This article originally appeared in the Financial Times on 25 July 2017.
Five years ago this week, Mario Draghi’s landmark “whatever it takes” speech turned the tide of the euro crisis, the president effectively clarifying the European Central Bank’s role as a conditional lender of last resort to eurozone sovereign borrowers. Having bought time for countries and the wider region to address structural vulnerabilities, how much progress has been made? From our perspective as an investor, the conclusion is: not nearly enough.
Despite Emmanuel Macron’s election as president of France, prospects for deepening monetary union remain poor. Without a mutualised debt instrument or a “supranationalised” banking system, periphery sovereigns such as Italy and Spain remain prone to act more like corporate bonds in periods of cyclical weakness.
What makes the bonds of “periphery” countries act like credit rather than “risk-free” debt? They face a fundamental contradiction: Their economies need to grow fast to reduce debt, but growth must stay weak if competitiveness is to be regained through internal devaluation. As long as surplus savings economies like Germany and the Netherlands fail to deliver more domestic demand, this contradiction will persist.
The peripherals’ vulnerability stems from several adverse macrofinancial dynamics.
First, given high debt levels, the fungibility of the euro across borders is still prone to breakdown. During periods of weak growth, sovereign debt sustainability comes into question. Periphery economies have little recourse to countercyclical fiscal stimulus.
Second, periphery economies are forced to undergo painful internal devaluations to regain competitiveness due to the fixed exchange rate mechanism. With average euro area inflation very low, internal devaluation is politically and financially destabilising.
And third, low potential growth rates and negligible inflation prevent debt levels from falling much during cyclical upswings. Debt sustainability remains elusive.
Euro area banks: still national
Draghi’s 2012 speech followed a European political commitment to create an area-wide banking union. If banks could be supranationalised, then they would be more immune to asymmetric shocks that might hit weaker governments in the future.
This initial commitment has resulted in a single bank regulator, a new resolution regime, a common rule book and a single resolution fund eventually equivalent to 1% of insured euro area deposits. Despite these positive steps, the aim to insulate banks from their respective sovereign parents still falls short.
The bank resolution regime imposes heavy burden-sharing on private bank creditors without having repaired the banking system first. Pockets of bad legacy debt persist. Moreover, much of the system remains poorly profitable and in desperate need of consolidation.
Forced to issue expensive bail-in-able debt, weak banks become weaker still, thus reinforcing procyclicality. Similar to the wholesale funding crisis of 2008, bank creditors are prone to run away in periods of uncertainty.
Given the overhang of bad debt and persistent conflict between national regulators and newly established supranational bodies, political willingness to establish common deposit insurance is lacking. Without this, the incentives for cross-border mergers and acquisitions are lacking. Banks will remain national in both life and death.
ECB support contingent on ceding sovereignty
ECB asset purchases have served as integral bridge financing for periphery sovereigns to smooth private sector deleveraging. But as core countries like Germany and the Netherlands, with current account surpluses averaging more than 8% of GDP, fail to deliver stronger domestic demand, the periphery is condemned to deflate to retain competitiveness.
Unsurprisingly, structural reform efforts have fallen short in periphery economies already beset by weak growth and fragmenting political systems.
In the event of future shocks, the ECB’s program to buy unlimited quantities of sovereign debt retains a fatal flaw: Its commitment is contingent on a government’s political willingness to adhere to Brussels diktat.
As indirect financing support associated with ECB quantitative easing draws toward a close, countries in need of financing will need to cede sovereignty to Brussels in return for funding. But this is only likely to happen after a sharp rise in sovereign spreads that is potentially destabilising to the banking sector.
Against a backdrop of weak potential growth, elevated unemployment and fragile banks, the high bar for political intervention remains a recipe for accidents. Despite three years of above-trend growth, investors should keep their seat belts on. Europe is still unsafe at any speed.
For more, see our long-term outlook for Europe.
Gene Frieda is a global strategist based in PIMCO’s London office and a frequent contributor to the PIMCO Blog.