16 June 2013

Wolfgang Münchau: Bond market nerves threaten to end Europe’s calm

There is quite a bit of bad news still to come out of the eurozone itself, writes Münchau in his FT column. What he predicts with a high degree of probability is that once sovereign yields rise again, the eurozone will not be prepared.

Last week’s hearings in Germany’s constitutional court brought a reminder of how thin the substance is behind the Outright Monetary Transactions – the yet untapped programme for buying government bonds that stands behind Mr Draghi’s guarantee.

When the ECB talks in English, the programme is uncapped. But once it uses German, the emphasis is on the limits of the programme, rather than its potential. This is not so much a translation error but an extremely risky communication policy to send diverging messages to English-speaking investors and German-speaking eurosceptics. Jörg Asmussen, a member of the ECB’s executive board, told the court last week that the programme was unlimited only in the sense that there is no formal ceiling imposed in advance, but was capped in reality because of its design. Mr Draghi’s message to international investors was much less nuanced. I am still struggling to come up with a snappy German translation for “whatever it takes”.

The problem is not the German constitutional court as such. It has no jurisdiction here. It is that German legal interpretation has a habit of prevailing in eurozone crisis responses. The ECB is not going to monetise debt on a large scale. And this is something bond investors may ultimately realise as they re-evaluate their risks. It is best to think of the OMT as a stabilisation programme that can be triggered in a market panic. There may be no formal financial ceiling but this programme is not designed to address the solvency problems of various private and public entities in the eurozone.

What will also become clearer in due course is that the banking union may not fulfil its promises either. Its principal economic function would have been to separate banking and sovereign risks. The main debate now is whether the European Commission or someone else should run the resolution authority that would clear up the wreckage of failed institutions.

The real issue, however, is how to insure against potentially enormous systemic risks. An optimistic estimate of accumulated losses from asset price bubbles, market crises and a double-dip recession with no clear path of recovery would be 5 per cent of the eurozone’s aggregate financial sector balance sheet. That would put the total of hidden losses by banks at about €1 trillion, a large portion of which would have to be covered through new capital. You could double or treble that without appearing unreasonable. Add in a certain amount of sovereign debt unlikely to be repaid, and you have a decade of unprecedented zombification, unprecedented default, or both in succession.

Bond market sentiment is, of course, hard to forecast. But it only takes minuscule changes in perceived default probabilities to produce big shifts in market interest rates. This is why we have observed long stretches of self-fulfilling sovereign debt rallies and downturns. Rising rates give rise to a vicious circle because investors question the borrower’s debt sustainability and want to be compensated for the higher risk. Likewise, when rates fall, a virtuous circle sets in.

© Financial Times