Old fault lines are threatening to rock the Eurozone
After years in which central-bank backstops encouraged Eurozone investors to look the other way, the bond market has finally started to notice, writes Helen Thomas
Fifteen years after the Eurozone sovereign debt crisis, its old fault lines are beginning to reappear. Political risk is rising across Europe just as global bond markets are selling off. That is a toxic combination for highly indebted, low-growth governments whose finances become progressively less sustainable as borrowing costs rise.
France is now the weakest link. The spread between French and German 10-year government bonds has widened to around 150 basis points, levels not seen since the sovereign debt crisis. Back then, higher bond yields threatened to trigger a self-reinforcing doom loop. Rising sovereign borrowing costs damaged the value of government bonds held by domestic banks; weaker banks increased the prospective burden on governments; investors demanded still higher yields.
Membership of the euro made the adjustment particularly brutal. A country could neither devalue its currency nor set its own interest rate. Instead it had to restore competitiveness through politically painful fiscal and economic adjustment. Ironically this now leaves the so-called peripheral PIGS (Portugal, Italy, Greece and Spain) in a stronger position looking forward. It is the core countries that are now posing existential questions for the European project.
France intends to issue a record €340bn of medium and long-term government bonds next year. Germany’s debt agency expects its own borrowing to exceed the record planned for 2026. Both countries have right-wing parties topping their polls and achieving greater electoral representation. Le Pen’s National Rally just gained enough representation in the Senate to be able to form a parliamentary group in the Upper House for the first time. The AfD came within three seats of an outright majority in the Saxony Anhalt regional election.
And now Spain faces an early general election which could usher in a right-wing coalition government that might include the far right Vox party. Socialist Prime Minister Pedro Sanchez has decided to go to the polls on 29th November rather than let the parliament run until next August, hoping he can capitalise on public outrage over housing scarcity that recently led to the eviction of an 87-year-old woman. Sanchez is the great political survivor and his country has at least experienced some growth in the last few years which has helped to reduce its deficit. But it increases the moment of peril by introducing more uncertainty to the Eurozone.
The previous crisis involved a weak periphery threatening to contaminate a strong core. What happens when the core itself becomes the source of instability?
France, after all, is not Greece. It is the Eurozone’s second-largest economy, a nuclear power and one of the founding political pillars of the European project. It may prove not merely too big to fail, but too big to bail.
Except the European Central Bank (ECB) has something up its sleeve. In July 2022 it created the Transmission Protection Instrument, or TPI. Its purpose is ostensibly technical: to ensure that monetary policy is transmitted evenly through the Eurozone. If bond markets move in an “unwarranted” and “disorderly” manner such that financing conditions deteriorate beyond what economic fundamentals justify, the ECB can buy the affected country’s government bonds. Purchases are not restricted in size in advance.
It is an ingenious construction. It is also exquisitely ambiguous. It is hard to judge when a repricing becomes disorderly rather than merely a reflection of shifting fundamentals. If investors demand a higher yield because a government has excessive debt, persistent deficits and unstable politics, is that an impairment of monetary transmission or simply the market doing its job?
The distinction matters because European Monetary Union contains an unresolved contradiction. There is one central bank setting the price of money but national governments still control their own taxation and spending. The treaties prohibit the ECB from simply financing those governments.
Hence the elaborate criteria attached to the TPI. The ECB must consider fiscal sustainability, macroeconomic imbalances and compliance with EU fiscal rules before intervening. Activation ultimately requires the Governing Council to make a judgement that intervention is proportionate to maintaining price stability.
France demonstrates how murky this could become. It is currently subject to the EU’s Excessive Deficit Procedure. Yet in June the European Commission judged that France had taken “effective action” towards correcting its excessive deficit, meaning the procedure remains open but is currently held in abeyance. Under the ECB’s carefully worded TPI criteria, that leaves at least some wiggle room over how eligibility might ultimately be judged.
So the firewall designed to reassure markets ultimately rests on judgement calls made by central bankers. And unlike Mario Draghi’s famous promise in 2012 to do “whatever it takes” to preserve the euro, the TPI has never been tested. When asked in July 2022 how it would operate, ECB President Lagarde waffled that “the decision to begin TPI purchases, as I said, will be in the entire discretion of the Governing Council. Now, clearly, to assess whether you have unwarranted, disorderly market dynamics, the Governing Council will take into account multiple indicators to determine the warranted versus unwarranted, and to determine the orderly versus disorderly, and multiple indicators have been discussed and will be taken into account by the Governing Council”.
The ECB’s dilemma is becoming more acute because it is currently fighting inflation with higher interest rates. Those same rates worsen the debt arithmetic of highly indebted governments. Buying their bonds to suppress yields while raising interest rates to suppress inflation would be an uncomfortable balancing act. The alternative pressure valve is the euro itself. But a weaker currency raises imported inflation, potentially requiring still tighter monetary policy.
Something, somewhere, therefore has to give.
Europe’s citizens are becoming more politically rebellious. Its governments are becoming more indebted. And after years in which central-bank backstops encouraged investors to look the other way, the bond market has finally started to notice.
The people are revolting. The question is whether the ECB can stop the bond market from joining them.