Despite the fact that the ECB’s recent round of bond purchases appears to have calmed markets and sparked a rally in European bonds and stocks, there are plenty of reasons to doubt that the good times will last.
While the January round of fundraising has so far been ‘successful,’ there is still a mountain of debt yet to come to market in Europe, including large offerings from some suspect issuers like Italy, Spain, and Belgium. With such a quantity of debt unlikely to clear the market without help, the ECB’s bond purchases look set to accelerate in 2011.
But there are good reasons to believe this will have significant negative consequences for growth across Europe, making it very difficult to repair sovereign balance sheets in the most indebted countries. Crowding out of private investment is liable to lower growth by almost a percentage point in the most affected economies, a scenario that would bring into play the long-tail risk of capital flight from heavily indebted countries, most notably Italy. While the ECB’s bond purchase program has so far supported the markets, its long-term effects might be to exacerbate solvency concerns in low growth, heavily indebted economies.
Before we delve into the theoretical problems with the ECB’s bond purchase program, it is instructive to get a handle on just how much debt Europe is going to have to issue in 2011. According to a recent report from RBS that was summarized in a Financial Times article entitled “Crunch time for eurozone bonds,” gross bond issuance across the eurozone was estimated at 814 billion euros for 2011. The largest borrower is expected to be Italy at 215 billion, followed by France at 194 billion, Germany at 185 billion, and Spain at 80 billion. About 80 billion euros is expected to come to market in the month of January, and while we have not quite seen the end of this month’s issuance, markets have jumped on the idea that Europe is out of the woods after well-bid auctions from Portugal, Spain, and Italy earlier in the month.
Not so fast, I would caution. Even if we get through the month without a blip, the amount of debt auctioned in January is very nearly going to have to be replicated every month of 2011. In addition, February and March should bring some 50 billion euros of Italian debt to market, a much larger sum than we have seen so far. There is still quite a lot of capital to be raised in the next few months, and the fact that Spain and Portugal abandoned auctions in favor of syndicated offerings last week indicates that funding problems persist in the markets. With bond demand from private capital likely to remain insufficient to cover new bond issues, it seems that the ECB bond purchases are going to remain a regular part of the bond market in 2011.
But whether the ECB’s bond purchasing program can prevent the spreading of Europe’s debt woes is an open question. As it currently stands, the ECB’s program for intervening in sovereign debt markets is a different animal from the Fed’s quantitative easing program because unlike the Fed, the ECB attempts to offset its bond purchases by draining reserves from the banking system.
This key difference, no doubt designed by those with an historical memory of the money printing and hyperinflation of the Weimar Republic, will no doubt meet the approval of sound money proponents around the world. But the cost of sound money is that funds previously available for loans to the private sector will be transferred to the inefficient public sector. The effect is a crowding out of private investment across the eurozone that will be most pronounced in the places where banks hold a significant amount of distressed sovereign debt. The crowding out of private investment is likely to have a significant effect on growth throughout the eurozone, and what follows is my attempt to estimate the potential magnitude of the growth effect.
Since beginning the bond purchase program in May of 2010, the ECB has purchased about 76 billion euros of bonds. Assuming at least a similar level of support will be required in 2011 gives a full-year estimate of around 100 billion euros of bond purchases, which is probably conservative given the likelihood that the ECB will have to support much bigger economies over the next year.
In addition, we must include the multiplier effect as a result of fractional banking to determine how the sterizilation of bank reserves will affect the loanable funds available to private borrowers. Assuming a 10-to-1 ratio of loanable funds to reserves, one can see that draining 100 billion euros of reserves from the banking system will actually shrink lending in the eurozone by one trillion euros.
According to the ECB, the total market for loans to households and non-financial corporations in 2010 was around 11 trillion euros. Thus, the ECB’s bond purchases could result in a contraction of private lending of around 9%. This would have a dramatic effect GDP growth, as documented in a working paper that can be found on the ECB website entitled “Do bank loans and credit standards have an effect on output?” (pdf).
Using regression analysis, the authors estimate that a 5% drop in bank lending would lower overall GDP growth by 0.4 percentage points in the short term, with possibly much larger long term effects. Thus, a 9% drop in private lending could knock 0.8 percentage points off GDP growth in some European countries, a pretty significant impact considering The Economist estimates that GDP growth across the entire eurozone will only reach 1.5% in 2011.
Even still, that might be an acceptable cost to pay provided that austerity measures by themselves could return problem countries to a state of solvency. That may be the case in Spain, where the debt-to-GDP ratio is just 65% and the simple act of balancing the budget will remove most funding concerns. But in Greece and Italy, where the debt-to-GDP ratio was over 120% at the end of 2010, the growth in interest on the debt would likely swallow up any savings brought by austerity measures taken to balance the budget. Belgium and Portugal, each with debt-to-GDP ratios hovering around the 90% level that has been made famous by Ken Rogoff and Carmen Reinhardt (they estimate that breaching this level knocks 1% off GDP growth), might also be stuck on a treadmill of ever higher debt levels as interest on the debt rises and economic growth stagnates.
Without the prospect of at least moderate GDP growth to increase the denominator in the debt-to-GDP ratio, the solvency of Portugal, Belgium, and most importantly, Italy becomes a legitimate long term question. And given that Italy is expected to be Europe’s largest borrower in 2011, the refinancing risk is real and immediate. The argument that has saved Italy up to now is that private savings in Italy are both substantial and also immobile, allowing Italy to roll over its debt without a problem. But since Italian GDP is only estimated to grow by 1.1% this year, the crowding out effect from ECB bond purchases might very well lead to complete economic stagnation. If the economy stagnates, Italy’s primary deficit is sure to increase due to entitlement payments.
This raises the prospect that Italy might have to import capital from abroad at the very same time as its fiscal situation is deteriorating. That might lead to a very dangerous scenario where investors perceive growing risk in Italian debt and force yields higher as some 215 billion euros of new debt comes to market. The prospect of 5.5% yields for Italy is very painful to contemplate with such a high debt burden, and there is always the possibility that Italian bond yields will blow out to levels that would make the country's insolvency beyond question. That would be a nightmare scenario for the ECB, but it might well be a long tail risk of the ECB’s current bond purchase and monetary sterilization plan.
Among the growth promoting alternatives to the current program, direct fiscal transfer is likely to be the most robust solution as it maintains reserves in the banking system and instead takes money from EU treasuries to subsidize debt in distressed countries. However, given the unpopularity of such a solution in creditor countries, its political prospects still look dim.
On the other hand, a policy of quantitative easing that maintains banking reserves and allows for monetary expansion to subsidize distressed debt would be equally unpopular, especially in Germany where the aversion to money printing runs deep. And with inflation in the EU recently reported at 2.2% year over year (above the ECB’s 2% target), quantitative easing remains unlikely for a central bank whose sole mandate is price stability.
Barring these two alternatives, the only other option is an eventual restructuring of debt for the EU’s biggest problem children (Greece, Ireland, and likely Portugal) in an attempt to ring fence the debt of less imperiled nations. European officials have made plain their distaste for this option, and the lack of capital raises among Europe’s big banks indicates that the EU is still very far away from contemplating any sovereign default or restructuring.
But with the bond purchase program likely to hurt growth and the notion of fiscal union or quantitative easing still anathema in most circles, investors are left wondering if there is any coherent plan should markets come under further stress. European authorities are hoping for the best, but they still appear ill-prepared for the worst. That is no way to combat a crisis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.