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Since 2007, however, the process has gone sharply into reverse. Eurozone banks’ cross-border holdings of government and corporate debt as a share of their total debt holdings have fallen to levels not seen since just after the euro was introduced in 1999. Even as the eurozone crisis has eased over the past year, there has been little improvement, according to a Financial Times analysis of European Central Bank data. But while the “re-domestication” of eurozone debt markets may have increased short-term stability, it could spell longer-term dangers – as well as undermine progress made towards the integration of European debt markets.
Re-domestication is a global phenomenon. Banks’ risk appetites have fallen and regulators have encouraged holdings of safe assets issued in home countries. In the eurozone, the trend has been more pronounced, however, because of worries about countries being forced to exit the euro. German banks’ cross-border government bond holdings were being reduced even before the eurozone crisis erupted in early 2010, the ECB figures show. The decline in France came later in 2010 when the crisis spread beyond Greece.
The short-term benefits have been seen in recent weeks. Comments by Ben Bernanke, chairman of the US Federal Reserve, about a possible “tapering” of the Fed’s quantitative easing programme triggered a sell-off in bond markets globally. But unlike in previous periods of stress, the sell-off of eurozone “periphery” economies was modest – until the ECB meeting last week disappointed investors’ hopes of further monetary policy loosening.
A longer-term danger, however, is that re-domestication of bond markets ties together the fates of banks and their respective national governments. Vincent Chaigneau, global head of rates strategy at Société Générale, says: “It has been ‘win-win’ recently, because banks have made money on their long positions and in buying so many bonds have contributed to stability and the rally in periphery markets. The risk is that there is an accident – at the government or bank level. Then it becomes damaging for both governments and banks. That increases systemic risks.”
Re-domestication also poses broader political risks. “If you have less cross-border exposure, there is a case for countries becoming more insular in their outlook, less willing to accept the cross-border mutualisation that we think is necessary for long-term stability”, says Andrew Balls, London-based manager of Pimco.
As worries about a possible euro break-up recede, eurozone banks could become keener to increase cross-border holdings – especially given the higher yield offered by southern European debt markets. Divergences in yields show markets are pricing risks more effectively than before the crisis, the ECB believes. Although progress so far has been slow, steps towards a European banking union should further encourage market integration. But pre-crisis levels remain a distant prospect.
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