While many observers have seen this coming for a long time, the moment where the eurozone is at a crossroads has been brought forward by the impact of the coronavirus pandemic.
The Northern countries will either have to accept some form of debt mutualization and all that it implies, or they have to let the ECB backstop (basically bail-out as this is more than just a liquidity crisis) countries which will have horrendous public finances (and there are likely quite a few of these) after this is over.
Our bet is on the latter, because the alternative (a eurozone breakup) is the last thing the world economy can deal with right now, and the ECB buying basically limitless quantities of Italian bonds seems the way of least resistance.
But resistance there is, make no mistake about that. The Germans are absolutely seething. This is not what they have signed up to.
Coronavirus whacking public finances
The eurozone is not only one of the hotspots in the coronavirus pandemic, it’s also what keeps many financial commentators awake at night as the economic fallout can be especially large here due to how the common currency, the euro, works.
The pandemic has hit countries like Italy and Spain the hardest, at least so far. They have had to resort to strict lockdowns of their economy and unleash massive public spending in order to maintain companies and people on their feet.
The self-induced economic coma that is a lockdown is also tanking the economy and tax receipts faster than anything that has gone on before. So the upshot is, the longer this lasts, the bigger the impact on the public finances of countries.
With the public finances of Italy, Portugal and Greece, and to a lesser extent Spain and France already in a very bad shape, countries are likely to come out of the other end of this with public debt/GDP ratios in the order of 150-200%.
Greece of course is already there, Italy will follow rapidly with the others a little more slow. Other countries might very well come out of this with similar sky-high debt/GDP ratios, for instance the US.
However, the thing to keep in mind here is that in essence, the debt of eurozone countries is denominated in a foreign currency over which the individual countries have minimal control.
Germany’s, which until recently was basking in a budget surplus, falling public debt:
A ridiculously large trade surplus (8%+ of GDP) and reasonable economic growth is in a position to unleash a big bazooka to preserve its prosperity. It has introduced a 750B euro stimulus package (20% of German GDP).
It can do that given its fiscal situation, but the southern eurozone countries are unable to do so. Italy has embarked on a 25B euro package and a 350B euro guarantee for banks to keep them afloat as non-performing loans, already a big problem, will surely skyrocket.
And that will bring memories from the sovereign-bank doom loop that threatened to derail Italy in the previous eurozone crisis:
- Government bailing out banks
- Which is worsening public finances
- Investors running from Italian sovereign debt
- Bank balance sheets worsening further as they are the biggest holders of Italian sovereign debt.
And this in the context of a big economic shock (which, according to Goldman Sachs (NYSE:GS), will lead Italian GDP declining by 11.6% this year) worsening bank bad debt problems as well as ravaging public finances.
Apart from huge refinancing needs for existing debt, it will have to issue a ton of new debt, at a time when most countries in the world are doing the same.
Who will buy all that debt?
The market might very well balk at buying all that debt, which will set off a vicious circle, actually various ones, as we described here. The result of that won’t be pretty, so this has to be prevented.
There are basically two ways to deal with this:
- Debt mutualization
- ECB buying
Some form of debt mutualization (Coronabonds!) have been suggested by many as a way out of the financing constraints and reducing overall borrowing cost (more especially for the countries in most dire circumstances).
Northern countries like the Netherlands and Germany (in German, behind paywall) have resisted calls for eurobonds as they fear reduced pressure to reform on southern countries and fear having to foot part of the bill.
Also, the Netherlands has been rather vocal in thwarting proposals, although as we write this, the Dutch PM Mark Rutte is now proposing a common fund for medical cost (but not for reviving economies).
The EU Commission is proposing a 100B euro SURE fund which countries can borrow from to finance work shortening schemes. It’s a good initiative, but much more is needed.
Nine eurozone members (Italy, Spain, France Portugal, Ireland, Greece, Slovenia, Luxembourg and Belgium) even threatening to device their own fund (issuing bonds which the ECB is then supposed to buy), which could be seen as a prelude to a eurozone break-up.
While in and of itself this might very well be a useful proposal, it doesn’t come anywhere near debt mutualization.
A problem with eurozone bond proposals is that credit ratings depend on which institution is backing these bonds. If it’s the EU, it should have increased capacity to tax and spend, as the capacity to tax and assets on a balance sheet is what backs up the value of the bonds.
