TWN Info Service on Finance and Development (June10/02)
21 June 2010
Third World Network

Investor confidence erodes over fiscal concerns in euro area
Published in SUNS #6946 dated 17 June 2010

Geneva, 16 Jun (Kanaga Raja) -- The surge in volatility in the global financial markets from mid-April to early June has been due to a rapid deterioration of confidence among investors on account of fiscal concerns over Greece and other euro area sovereigns, as well as the risk of weaker growth, the Bank for International Settlements (BIS) has said.

In its latest quarterly review, the Basel-based central bank for the world's central banks said that investor worries about unsustainable fiscal positions crystallized around the problems of Greece and other euro area sovereigns.

Faced with growing uncertainty, investors cut risk exposures and retreated to traditional safe haven assets. The announcement of a significant European rescue package bought a temporary reprieve from contagion in euro sovereign debt markets, but could not allay market concerns about the economic outlook, said BIS, adding that instead, the flight from risky assets continued, resulting in additional increases in risk and liquidity premia.

According to BIS, a number of developments led investors to question the robustness of global growth. In advanced economies, investors and market commentators focused on the risk that the surge of public debt could derail the economic recovery. At the same time, rising Libor-OIS spreads reflected growing concerns that the financial system is more fragile than previously thought.

(OIS is the acronym for Overnight Indexed Swaps, an interest rate swap historically considered less risky than the Libor and, in the US, the rates are calculated daily on the basis of the daily Fed funds rates.)

Economic policy tightening in China, Brazil and India, among others, fueled doubts that emerging economies could provide the necessary global growth momentum. Market confidence was further dented by rising geopolitical risk on the Korean peninsula and Spain's second downgrade, together with the difficulties of a number of Spanish savings banks, in late May.

The BIS review observes that over the six weeks to the end of that month, prices of risky assets fell and volatility rose. Stock markets fell in advanced and emerging markets alike, bringing global equity prices below end-2009 levels. Corporate credit spreads, which had remained broadly stable for several months, widened in late April.

Faced with significantly higher uncertainty, investors increased their demand for US Treasuries, German government bonds and gold. Implied volatilities of equity prices and credit spreads rose sharply, reaching new highs for the year.

The challenging fiscal situation and uncertainty about the growth outlook for the euro area also led to a significant weakening of the euro against other major currencies. By the end of the period, investors had become increasingly concerned about the global growth outlook and, as a result, again pushed back their expected timing for the normalization of monetary policies in the advanced economies.

According to BIS, concerns about the fiscal positions of Greece and other euro area sovereigns had been on investors' radar screen since November 2009. These worries were evident in the widening of sovereign bond spreads of those countries relative to comparable German bonds.

BIS recalls that growing fears about the risk of a credit event were first signaled in the inversion of Greece's credit default swap (CDS) spread curve in January. Two-year CDS spreads rose above spreads on 10-year CDS, consistent with the perception that the risk of a credit event was higher in the near term.

At the same time, the inversion also reflected the view that, if Greece managed to meet its obligations during the next few quarters, the situation was likely to stabilize to some extent, hence, resulting in lower average CDS spreads over the longer term.

Consistent with this, as worries about the creditworthiness of Greece intensified in late April, the negative steepness of the Greek curve accelerated. In addition, the price of Greek government bonds fell sharply, leaving banks and other investors with large mark-to-market losses.

According to BIS, the catalyst for this sudden loss of market confidence was Standard & Poor's 27 April downgrade of Greek government debt to BB+ after Greece posted a worse-than-expected budget deficit. Portugal's simultaneous downgrade and Spain's subsequent one added to the negative sentiment.

In the light of the Greek downgrade and escalating protests by the Greek public, the 45 billion euro EU-IMF support package announced on 11 April appeared insufficient. Market participants questioned politicians' resolve and their ability to disburse the funds. An enlarged 110 billion euro package announced on 2 May also met with skepticism. Despite the ECB's (European Central Bank) decision to suspend its minimum credit rating thresholds for Greek government bonds, prices fell to distress levels.

Euro area sovereign CDS spreads rose sharply following the 27 April downgrade. CDS spreads on five-year Greek debt rose to more than 900 basis points, similar to those of Argentina, Pakistan and Ukraine. Portugal's sovereign CDS spreads also rose sharply, albeit to much lower levels, as investors expressed their concerns about its fiscal position.

By contrast, the daily movements in sovereign CDS spreads for Ireland, Italy and Spain were more muted, consistent with differences in terms of fiscal challenges, says the review.

