ECB Loans Plant Seeds of European Disintegration

ECB Loans Plant Seeds of European Disintegration
The ECB began two rounds of extraordinary three-year loans at an interest rate of 1 percent in December in its longer-term refinancing operations. Photographer: Hannelore Foerster/Bloomberg

European Central Bank measures to stem the region’s debt crisis threaten instead to undermine the euro.

ECB loans worth more than $1.3 trillion have been recycled into government bonds, capping borrowing costs. As Italy’s reliance on its local institutions increases and Spanish banks accelerate purchases of domestic government securities, however, the economic ties that bind the fate of euro members to each other loosen, weakening the incentives for cross-border support to defend the currency union.

“As the local bond markets have become owned only by domestic institutions, there is less and less incentive for the other countries to support and bail out one of those,” said Stephane Monier, who helps manage more than $150 billion as head of fixed income and currencies at Lombard Odier Investment Managers. “Basically you’re planting the seeds for the disintegration of the euro zone.”

The ECB began two rounds of extraordinary three-year loans at an interest rate of 1 percent in December in its longer-term refinancing operations. Italian banks boosted their government debt holdings to 323.9 billion euros ($428.1 billion), from 301.6 billion euros in February and 247.4 billion euros in November, according to the ECB. Spanish banks own 263.3 billion euros of government securities, up from 245.6 billion euros in February and 177.9 billion euros in November.

Off Target

Since the LTROs, both nations have said they will miss deficit-reduction targets agreed with the European Commission, driving Spain’s two-year yield to 3.36 percent, more than one percentage point above this year’s low. Italian yields have jumped almost 1.5 points since their 2012 low, reaching 3.14 percent, while German yields fell to a record-low 0.075 percent on April 27.

Meanwhile, foreign investors are selling, separate data shows. Non-residents cut their holdings of interest-bearing Spanish government bonds by 20 billion euros, or 9.3 percent, in March, according to a document published on the website of Spain’s economy ministry on April 27.

“Everywhere when you have a crisis, you have a re-domestication of markets,” said Laurent Fransolet, head of fixed-income strategy at Barclays Capital in London. “In Spain and the other peripheral countries, it is clear there has been very large selling by foreign investors and someone needs to pick that up. The uncertainty is making investors more jittery.”

Deeper Recessions

Spain’s cost to borrow for 10 years rose 42 basis points last month, and reached 6.16 percent on April 16, the most since Dec. 1. Italy’s 10-year rate has risen to 5.39 percent from 5.12 percent at the start of April. The euro weakened to a more than 16-month low of $1.2624 in January. It fell 0.1 percent today to $1.3209 at 4:17 p.m. London time. Euro-region government bond markets are closed for a holiday.

Deepening recessions in the two nations contributed to the slide in the securities as shrinking tax revenue makes it harder to cut deficits. Spain’s economy contracted 0.3 percent in the first quarter, putting the euro region’s fourth-largest economy into its second recession since 2009, data showed yesterday. Italy’s consumer confidence plunged this month to the lowest since 1996 as Prime Minister Mario Monti’s austerity measures crimp growth.

Bonds from the two nations handed investors the biggest losses in the euro region last month, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. Spanish government bonds lost 1.8 percent in April, while Italian securities declined 1.3 percent, the indexes show.

Rating Cuts

Spain’s rating was cut on April 26 for the second time this year by Standard & Poor’s, which cited concern the country will have to provide further support to its banks as the economy contracts. S&P yesterday lowered its grades for 11 Spanish banks, including Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, citing “potentially negative implications” from the sovereign cut.

“The ECB’s liquidity measures are a double-edged sword,” said Gianluca Ziglio, an interest-rate strategist at UBS in London. “On one hand they boosted demand for the sovereign paper, but on the other they increased the exposure of the banks to the volatility and widening spreads.”

‘Marked Deterioration’

The sovereign-debt crisis has caused a “marked deterioration” in financial integration in the euro area, the ECB said in a report published on April 26. “During 2011, the intensification of the sovereign-bond crisis strongly affected the euro-area financial system” it said. The ECB’s next policy meeting is on May 3.

Luxembourg Prime Minister Jean-Claude Juncker yesterday said he’s stepping down as head of the group of euro-area finance ministers because he’s tired of Franco-German interference in managing the region’s debt crisis. “They act as if they are the only members of the group,” he said at a podium discussion in Hamburg.

“The magic of the LTROs has worn off quickly because non-residents have sold off their holdings,” said Richard McGuire, a senior fixed-income strategist at Rabobank International in London. “The LTROs seem to be accelerating de-euroization, the euro-region financial system seems to be compartmentalizing and investors are tending to stick to their home market. That makes them much more vulnerable.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE