Were it not for the ECB calling an emergency meeting last Thursday, most market participants would not have realized there was an emergency in the bond market.
Apparently, the sharp rise in yields on Italian bonds after the ECB stopped buying amounts to an emergency. The “emergency” label draws attention to the precarious state of public finances in parts of Europe. We would argue that debt levels are what is a real emergency, not the level of credit spreads or interest rates.
Instead of giving highly indebted welfare states breathing room to reduce their debt burdens, it led to the exact opposite: countries increased their debt levels. It depends on your view as to whether the ECB had acted in the last few years as a buyer of last resort or as a greater fool who vastly overpaid for bonds that should have had much higher yields.
The episode reminds us of the 1992 currency crisis of the European Monetary System (EMS).
Replay of 1992
The 1992 crisis of the EMS is today best remembered for when George Soros broke the Bank of England and forced the British Pound’s exit from the system. Of course, that is the popular depiction of events. The reality to us is that the pound would have had to exit the EMS irrespective of whether or not it had been shorted by the Quantum Fund.
Less well remembered is the 7% devaluation of Italy’s Lira over the weekend before September 14, 1992 [i], which preceded the exit of the British pound from the EMS on September 16, 1992[ii]. Over the two years following that devaluation, the Lira weakened further by a total of nearly 30% [iii]. Italy had achieved a balanced primary budget at the time, meaning that if you ignored the cost of interest on debt, the government had no deficit. However, once you took debt costs into account, the actual budget deficit was 10% of GDP [iv]. With interest rates on the rise and debt representing 105% of GDP[v], Italy was headed down an unsustainable fiscal path. Italy’s central bank increased the discount rate from 11.5% in November 1991 to as much as 15.0% in September 1992, an increase of 3.5 percentage points [vi]. Yields on 10-year Italian government bonds rose from 12.5% in May 1992 to 14.4% by October [vii].
If we compare this to the current situation, then Italy is not actually in as precarious a situation as it was in 1992. The 2021 government deficit represented 7.2% of GDP [iv] including debt cost compared to 10% in 1992.
But the lower deficit is achieved in an environment with much lower debt service costs. As a result, Italy’s primary budget deficit could be in a really bad spot. Reuters reports that it expects a level of 5.6% for 2022 [viii]. Moreover, as of 2021, debt stands at 151% of GDP compared to 105% in 1992.
Italy entered the 1992 devaluation with a manageable level of debt (which would be comparable to the U.S. today) but high interest rates, which could arguably only go down. In 2022, however, Italy enters an interest rate hiking cycle with debt at a crippling level, and low interest rates that can arguably only go up. It is a recipe for disaster.
Where the parallel to 1992 of last week’s ECB meeting becomes relevant is when we consider the trigger of the 1992 currency crisis. On September 5, 1992, finance ministers and central bankers met in Bath but failed to agree on a plan to realign currencies in combination with a rate cut by the Bundesbank. This meeting drew attention to the disequilibrium that high interest rates were causing across the currency system. Everybody knew the problems that the EMS was facing, but the failure of the meeting became the catalyst for a panic.
We believe that the ECB emergency meeting has had a similar effect, albeit the immediate impact is likely to remain much less dramatic than the events that unfolded in 1992. Nevertheless, by lifting the Italian debt sustainability question to the level of an ECB emergency meeting, the ECB turned a latent problem into a near-term danger.
Over-reliance on banks
What makes sovereign debt problems in Europe more dangerous for the economy than elsewhere is the high prevalence of bank loans in the financing of businesses. While in the U.S., 80% of corporate financing happens in the bond market; in Europe, 80% of such financing is done via bank loans [ix]. That means that if banks are in trouble, companies no longer have access to financing and what starts as a credit crunch becomes a full-blown credit crisis. And because banks are required by various regulations to invest in government bonds, a haircut on sovereign debt will result in a banking crisis. In the U.S., the bond market may be able absorb a shock to the banking system, at least given the right circumstances. With the corporate bond market being underdeveloped in Europe, that isn’t in the realm of possibilities.
Of course, that’s what happened during the Greek sovereign debt crisis and is the reason why Europe had no choice but to bail out its banks. In the meantime, nothing has been done to reduce the reliance on the banking sector. Officials remain as suspicious of financial markets as ever.
The endgame: yield curve control
We see no easy solution for Europe’s predicament of high government debt levels and expensive welfare states that lead to budget deficits, which further increase debt levels. The ECB may have only one way out: yield curve control in the hope that inflation will reduce the real burden of government debts. Unfortunately, that is exactly what Northern Europeans wanted to prevent when the Euro was created, and insisted on the stability pact, which has become obsolete. We will not make predictions on the political implications within the European Union, but it’s clear that it won’t be pretty.
[I] Christina Sevilla: “Explaining the September 1992 ERM Crisis: The Maastricht Bargain and Domestic Politics in Germany, France, and Britain.” Presented at the European Community Studies Association, Fourth Biennial International Conference, May 11-14, 1995.
[iii] Andrea Capussela: “Italy’s crisis viewed from the year 1992.” Il Mulino, June 6, 2018.
[iv] Italy Government budget deficit. retrieved from countryeconomy.com.
[v] Italy Government Debt to GDP. National Institute of Statistics (ISTAT) retrieved from tradingeconomics.com.
[vi] International Monetary Fund, Interest Rates, Discount Rate for Italy [INTDSRITM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRITM193N, June 20, 2022.
[vii] Organization for Economic Co-operation and Development, Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for Italy [IRLTLT01ITM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01ITM156N, June 19, 2022.
[viii] Giuseppe Fonte, Gavin Jones: “EXCLUSIVE Italy to stick to 5.6% deficit target despite slashing growth outlook.” Reuters, March 29, 2022.
[ix] Torsten Sløk: “US and European Companies Financed Differently.” Deutsche Bank Research, retrieved from ritholtz.com/2020/10/financed-us-europe/