Credit where credit is due

Buttonwood
Sep 28th 2005
From The Economist Global Agenda

When markets don’t price risk properly, weak governments—and their taxpayers—are in even bigger trouble

A FRIEND of Buttonwood’s is cross these days. For some months he has had a biggish bet that yields on Italian bonds would rise relative to German ones. It was a no-brainer, one might think. Big-spending Italy has the world’s third-biggest stock of debt, equal to more than 109% of its GDP and heading up, while Germany, though no fiscal angel these days, has a debt ratio of under 68%.

He has yet to make money. The gap between Italian and German yields has barely changed in recent months, and at close of trading on Tuesday September 27th was a mere 20 basis points (hundredths of one percent). Standard & Poor’s (S&P) put Italy, rated AA-, on “negative outlook” in August. And Italy’s finance minister resigned last week in despair over his country’s shambolic economic decision-making and his failure to dislodge the compromised central-bank chief. Neither event affected yields for more than a moment or two.

It was not always thus, as the chart below shows. Before monetary union in Europe, the yield on the Italian government’s ten-year bonds could be more than 650 basis points higher than that on Germany’s, over which the rigorous Bundesbank kept watch. That gap narrowed sharply when currency risk disappeared, a big new euromarket reduced trading costs, a single central bank took charge of interest rates and monetary membership rules promoted unwonted fiscal discipline.

Now the bonds of all the AAA-rated euro-area governments—Germany, France, Austria and so forth—trade within a few basis points of each other. The specifics of different bond issues (how big, how liquid, how useful for repurchase agreements and so on) determine minor differences.

Italy and Greece move around a little on bad news, but not much. The credit-default swaps market tells a slightly different story: the price of insuring against an Italian default was around 14 basis points earlier this year and is about 21 points today. And bond buyers are not wholly blind to countries’ ability to repay. Economists at Goldman Sachs found, in a research note in late July, that while they tend not to pay attention to issuers’ current fiscal deficits, they do ask a bit more of those with high stocks of outstanding debt. But these are nuances. Broadly, bond yields are not reflecting risks.

Italy’s economic problems are too well known to need long rehearsing here. It produces too few of the high-tech goods in which trade has been expanding and too many of the low-skilled goods where the threat from Asia and Eastern Europe is greatest, points out Luigi Speranza of BNP Paribas. As a consequence it has lost 30% of its export market share since 1995. Barely out of recession, it is expected by the International Monetary Fund to show zero growth this year.

Against this backdrop, its government began eurolife with an impressive show of fiscal rectitude, but subsequently lost the plot. Like Germany, France and others, Italy’s budget deficit is over the limit set for monetary-union members (3% of GDP), and it has been given two years to regain the right path. One reason for the resignation of the finance minister, Domenico Siniscalco, was deep opposition within the ruling coalition to his swingeing draft budget. His successor now has less than a week, in law, to get a budget through the government. Italy seems to be imploding before our eyes.

But perhaps the reason why the yield gap with Germany is shrinking is that Germany is getting worse too. Bond-market benchmark or no, it is no role model nowadays, with a fiscal deficit this year forecast at 3.9% of GDP. S&P gave warning last week that Germany could lose its AAA status in a year or more if it fails to get a grip.

Why, then, do investors still seem happy to snap up whatever European government bonds come their way? There are several reasons. The first is the tide of low-interest liquidity worldwide that is lifting all boats. The yield on the ten-year German Bund touched 3% last week, an historic low and more than a percentage point below America’s comparable bond.

When the general level of yields is low, as it is in slow-growing Europe, there is less room to differentiate. Finland, with a 2.1% fiscal surplus and tidy debt, was yielding just five basis points less than Germany on Tuesday.

There are other reasons why Italian bonds in particular are popular. Banks can present any government bonds to the European Central Bank as collateral against borrowing. The ECB does not discriminate among member issuers, so Italian bonds serve the purpose just as well as Finnish ones. Banks tend to prefer presenting bonds of weaker quality, keeping the stronger ones on their own books. The fast-growing market in “covered” bonds—securitised notes backed by future cash flows from mortgage or public-sector loans—is also boosting demand.
Many issuers like to hold Italian government bonds in their cover pool, enjoying their slightly higher yield while paying out lower ones to bondholders.

A third reason is that while no one expects a West European country to default on its loans, the assumption is that if a Greece or an Italy got into trouble, either its European Union (EU) colleagues or the ECB would stand ready to pay off its obligations. But that is an assumption on which it would be dangerous to rely: the ECB has neither the mandate nor, perhaps, the resources to do so.

Is this all as loony as it looks? Maybe not. “One of the points of monetary union was to dampen volatility, encourage fiscal responsibility and reduce borrowing costs, and in that it has succeeded,” observes Laurent Fransolet, head of European fixed-income strategy at Barclays Capital. But there are limits.

The problem now is that we seem to have the worst of both worlds. Bond yields do not reflect real risks, so market discipline isn’t doing its job. Neither are the Eurocrats. The EU’s fiscal requirements for euro members are being flouted left, right and centre; Italy will be the first real test of whether even the new, watered-down version of them will prevail. So making tough decisions to reduce structural deficits and keep debt from taking off falls squarely on the shoulders of national governments. And these are not very robust.

The rewards for making difficult adjustments to get into monetary union were obvious: lower borrowing costs, access to a bigger market. The rewards for making them now appear to be recession and getting chucked out of office. A leader with a strong mandate would find it hard. The broad coalitions that dominate the landscape in both Italy and Germany will find it all but impossible.

Buttonwood’s friend has less than a year to realise his bet. It’s not looking good.

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