towards the periphery will improve. Therefore, yields of peripheral debt will drop further in the early stages prior to the actual implementation of the reforms, in spite of the significant declines in Italian yields that resulted from the formation of the new coalition government.

After implementation, peripheral yields may rise again. But we believe yield spreads will eventually converge as financial markets acknowledge that the new eurobond reduces both sovereign default risk within the eurozone and existential threats to the currency union, assuming mandatory fiscal rules and discipline are enforced.

Enforcing fiscal discipline at the national level is important because, under the new policy, the abolition of QE of national sovereign debt could be perceived as enhancing rather than mitigating default risk. However, we believe that markets will be willing to look past this, at least initially, since the creation of a QE-eligible eurobond implies that large amounts of national debt will be “mutualized” and hence carried by the eurozone system as a whole. This would create a new reality, or at least a novel perception, of reduced default risk in the periphery.

2. The Euro

The new policy effectively transfers risk from the national to the supranational level. As a result, country risk (premiums) in the periphery will drop, provided that countries are incentivized to implement reforms. We believe the outlook of entering an ESM debt-restructuring program and the end of QE of national sovereigns should serve as a strong deterrent to overly lax fiscal policies and lead to self-imposed budget discipline, even though we would expect Europe’s fiscal policy in aggregate to become more countercyclical.

Markets would probably view the new policy mix as positive for the euro given that risk perception of euro-denominated investments in general will be reduced and growth will pick up due to fiscal expansion. Therefore, we expect an appreciation in the euro-dollar exchange rate. Politically, it should (temporarily) mollify President Donald Trump and US exporters and hopefully disincentivize the US government from embarking on a full-scale trade war with its most important political, economic, and military ally. An additional longer-term benefit would be a boost in the euro’s status as a reserve currency.

Finally, with Brexit pending, this reform package would demonstrate European unity, provided political leaders push through the whole package and not some watered-down version and continue to strengthen the common currency bloc through financial reforms.

3. Banks

We expect the new policies and change in risk-weightings of national sovereigns will bring about a reallocation of capital. The dysfunctional repo market will roar to life: Banks that are currently unwilling to take on peripheral debt will be eager to hold QE-eligible eurobonds in the future. Clogged lending channels and the functioning of European interbank markets should improve as well.

Economic activity and demand for bank credit should pick up too since eurobonds can be issued to finance deficit spending at the center, thereby providing a welcome boost to aggregate demand. Hence, banks’ profitability in the core should improve, not least because yield curves will steepen.

In the periphery, profitability may actually deteriorate somewhat initially as national sovereign yields fall. This will flatten the curve as lending rates will continue to be based on national sovereign yields, at least for the foreseeable future. On the other hand, peripheral banks may receive an immediate one-off gain in their trading portfolios if yields on Italian BTPs fall early on. The opposite could occur in the core countries. The possible negative short-term impact on profitability in the periphery could be mitigated or reversed by improving credit demand. In the case of Italy, for example, the creation of a bad bank, something not currently possible under EU rules, to accelerate the pace of bad loan disposals would be of great help. Those loans accounted for approximately €360b, or about 20% of GDP, in 2016 but had fallen to around €200b at the end of 2018.

In the mid to long term, we expect yield curves to steepen across the board, and not only in the core. Consequently, the initial divergent impact on profitability in the core and the periphery will be short lived. Therefore the entire EU banking sector stands to benefit. Given depressed equity valuations, perennially underperforming EU financials, could be poised to potentially outperform their US peers, at least for a while, if Europe really commits to more structural reforms. Of course, that’s a big unknown in the current environment.

More generally, we believe that the EU would become a stronger economic and political block, a necessity in today’s increasingly “hostile” world.   

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The views, opinions, and assumptions expressed in this paper are solely those of the author and do not reflect the official policy or views of JLP, its subsidiaries, or affiliates.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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