September 3, 2012 8:26 pm
Eurozone: Convergence in reverse
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European economic convergence, that grand post-1945 vision of a borderless financial system, is starting to unravel. After decades of progress, banks are retrenching behind national borders.
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Businesses, consumers and governments in the south are facing dramatically higher borrowing costs than those in the north – in turn deepening recessions. The European Central Bank is replacing private cross-border capital on a large scale.
The disintegration of the eurozone’s financial system highlights how the benefits brought by the euro’s launch in 1999 – a crowning moment in the push to integrate the continent’s economies – are fading. It is causing alarm at the Frankfurt headquarters of the ECB. “If we want to get out of this crisis, we have to repair this financial fragmentation,” Mario Draghi, president, warned in July.
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The wild variations in borrowing costs show how the ECB has lost control over interest rates – the main weapon in a central bank’s armoury. Mr Draghi is worried about the destructive impact of eurozone break-up speculation on rates. On Thursday, the bank’s governing council will debate plans for intervention to regain control of interest rates in sovereign debt markets and calm the worst fears about Europe’s monetary union.
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Fragmentation is about much more than just monetary policy, however: The risk is that it will fuel public opposition to the euro in troubled economies and erode the arguments for membership – perhaps making a break-up more likely.
“We are making a mockery of the single market and closing down access to financial markets,” says Jean Pisani-Ferry, head of the Bruegel think-tank in Brussels. “Can it be reversed? We don’t know. We have not seen that so far. What we have seen, unfortunately, is a continuation of the process. The ECB is very rightly concerned.”
Until a few years ago, eurozone policy makers could hail the convergence of markets and economies in the bloc, now comprising 17 countries. Most striking was the narrowing of the “spread” between the interest rate demanded by investors on ultra-safe German bonds and those of other members. In November 2009, the yield on a Greek 10-year bond was less than 2 percentage points higher than on the German equivalent. It is now 22 percentage points.
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With hindsight, such convergence was not all positive. Low borrowing costs in the south encouraged credit and housing booms – and reckless fiscal policies in Greece.
Worried about a possible break-up, bond markets are now forcing weaker members to pay a heavy price. Foreign investors have pulled out of Spanish and Italian sovereign debt markets – leaving only domestic banks to buy new issues, using money borrowed from the ECB. Unsustainable borrowing costs and banking crises have pushed Greece, Portugal, Ireland and Cyprus into emergency bailout programmes – and Spain has asked for help for its banks.
Adding to the pain, banks have cut back on lending and cross-border exposure, pushing interest rates up further, especially for small- and medium-sized companies. A company borrowing less than €1m for up to five years can expect to pay an interest rate of 6.5 per cent in Spain, but just 4 per cent in Germany.
It is not just markets that are driving fragmentation. Banks face domestic pressure to reduce cross-border exposure. “Every national regulator is asking: ‘How can I reduce the risk of my banks being impaired if something goes wrong in the eurozone’. This ‘financial protectionism’ is not going to go away,” says Huw van Steenis of Morgan Stanley.
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The ECB estimates that since mid-2011, the share of cross-border credits in overnight money markets – which oil the financial system – has fallen from 60 per cent to less than 40 per cent. “Speculation about the exit of individual crisis-hit countries – linked with a devaluation – are massively influencing the interbank lending market,” Jörg Asmussen, an ECB board member, said last week.
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Fragmentation is having a “freezing impact” on corporate investment, says Mark Cliffe of ING. “If you are a large multinational, you are not going to be in a hurry to invest in the periphery. That’s one reason why companies are sitting on so much cash.”
As private cross-border capital flows have dried up, the ECB has expanded its supply of liquidity to eurozone banks. Spanish lenders are borrowing more than €400bn, equivalent to 11 per cent of total bank assets. For Italy, the figure is almost €300bn.
The result has been soaring imbalances on the Target 2 cross-border payments system used by eurozone central banks. Mirroring the southerly flow of ECB funds, Germany’s Bundesbank has Target 2 claims in excess of €700bn.
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The significance of such imbalances is hotly disputed among economists. Some, including those at the Bundesbank, argue they reflect an ECB response to the crisis and are not a guide to the bill a country would face in the event of a eurozone break-up.
Still, they have gained political significance. The ECB’s actions have “supercharged the politics because the liabilities have become socialised and it is the taxpayer who is on the hook”, argues Mr Cliffe. “If the monetary union breaks up, then the liabilities would crystallise and somebody has to pick up the bill.”
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Reversing the eurozone’s fragmentation will require encouraging financial flows back into the periphery countries – which in turn will require rebuilding confidence in the euro’s future. That is the challenge facing Mr Draghi and eurozone politicians in the days and weeks to come.
Additional reporting by Robin Wigglesworth
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Copyright The Financial Times Limited 2012.
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