Currency Convertibility Is Back as a Risk in European Bonds
Besides default, perhaps the biggest risk to holders of euro-denominated bonds is currency convertibility. It isn't talked about all that often, but it hangs over the market like a black cloud. The fear is that some geopolitical event causes a member of the euro zone to decide to exit the union and investors holding sovereign bonds denominated in euros are suddenly left with securities denominated in some other currency.
This risk was on full display during the Greece debt crisis. The nation's bonds plunged not only because of its fiscal troubles, but also because of speculation the country might leave the euro zone and resurrect the drachma. If you lent money in euros, you surely don't want to be paid back in devalued drachmas. Now, investors are confronted with currency-convertibility risk again as Catalonia’s separatists in Spain have say nothing will stop their drive toward an independent state. Whether you believe Catalonia will successfully secede or not, the developments demonstrate the democratic power of local politicians to hold such referendums.
Although the Catalans say they want to stay in the euro zone, that's little solace to holders of Spanish bonds: The region accounts for 20 percent of the country's gross domestic product. Since the referendum issue heated up early September, weakness in Spanish bonds has even caused European peripheral yield spreads to widen in sympathy. That suggests markets see a risk that if Catalonia succeeds, populist movements in other European countries might seek to hold similar referendums, threatening the euro. Populism and currency-convertibility risk are closely related. Recall the market anxiety during the recent French presidential election when candidate Marine Le Pen ran on a campaign of leaving the euro.
Despite sound economic fundamentals and corporate earnings, Spanish equities have traded down. The concern is that higher bond yields could cause financial conditions to tighten, driving down stocks further and hurting the economy. What results is a negative feedback loop between government bonds and the economy.
Spanish 10-year yield and the IBEX 35 stock index
Credit-default swaps tied to Spanish government bonds are also widening, putting pressure on swaps tied to Italian and Portuguese debt. During the 2010-2012 European debt crisis, sovereign credit-default swaps were a barometer of concern about potential default and exits from the monetary union. Although implied default probabilities derived from the swaps are much lower now than during the crisis, that could change once the European Central Bank begins tapering its quantitative easing program or if the Catalonian political crisis were to escalate.
Although small, illiquid and mostly dominated by foreign investors, the market for Catalonian bonds bears watching as another sign of sentiment. Catalonia relies entirely on funding from the Spanish central government, but the debt has plunged in value amid speculation there could be a currency conversion in case of an independence declaration, even if deemed illegal by the Spanish constitution.
The European Monetary Union project has political risk that is different from other countries. In Europe, the democratic system allows populist parties to be part of a government coalition and able to call for referendums. Their anti-European view can significantly influence decision-making and affect public perceptions negatively about the future course of Europe, even when economies are in good shape. This democratic legitimacy is the convertibility risk the ECB can't fully eradicate despite its arsenal of policy instruments such as QE and Outright Monetary Transactions. Catalonia is a strong reminder to investors that democratic choice carries an economic and financial risk in a monetary union.
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