The problem with that is that the EU budget is tiny, it amounts to just 1% of the EU economy (and not all EU member states are members of the eurozone).
An alternative would be for the rescue fund, the EMS, to issue bonds, something it has already done to finance the rescue packages of Spain, Ireland, Greece and Portugal.
The EMS actually has a balance sheet with assets, the capital provided by member states in relation to the size of their economies, and as a result, EMB bonds enjoy a triple A credit rating.
Eurozone member states could provide the EMS with new capital, which it could then leverage to issue bonds (in fact, it can issue some 400B euro even without new capital).
However, the mandate of the EMS might have to be changed because its actions are restricted to bailout programs on the basis of conditionality, which in the midst of a pandemic makes little sense.
Another problem is that it provides loans to countries in distress but these still worsen their public finances, even if it might provide them cheaper credit or even credit at all (as they might be without access to the markets at any reasonable price).
The ultimate backstop is of course the ECB, and in the absence of any debt mutualization it will have to do the job or see the eurozone’s centrifugal forces rip it apart at some stage.
While by law the ECB isn’t allowed to directly buy public debt in the primary market, it can buy public debt in the secondary market and after an initial hiccup by the incoming new ECB president Christine Lagarde, it has been doing just that.
Since the ECB has been freed of some limitations (like buying government bonds from countries according to the paid in capital at the ECB) it can even do so, disproportionately helping the most affected countries.
There are quite a number of countries which will not be happy with this, like Germany, the Netherlands and Austria, but the alternative is simply a break-up of the eurozone, which in the present climate would suck the world economy into a depression.
Apart from the raw numbers, which are certainly going to be staggering (we don’t think the 750B euro QE package the ECB grudgingly announced is going to be enough), it has suspended:
- Buying according to paid-in capital ratio.
- The 33% rule (the ECB cannot purchase more than one third to the value of each individual bond issue and it cannot hold more than one third of all bonds in circulation issued by any one member state).
- Greek debt now included.
The paid-in capital rule is now a ‘guidance’ but the ECB has the liberty to deviate under these special circumstances. This opens the door for the ECB to basically bail out Italy, Greece and perhaps other countries that already have precarious public finances and have to flood the market with bonds as a result of the corona crisis.
But the Lagarde “whatever it takes” is quite different than the 2012 Draghi version. Draghi had the backing of all ECB governors, Lagarde didn’t, and we’re only in the early innings of the problem.
Given the magnitude of what is happening, the ECB will either have to backstop Italy, Greece, Portugal as these states threaten to become insolvent with few if any buyers for their bonds.
Investors are already spoiled for choice when the markets are flooded with bonds from more solvent countries like Germany and the Netherlands, and Italian (and other European) banks might very well use any ECB buying to unload some of their existing holdings of Italian bonds.
One wonders how many Italian bonds the ECB can ultimately buy with the Germans already calling the present 750B euro emergency package a clear breach of Article 125, which prohibits the ECB from bailing out individual member states.
But what is the alternative? There isn’t one, apart from Italy leaving the eurozone and becoming master of its own monetary affairs again (and after a massive devaluation).
The eurozone will approach a make-or-break moment. From developments on the ground it will be clear that Italy and Greece’s (and perhaps a few other member states like Portugal’s) finance needs will be more than what the market can absorb.
Italy’s financing needs will be astronomical, especially when some of its banks have to be refinanced, which is an obvious possibility.
The solution is either to issue some form of eurobonds or allow the ECB to basically backstop insolvent countries, neither of which are options which countries like Germany have signed up for.
But it’s either that or a breakup of the eurozone, which might very well unleash such nationalist forces that the EU itself might not survive. There are two takeaways for investors:
- Given the tremendous tensions in the eurozone and the safe haven status of the dollar, EUR/USD is likely to fall further.
- Given the unattractiveness of any of the ways out (debt-mutualization, ECB de-facto bail-outs, or eurozone breakup), expect the people and institutions driving this to the brink, at which point markets become so scared that a solution will be forced on the politicians and institutions involved.
It’s likely that the ECB will be able to calm the markets for some time to come, but even that depends on the trajectory of the present corona predicament, which comes with few certainties.
But before the year is out, the question of how many Italian bonds the ECB is allowed to buy will impose itself on the Germans, and they will have to come up with an answer.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.