Is the eurozone crisis all down to sentiment?
Research from the Centre for European Policy Studies suggests that the spikes in borrowing costs for eurozone countries has a lot to do with sentiment, rather than fundamentals.
That market fears over the debt sustainability of an issuer can trigger a self-fulfilling spiral of bankruptcy – which, to a large extent, is disconnected from underlying fundamentals – has been painfully demonstrated among financials and sovereigns in recent years. In short, it’s a thin line between illiquidity and insolvency with fear/rumour standing in between.
In this vein, the Centre for European Policy Studies has put out a working document investigating the extent to which eurozone government bond markets are more susceptible to self-fulfilling liquidity crises driven not by fundamentals, but by sentiment.
This paper tests the hypothesis that government bond markets in the eurozone are more fragile and more susceptible to self-fulfilling liquidity crises than those in ‘stand-alone’ countries, i.e. countries that issue debt in their own currencies. We find evidence that a significant part of the surge in the spreads of the PIGS countries (Portugal, Ireland, Greece and Spain) in the eurozone during 2010-11 was disconnected from underlying increases in the debt-to-GDP ratios and fiscal space variables, but rather was the result of negative selffulfilling market sentiments that became very strong starting at the end of 2010
Supporting CEPS's hypothesis are the two graphs below:
If you look at the two graphs, you can see that post-2008 a eurozone country’s debt-to-GDP ratio has had a clear positive correlation with its spreads, whereas before 2008 there is little observable relationship between the two. In contrast, the relationship between spreads and debt-to-GDP ratios in stand-alone countries hasn’t really changed since 2008.
This suggests that the markets are unsurprisingly treating eurozone sovereigns differently to sovereigns with monetary flexibility, and in a fashion that isn't causally dependent on those sovereigns debt-to-GDP ratios. CEPS comes to the conclusion that the only explanation for a number of surges in eurozone sovereign spreads is panic in the markets engendering a mispricing of risk:
“In the eurozone we detect some increasing positive time effect since 2010Q2. Noticeably there exist significant and positive time effects from 2010Q4 to 2011Q3 in the periphery of the eurozone. Thus, during the post-crisis period, the spreads in the peripheral countries of the eurozone were gripped by surges that were independent from the underlying fundamentals. Finally we plot the time effects obtained from Table 5 in Figure 8a and 8b. This suggests, especially in the periphery, that ‘departures’ occurred in the spreads, i.e. an increase in the spreads that cannot be accounted for by fundamental developments, in particular by the changes in the debt-to-GDP ratios and fiscal space during the crisis. This result can also be interpreted as follows. Before the crisis, the markets did not see any risk in the peripheral countries’ sovereign debt. As a result they priced the risks in the same way as the risk of core countries’ sovereign debt. After the crisis, spreads of the peripheral countries increased dramatically and independently from observed fundamentals. This suggests that the markets were gripped by negative sentiments and tended to exaggerate the default risks. Thus, mispricing of risks (in both directions) seems to have been an endemic feature in the eurozone.”
In short, it's a simple point but worth noting: this empirical study confirms that a cycle of fear - not necessarily debt metrics - has heaped on bailout risks for eurozone economies. After all, Italy notched a positive budget surplus in the 2011 fiscal year while Spain's current debt-to-GDP ratio stands at around 80%, compared with the eurozone's average at 90%.
While the eurozone summit might have provided policymakers with a couple of months breathing room, most analysts reckon ECB action, such as aggressive spread targeting, and/or fiscal transfers are the only game-changers capable of encouraging real money non-resident investors to snap up peripheral European sovereign bonds once more. In sum, this report will no doubt provide much ammunition for those that decry the fiscal hawks in Berlin and Brussels who still argue fiscal consolidation must come first.