Risk aversion will undermine euro

DEMAND for risky assets has been undermined this week by concerns about both the strength of the US recovery and that Chinese growth may not be as rapid as had previously been thought. The euro has also started to wobble again, destabilised by a resurgence in fears about Europe’s banking sector. These worries about the health of Europe’s banks cannot be separated from fears about sovereign insolvency.

Since the middle of June, the euro has strengthened against the US dollar, which might have given the impression that the debt crisis that has been weighing on the single currency all year has started to dissipate. However, many indicators of risk continued to flash warning signals throughout this period – it is quite possible that the overall level of anxiety in financial markets may once again be taking a turn for the worse.

The recovery in euro-dollar between 7 June and 21 June coincided with an improvement in the tone in equity markets. While both of these events helped to massage investor confidence, the Libor rate remained elevated compared with its levels at the start of the year and the cost of insuring bank debt has remained extremely high. These indicators show that suspicion and uncertainty about the level of bad debt in the banking sector, specifically in Europe, is refusing to go away.

To head off concerns about non-performing loans, the Bank of Spain recently agreed to publish the results of stress tests on its banks; a move which forced the European Central Bank (ECB) into promising that its own stress tests on 26 of the Eurozone’s banks would be published. Greater transparency had been demanded by the markets and is widely welcomed by investors. That said, there is an obvious caveat to the publication of stress tests since it does not guarantee that all the news will be good. The market is fearful that the stress tests will force some banks into writing down losses on non-performing loans. The coming months could be troubling for the European banking sector.

The president of the French central bank Christian Noyer recently warned that some banks (in Europe) had started to have funding problems. This was followed by reports suggesting that some banks in Greece, Ireland, Portugal and Spain were particularly reliant on the ECB for funding. Faced with the expiration of last June’s 12-month €442bn loan, nervousness has increased.

Spanish finance minister Elena Salgado questioned this week whether the ECB was conscious of Spain’s funding needs. The one-year loan was part of the ECB’s emergency response to the financial crisis and the central bank has indicated that it will not be replaced. But the ECB has countered that it is providing extra liquidity, though in shorter-dated loans.

National governments have been issuing reassurances about the position of their banking sectors. The Banque de France has declared that the expiry of the ECB’s 12-month loan will not be a problem for them. Despite reports that the Spanish property market may yet see prices fall by another 30 per cent and related concerns about non-performing mortgage debt, the Spanish government has recently reassured the markets about the health of its banks. The Irish regulator is expected to have completed stress tests on Ireland’s three nationalised banks by September; the Irish taxpayer having already paid a heavy price to avoid bank collapse.

Despite these reassurances, investors are likely to stay wary given that sovereign balance sheets can generally ill-afford to support the banks further. Since most of the concerns about banks centre on the Eurozone, it will be a brave investor that chooses to take on an aggressive long euro position in this environment.

The reaction of many analysts and journalists to the weekend’s G20 meeting was fairly scathing. And the lack of any notable reaction in asset prices suggests that the markets also took the meeting with a hefty pinch of salt.

The reason for this reaction stems from the fact that it was clear well ahead of the meeting that the G20 were not going to agree on either the issue of financial reform or on the debate over fiscal repair versus fiscal support.

Now that the global economy is no longer in the heights of the financial crisis it seems that it is not so easy to find common ground on which to agree. Instead, elected officials are understandably drawn more by national interests that by proposals that might satisfy the electorate elsewhere. It may be true that communiqués appear to be drawn up with a “something for everyone” mandate in mind and that targets mentioned may fail to be followed by any reference to procedure but the G20 is still an important political forum. The fact that the Chinese felt pressured to announce an abandonment of their currency peg ahead of the meeting is a measure of that. World economic policy can rarely be shaped to a “one size fits all”, but as a forum for communication, the G-20 summit should not be downplayed.