Do not expect any indulgence from markets!
Authorities have only a short time to reach credible agreements.
In a recent address to the Institute for Global Financial integrity in Luxemburg, David Wright, former Deputy Director General at the European Commission, insisted on the fact that 2011 is a crucial year for progressing with the reforms necessitated by the financial crisis, both at European and global level,.
This diagnosis is all the more relevant that, despite the significant legislative and regulatory work already accomplished on both sides of the Atlantic, the revival of financial markets (in particular stock markets) and the timid economic recovery are leading the responsible actors to forget the urgency of continuing their efforts. They seem, indeed, more and more sensitive to the lobbies advocating a return to business as usual.
However, time is fast approaching when the contradictions, inherent to many of the policies currently being implemented, will lead inexorably to Cornelian choices.
Let us start from a factual observation: since a few weeks, medium and long term interest rates are rising, leading to a significant increase in the yields of benchmark issues (US Treasury securities, Bunds, Gilts). This increase is passed on to all “correlated” issues which are affected on two levels:
- Mechanically, in order to maintain the spread with the relevant benchmark.
- More significantly, by the fact that the spread tends to widen when the yield of the benchmark rises.
This latter phenomenon is partially due to the fact that once a given absolute level of interest rate is reached (which is already the case for some borrowers and on the verge of being so for others), the additional cost of financing cancels all or part of the efforts made elsewhere to restore budget equilibrium. For weaker issuers, continued access to the market becomes an issue, leading in due course to questioning their solvency. This process has additional side effects such as the downward revision of the issuer’s ratings which has immediate repercussions on their financing costs reinforcing an already vicious circle.
At present, the increase in rates is a reflexion of higher inflationary expectations; they are based to a large extent on the real increase in commodity prices induced by the economic recovery, in particular in emerging economies. It is, nevertheless surprising that the three Central Bankers, Messrs. Bernanke, Trichet and King, in a touching display of unanimity, justify keeping their base rates at historical low levels on the basis that the observed inflation is “external” – and therefore beyond their control – while all “internal” inflationary pressures remain benign. This distinction and reasoning appear somewhat specious and is reminiscent of the proverbial impossibility of being only partially pregnant.
The net outcome, however, is an underlying inflationary trend, already strongly felt by consumers (energy – food) and confirmed by the latest European statistics. This creates a dilemma for monetary authorities:
- Either they believe that the world economic recovery is only temporary and that inflation (commodity prices) will abate without any need of a change in monetary policy. This hypothesis, hardly conducive to further growth and lower unemployment, should lead to additional austerity measures if the priority ascribed to restoring public finances is maintained in order to reassure financial markets.
- Either they come to the conclusion that the longed for recovery is sustainable; then a rapid increase in base rates will be in order if the mandate to maintain “price stability” is to be successfully met.
In this second hypothesis, the measures that President Trichet has, in the name of the Governing Council of the ECB, vowed to implement in due course, need to be taken at a sufficiently early stage in order for their “preventive” character to be effective. In addition to rate increases, complementary measures withdrawing excess liquidity from the market will be necessary, making credit more expensive and less available to both the public and private sectors. If one delays too much, the increased borrowing costs for industry and for governments will, in turn, become inflationary factors reinforcing “second round effects” on prices as is the case for salaries.
Second round effects will not be limited to accelerating inflation but will also spread to the solvency of the banking sector. We have drawn the attention on numerous occasions, on the increasing incestuous interdependence between the solvency of the public and financial sectors; it follows that any further deterioration in the value of Sovereign debt portfolios held by banks will put their own solvency in jeopardy and require additional recapitalisation efforts in order to conform to the standards of Basel III. It will be necessary, in designing the scenarios for the next series of “stress tests”, to include in the evaluation of the impact of interest rate increases not only the “market risk” normally associated with debt securities but also the “solvency risk” associated with the issuers of said securities. This latter aspect was totally overlooked in the 2010 tests.
David Wright insists in his address on the idea that the new European Systemic Risk Council should not hesitate to “rock the boat” if it is to be credible. One of its priority tasks should be to evaluate the systemic risk associated with the default/restructuring of an EMU sovereign debt issuer. Indeed this risk has already been recognised – at least implicitly – as it was a decisive argument in justifying German participation in the Greek and Irish rescue packages. The perception of the risk to which its own financial institutions were exposed weighed heavily in the balance, risk that would be significantly increased if a larger EMU Member, Spain for instance, were to face refinancing difficulties.
One should also bear in mind that the only scenario in which an already heavily indebted State can face a significant increase in debt servicing costs while maintaining unfettered access to the market, is one in which the tolerated rate of inflation is sufficient to ensure that de depreciation of the value of the total debt sufficient to compensate for increased servicing costs. This will clearly not be the case in the event that price stability, as defined, remains the sole mandate of the ECB and budgetary equilibrium for all EMU Members the unshakeable credo of Germany. If social unrest is to be avoided, (possibly abetted by unwarranted parallels with the demands voiced recently by Arab populations), a fair distribution of the burdens will need to emerge in which the solidarity of the wealthier towards those most in need will be perceived by the former as being in their own self interest.
It therefore of paramount importance to reach quickly agreement on reinforcing the institutional structure of EMU, emblematic expression of the solidarity and the political will to protect all that has already been achieved and in particular the Euro. This urgency has been fully recognised by entrusting to President Van Rompuy the negotiations that should, no later than mid-March, lead to proposals relating the European Financial Stability Mechanism (successor to the EFSF) and to reinforcing coordination within the Eurozone (Stability and Growth Pact, European Semester, Competitivity).
One should also avoid past errors such as the attempt to hide deliberately from the market last spring, when the EFSF was established, that its true borrowing capacity was limited to €250billion rather than the purported €440 billion (reducing simultaneously the commitment of the IMF pro rata). An additional pitfall is the stalling of the reform procedure due to the forthcoming French presidential elections. A declaration of a shared view on EMU reforms by President Sarkosy and Dominique Strauss Kahn is highly desirable to prevent their respective political parties to transform this eminently sensitive topic into a vulgar political football.
The new structures to be implemented must be transparent and robust, failing which markets will not display the necessary confidence. They will focus on the half empty rather than half full part of the glass. The scenarios that they will dream up will be all the more outrageous (speculative) that political posturing, relayed with such delectation by the media, will severely compromise any chance of reaching the necessary consensus.
In conclusion, if the recently observed increase in interest rates continues, independently of the negotiating cycle, it is to be feared that its negative impact on the EMU sovereign debt market will take root before adequate solutions are in place to deal with it. Then, once more, it will be necessary to repair the damage rather than preventing it which is always considerably more onerous.
Brussels, 12th February 2011
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259