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ECB president, Mario Draghi, has
repeatedly claimed that the central bank will do everything necessary to save
the euro. Nothing has been formally agreed yet, but the ECB is expected to
announce a new government bond-buying programme following next week’s meeting
of its Governing Council. To have a significant impact on Italian and Spanish
borrowing costs, the latest effort must be big enough to dispel the
convertibility risk that lies behind the extreme polarisation of government
bond yields across the eurozone: investors are loath to hold Spanish and
Italian debt because they fear that the two countries’ membership of the
currency union might be unsustainable. Unfortunately, the ECB is highly
unlikely to do enough to convince investors that membership is unequivocally
forever, not least because the Bundesbank opposes any open-ended commitment to
cap borrowing costs.
Spain, Italy and the periphery
of the eurozone face unprecedentedly high real borrowing costs, which are
preventing a recovery in investment and hence economic growth. Without a return
to growth, they will fail to dispel investor fears over the sustainability of
their public finances and the solvency of their banking sectors. The Italian
and Spanish governments argue that their high borrowing costs largely reflect
convertibility risks and that the ECB should do as much as necessary to address
these fears. The eurozone’s members that currently benefit from exceptionally
low borrowing costs – Germany, Austria, Finland, the Netherlands and to a
lesser extent France – maintain that very high Italian and Spanish borrowing
costs largely reflect these countries’ failure to reform their economies and
strengthen their public finances. There is merit in both these positions, but
much more to the Spanish and Italian argument than the opposing one.
Opponents of open-ended ECB
action argue that Italian and Spanish borrowing costs are not actually that
high. Interest rates have just returned to levels seen in the run-up to the
introduction of the euro, when investors distinguished properly between the
countries that now share the euro. High borrowing costs are needed to focus
minds and instil discipline. Were the ECB to take aggressive action to bring
down borrowing costs, it would create so-called moral hazard; countries would
be free to delay reforms in the knowledge that they will not be punished for it
by having to pay high borrowing costs. According to this argument, it is a
positive development that investors are now differentiating so strongly between
the risks of lending to various governments. After all, the failure to do so in
the run-up to the crisis contributed to the under-pricing of risk across the
eurozone and reduced pressure on governments to reform their economies.
In nominal terms Italian and
Spanish borrowing are indeed comparable to the levels of the late 1990s. But it
is real cost of capital (that is, adjusted for inflation), that is crucial, and
not the nominal cost. Both countries face much higher real borrowing costs than
they did in the run-up to their adoption of the euro. Moreover, it is erroneous
to compare the present with the late 1990s. Italy and Spain are at very
different points of the economic cycle now than they were then. In the late
1990s both economies were growing, in the Spanish case rapidly, whereas now
they face slump and mounting risk of deflation. Countries facing depressions and
rapidly weakening inflation typically face very low borrowing costs: investors
invest in government bonds for a want of profitable alternatives. This is what
we see in the UK and US; borrowing costs remain at all-times low despite the
extreme weakness of both countries’ public finances and poor growth prospects.
Investors certainly need to differentiate between eurozone governments, in
order to ensure that risk is correctly priced. The Italian and Spanish
authorities acknowledge this. But the current spread between the yield on
German government debt and that of the Italian and Spanish governments wildly
exceeds what is required to make sure investors differentiate appropriately.
The polarisation of borrowing
costs has politically explosive distributional effects: Germany is borrowing
and refinancing its existing debt at artificially low interest rates. According
to the German Institute for the World Economy, investor flight from the
government debt markets of the eurozone’s struggling members to Germany has
already saved the German government almost €70bn. Other countries face
ruinously high borrowing costs, which are simultaneously increasing the scale
of their reform challenges and narrowing their political scope to make the
necessary reforms. The longer Italian and Spanish borrowing costs remain at
such elevated levels, the greater the economic damage to those economies will
be and the harder it will become for the two countries’ governments to shore up
the necessary political support for further reforms.
Why have government borrowing
costs across the eurozone diverged so much? The principal reason for the size
of the spread between the periphery and Germany is convertibility risk.
Investors believe that there is a chance that Italy and Spain will ultimately
be forced out of the currency union and are thus demanding a hefty premium to
insure against this eventuality. This feeds the convertibility risk by
weakening countries’ fiscal positions and raising private sector borrowing
costs (government bond yields set the cost of capital for the private sector).
With private and public consumption in both Italy and Spain set to remain
depressed for years to come, economic recovery requires stronger investment and
exports. But borrowing costs are crippling and credit scarce. In a vicious
cycle, the steep fall in the value of Italian and Spanish banks’ holding of
government debt, combined with mounting bad debts as a result of recessions
made worse by punitive borrowing costs, are forcing the banks to further rein in
business lending.
The ECB’s latest programme of
bond purchases will be big enough to ensure that Mario Draghi does not lose
face. But it will not be big enough to dispel convertibility risk and hence
demonstrate its credibility as a lender of last resort. And it is this
credibility problem, rather than the relative ‘credibility’ or otherwise of
member-states policies, that is the principal reason for the unsustainably high
borrowing costs faced by Italy and Spain.
by Simon Tilford
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