Asset management

21 January 2013

Economist Insights Seven sides of the same coin
ECB President Draghi recently listed seven factors that show a significant improvement in Eurozone market conditions. However, it could be argued that every point he made is all the result of one thing – the creation of the OMT, which drastically changed the risk perception of Spain. The OMT was a major achievement in crisis management, but to claim that the improvement in market conditions has addressed the problems within the Eurozone is optimistic, to say the least. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

At their last meeting the ECB Governing Council unanimously decided to leave interest rates unchanged, even though a rate cut was widely discussed in the December meeting. In justifying this decision, ECB President Draghi said that he is convinced that you can see a “significant improvement in the financial market conditions and a broad stabilisation of cyclical factors.” Or at least, he is keen to convince the markets that they can see such an improvement. He went so far as to enumerate a list of seven factors that show how much better things are: 1. “Bond yields and countries’ credit default swaps (CDSs) are much lower, significantly lower.” In other words, look how much Spanish bond yields have rallied since the OMT was announced (see chart 1).
Chart 1: It’s all about the OMT Yield on 10-year and 3-year Spanish government bonds 8 7 6 5 4 3 OMT announcement 2 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Spain 10y Sovereign rate Spain 3y Sovereign rate Jan-13

default. And we will just ignore the risk-on benefits from the US avoiding falling off the fiscal cliff (so far). 3. “Redemptions, as I have just said, are much lower than they were in September, down to one-fifth of the volume recorded in September.” In other words, companies are not deleveraging as rapidly as they were before because they are no longer as worried that Spain will collapse and bring the rest of the Eurozone with it. 4. “We are seeing strong capital inflows to the euro area.” In other words, foreign bond investors are now willing to hold short-dated Spanish and other periphery bonds because the ECB has effectively given everyone a free put option – assuming the OMT is activated, the ECB will buy those bonds if the price falls below an unspecified level. However, “strong” would really be too strong a word to describe the somewhat better but still historically low capital inflow data. Nonetheless, foreign investors stopped dumping Spanish bonds after the OMT was announced and increased their holdings substantially (see chart 2). 5. “The deposits in periphery banks have gone up.” In other words, Spanish depositors are no longer running scared after the bank recapitalisation plan and the knowledge that the ECB is standing behind the sovereign that is standing behind the banks. 6. “Target-2 balances have gone down.” In other words, capital is no longer fleeing Spain and the other periphery countries as quickly. Put another way, all those deposits are staying in the Spanish and other periphery banks rather than fleeing to the core. 7. “The size of the ECB’s balance sheet, which is often considered as a source of risk, is continuing to shrink!” In other words, banks in Spain and the periphery do not need to rely on the ECB so much for their funding needs.

Source: Bloomberg

2. “Stock market prices have increased and volatility is at a historical low.” In other words, look at how well the Spanish equity market has done and how much stronger other stock markets are now that they are not worrying about a Spanish

Every point that President Draghi made about improving financial conditions is all the result of one thing – the creation of the OMT, which drastically changed the risk perception of Spain. Make no mistake: this is a major achievement in crisis management and one of which the ECB should be justly proud (although the longer-term moral hazard consequences may be less welcome). But to claim that the improvement has addressed the problems within the Eurozone is optimistic, to say the least. President Draghi spoke hopefully of the idea of ‘positive contagion’. He argues that if financial risks can spread to cause problems elsewhere, reduction of those risks can also bring benefits elsewhere. He is quite right that the OMT has brought about ‘positive contagion’, but this may be primarily a removal of the tail risk. It does not change the underlying problems of Spain which are not solved by monetary policy (short of monetisation), because the key problems are slow economic weakness, very large external debt, structural issues in need of reform and huge fiscal deficits. Those fundamental problems are the same as they were before the OMT was introduced. In the language of fiscal economics, the OMT has removed Spain’s immediate liquidity problem but it has not removed its underlying solvency problem. In any case, the ECB has only offered to solve the insolvency problem using the OMT – it has not actually activated the programme. Activation would require Spain to request, and be granted, a fiscal programme under the European Stabilisation Mechanism. The Spanish government has so far resisted giving up its fiscal sovereignty in this way, perhaps hoping that the threat of the OMT will be sufficient. So far the threat alone has been enough, but that is unlikely to last. There are really only three scenarios from here for Spain. In the first scenario, Spain does not need to turn to the ESM and OMT because we suddenly find that Spanish economic growth has turned positive, unemployment is falling, mortgages are being repaid and budgets are being improved. Yields would remain low simply because Spain was doing better regardless of the existence of the OMT. While this would be a wonderful outcome, it is hardly going to be the central case for any investors. In the second scenario Spain joins the OMT of its own accord rather than waiting to be forced to by the market. In this case yields would not spike up beforehand because the market would be caught out. However, this scenario requires the Spanish government to change its trade-off between bond yield security and fiscal independence. If it is worth joining the OMT voluntarily now or in the future, then it was also worth joining last year. So far Spain has avoided taking the plunge, so why would the government decide all of a sudden to change position without being forced to?

Which leaves us with the third scenario: Spain is forced to join the OMT after the market loses faith and pushes yields up. Such a scenario could easily happen if there is disappointing data on growth or public finances. Or the data could come in in-line with expectations but markets could simply start to doubt whether Spain will ever join the OMT and hence to worry about the risks to their short-term bond positions. Unfortunately, this third scenario currently looks far more likely than the other two. There are some signs that suggest that the Spanish government might be preparing itself for just such an eventuality. The ECB is aware that the OMT creates moral hazard by encouraging governments that join the OMT to start issuing only short-dated maturities because they know that the ECB will buy those bonds even if nobody else does. To avoid this situation the ECB has said that it will only buy bonds that were issued prior to the country joining the OMT. In the four months since the option to join the OMT was announced Spain issued almost EUR 22 billion of short-dated debt (see chart 2). This compares to a net reduction of almost EUR 16 billion of similar maturity debt in the four months prior.
Chart 2: Short stuff Foreign purchases and issuance patterns for Spanish government debt before and after the announcement of the OMT 30 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30

(EUR billions)

Foreign buyings of government debt Post OMT

Pre OMT

Change in outstanding Change in outstanding debt with maturity debt with maturity up to 3y above 3y

Source: Spanish Ministry of Finance Note: Pre OMT is the period between 31 March and 31 July 2012. Post OMT is the period between 1 August and 30 November 2012 (except foreign purchases which are up to 31 October 2012).

A cynic might interpret this move as trying to cram in as much short-dated paper as possible prior to joining the OMT. Unfortunately, such a strategy also has the effect of increasing the rollover risk that is associated with Spanish debt. If the ECB is ultimately unsuccessful or unwilling to keep Spanish yields low indefinitely, Spain will have to re-issue this shortterm maturing debt at higher interest rates. This would lead to another crisis and require more support from the rest of Europe. But of course, one could easily argue that more support is ultimately what is needed in any case, and that the actions of the ECB are at best a temporary bandage.

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