During the first week of May, says BIS, the contagion from the Greek crisis quickly spread across Europe, inducing a widening of euro area sovereign CDS and bond yield spreads relative to German bunds. European equity markets fell, euro-dollar basis swaps widened, and the euro depreciated against major currencies. Market reports indicated that Portuguese, Spanish and Irish bond repo markets were becoming less liquid.

With the rise of sovereign risk, market participants focused on the exposure of different banks to Greek, Portuguese or Spanish sovereign debt, notes BIS, adding that by the end of that week, the impact had spread beyond Europe, causing a sell-off in global equity and commodities markets.

Continued policy tightening in China added to investor concerns about the downside risks to global growth.

"In response to greater global uncertainty, investors cut risk exposures and moved into safe haven assets. Gold soared above $1,200 per ounce, while bond investors moved out of most euro sovereign bonds into the relative safety of German and US government bonds."

According to the review, contagion from euro area sovereign debt markets also spilled over into interbank money markets, reviving concerns about rising counter-party risk and US dollar funding shortages. Three-month Libor-OIS spreads in the United States and euro area rose sharply, with implied forward spreads forecasting even greater increases. These price movements suggested that banks were facing difficulties in raising US dollar funding.

Highlighting the EU-IMF rescue package, BIS notes that having lived through the turmoil of 2008, policy-makers anticipated the end-game and took action to prevent a global confidence crisis. Their response took the form of a 750 billion euro rescue package announced in the early hours of Monday, 10 May. The ECB supported this move by taking the decision to purchase euro area public and private debt securities in the secondary markets to help restore market liquidity.

By early June, the ECB had reportedly purchased 40 billion euro of euro area government bonds, sterilized through the auction of one-week fixed-term deposits. Moreover, the ECB expanded its longer-term refinancing operations.

The Federal Reserve also took steps to relieve some of the US dollar interbank funding pressures by agreeing to reintroduce US dollar swap lines with key central banks. The US dollar swap lines were identical in size to those announced previously - $30 billion for the Bank of Canada and unlimited for the other four central banks involved - and were authorized up to the end of January 2011.

According to BIS, asset price movements immediately following these announcements initially suggested that the contagion from the Greek crisis had been halted. Euro sovereign credit spreads narrowed sharply, the euro appreciated, and global equity markets rose. Conditions in European money markets improved with the spread between EONIA and Eurepo rates narrowing, particularly for Italian government bonds.

US dollar liquidity conditions eased, the euro-dollar basis swap spread narrowing by 10 basis points. Broader credit spreads also improved, with a sharp fall in European corporate CDS indices, says the review, pointing out also that the safe haven flows of the previous week reversed, lifting German bund and US Treasury bond yields while weakening gold and the Swiss franc.

However, the relief in markets turned out to be temporary, as investor confidence soon deteriorated on worries about the possible interactions between public debt and growth. Peripheral euro area sovereign bond spreads widened, despite bond purchases by national central banks. The euro also weakened, with volatility jumping sharply against other major currencies.

As confidence dropped, investors also scaled back their appetite for risky assets, including carry trade positions targeting currencies of commodity-exporting economies, such as the Australian dollar, the Norwegian krone and the Brazilian real. These had appreciated over the previous months on expectations that their economies would particularly benefit from a global economic recovery.

Despite the overall negative tone, government bond auctions by Italy, Portugal, Ireland and Spain met with strong demand in the second half of May. Also, notwithstanding apparent strains in US dollar funding markets, participation at European central bank auctions of US dollars was limited with the ECB auctioning only 1 billion euro in 84-day dollar loans to six counter-parties.

While investors sought to understand the rapidly changing situation in the euro area, a number of financial regulatory initiatives added to an already complex situation, says the review, pointing as examples, EU finance ministers agreeing on
18 May to impose tighter restrictions on hedge funds and private equity firms operating in Europe.

Later the same day, the German financial regulator BaFin surprised markets by unilaterally announcing immediate restrictions in Germany on "naked" short selling by non-market-makers, i. e., short selling without holding the security. Despite its limited reach, the ban briefly increased short selling pressure in other markets, with French, Spanish and German banks' shares falling.

Then, on 20 May, the US Senate passed its financial reform bill, containing a number of measures designed to limit risk-taking by large banks.

According to BIS, as doubts mounted about the prospects for global economic growth, market participants pushed out the expected timing of monetary tightening in the major advanced economies.

