Against the tide: The eurozone’s nexus of debt
The debt crisis is not over. A renewed bout will spring from banks in the EU periphery.
Financial markets are booming and yield spreads over Bunds for the bonds of the distressed eurozone states have narrowed. Ireland has announced that it is exiting the EU-IMF bailout programme and going it alone for the funding of its future budget deficits and debt rollovers, having built up a cash reserve of €20 billion with which it can service its debt without further issuance until 2015. Spain reckons that it too can exit its banking bailout programme without further recourse.
So all is looking well in the eurozone and any new bout of crisis has receded beyond the horizon. Or has it? In my view, there will be a renewed crisis. This time, though, it will run from the banks to the sovereigns in peripheral states. Eurozone banks are still inadequately deleveraged and capitalized, especially in the peripheral economies. They face substantial rising bad debts in the corporate and household sectors in 2014. At the same time, sovereign debt sustainability is set to worsen, GDP growth is (and will remain) zilch; fiscal and economic reform is nonexistent; and banks are vulnerable on their loan books to the corporate sector as much as on their massive holdings of domestic sovereign debt.
And the eurozone’s banks, particularly in the periphery, face the tests of the European Central Bank’s asset quality review (AQR) and stress tests over the next year. This will provide transparency, but not the means of addressing the flaws it will uncover.
In the meantime, as I argued in my last column, the architecture of budding European banking union is riddled with Gruyère holes and is under-resourced. The political ambition to keep all funding resolutions dependent on private sector bail-ins and national government resources is likely to make banks more vulnerable to runs on them.
The nexus connecting excessive private and public debt in the eurozone is the banking system. Bank credit is still contracting; loan rates are still high in peripheral economies; and the breakdown in intra-eurozone credit and capital flows remains. There is an adverse feedback loop in which the eurozone’s banks are the weak link between still high private-sector (corporate and household) debt and rising sovereign debt.
Recently, I conducted my own exercise to determine the likely hit to peripheral eurozone banks. I reckon the Italian banking system faces around €200 billion in total potential losses, Spanish banks face €170 billion, Portugal around €28 billion, Greece €26 billion and Ireland €24 billion. As a result, banks in Italy, Spain, Portugal and Ireland will need to recapitalize in total to the tune of around €100 billion – twice the forecasts being made for the results of the ECB’s AQR stress tests. Two-thirds of this recap would have to be for Italian banks.
Italian banks hold over 30% of all Italian sovereign debt and their holdings constitute over 10% of all bank assets. Italian bank holdings of government debt are more than 2.5 times larger than tier 1 capital. If Italian government bond prices were to fall by, say 20%, Italy’s banks would face around €80 billion in potential losses, if their holdings were marked to market. The 10-year benchmark yield would rise from 4.2% now towards 6%, a level last seen at the beginning of 2012.
Square the circle
And the eurozone’s sovereign debt profile is not improving. Budget deficit targets for 2013 were relaxed for the peripherals by the EU bodies. But even so, many peripheral governments have failed to meet them. Greece has fallen short and will have a fiscal gap to make up in 2014 and 2015. Portugal sought to square the circle by siphoning off pension fund reserves. And Greece, Spain, Portugal and Italy met their spending targets by various one-off measures.
Despite the bottoming of eurozone economies in mid-2013, prospects for nominal GDP growth in 2014 and 2015 remain well below trend and, most important, below a level necessary to pay for rising interest costs on public debt. In 2014, gross public debt ratios in all the peripherals will continue to rise to levels more than double the EU long-term fiscal target of 60% of GDP.
Italy’s gross public debt ratio is now over 130% of GDP, more than twice the EU’s Fiscal Compact target of 60% by 2030 and is still rising. And Italy’s banks are tied more closely to the sovereign than any others in Europe. A crisis focused on Italy and the nexus between the sovereign and weak banks would be tough to deal with. Italy thus remains the real flashpoint for a new round of the euro debt crisis in 2014.