In the United States, federal funds futures and options suggested that the first rate hike was not expected to occur until late in the first quarter of 2011, with the probability of a hike in September and December 2010 declining. Forward rates in Europe signaled a similar postponing of the expected first rate hike by the ECB beyond 2011.

"Such revisions in policy expectations in part reflected communication by these central banks that rate hikes were not anticipated in the near term, as well as investors' concerns that volatile market conditions could derail the nascent economic recovery. A further reason for the change in market expectations about monetary policy was expected fiscal consolidation in a number of countries and its possible contractionary effects."

Against this background of heightened uncertainty, says BIS, market participants focused on the deteriorating financial market conditions while often ignoring positive macroeconomic news.

The United States, in particular, saw upbeat news related to the employment outlook and consumer spending. The April jobs report, for example, saw US non-farm payrolls increase by 100,000 more jobs than expected to 290,000, but the S&P500 Index fell by 1.5% on the day.

"Similar positive news in the United States and elsewhere was often discounted or ignored by markets."

According to the review, while European policy-makers introduced new support initiatives, a number of other monetary authorities continued to withdraw exceptional support measures. As planned, the US Federal Reserve completed its purchases of agency mortgage-backed bonds at the end of March. Although the Fed is no longer buying bonds, there are signs that its significant holdings of public sector bonds continue to help keep bond yields low.

While the decline in confidence further postponed the normalization of monetary policies in most advanced economies, other countries took steps to tighten policy from April onwards.

According to BIS, the Bank of Canada raised interest rates by 25 basis points on 1 June. Moreover, China raised its bank reserve requirements and took steps to cool its housing markets. The Central Bank of Brazil raised its target short-term interest rate by 75 basis points to 9.50% towards the end of April, citing upside risks to inflation. The Reserve Bank of India increased both its cash reserve ratio and its repo rate by a further 25 basis points on 20 April.

Market participants expected more policy tightening across a range of emerging market economies, although uncertainty about the pace of tightening increased.

On the one hand, many of these economies are facing rapid economic growth, currency appreciation and the risk of overheating in asset and property markets. On the other hand, the growth and inflation outlook has been complicated by the high volatility in commodity prices and the unpredictable effects on economic activity of the euro sovereign debt crisis, concluded BIS.

In another section of the review highlighting international banking and market activity, BIS finds that the integration of European bond markets after the advent of the euro has resulted in a much greater diversification of risk in the euro area.

As of 31 December 2009, banks headquartered in the euro zone accounted for almost two thirds (62%) of all internationally active banks' exposures to the residents of the euro area countries facing market pressures (Greece, Ireland, Portugal and Spain).

Together, they had $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal and $206 billion to Greece. French and German banks were particularly exposed to the residents of Greece, Ireland, Portugal and Spain.

At the end of 2009, they had $958 billion of combined exposures ($493 billion and $465 billion, respectively) to the residents of these countries. This amounted to 61% of all reported euro area banks' exposures to those economies.

According to BIS, French and German banks were most exposed to residents of Spain ($248 billion and $202 billion, respectively), although the sectoral compositions of their claims differed substantially.

French banks were particularly exposed to the Spanish non-bank private sector ($97 billion), while more than half of German banks' foreign claims on the country were on Spanish banks ($109 billion).

German banks also had large exposures to residents of Ireland ($177 billion), more than two thirds ($126 billion) of which were to the non-bank private sector.

Government debt accounted for a smaller part of euro area banks' exposures to the countries facing market pressures than claims on the private sector.

The joint foreign claims of banks headquartered in the euro zone on the public sectors of Greece, Ireland, Portugal and Spain ($254 billion) amounted to approximately 16% of their combined overall exposures to these countries. Once again, most of those claims belonged to French ($106 billion) and German ($68 billion) banks.

These two banking systems had sizeable exposures to the public sectors of Spain ($48 billion and $33 billion, respectively), Greece ($31 billion and $23 billion, respectively) and Portugal ($21 billion and $10 billion, respectively).

The largest non-euro area holders of claims on the above four public sectors were Japanese and UK banks ($23 billion and $22 billion, respectively). The greatest exposures of both these banking systems were to the Spanish public sector ($13 billion and $9 billion, respectively).

In terms of the banks' Tier 1 capital, the combined exposures of German, French and Belgian banks to the public sectors of Spain, Greece and Portugal amounted to 12.1%, 8.3% and 5.0%, respectively, of their joint Tier 1 capital, said BIS. +