Need for distressed debt markets in Europe
Financial fragmentation driven by withdrawal of private credit
Official lending takes up the strain
by David Marsh
Tue 18 Jun 2013
Financial fragmentation in the euro area has been officially declared as Public Enemy Number 1 by European politicians.
A large part of the challenging borrowing conditions across the euro area reflects simply the prosaic reality that banks are much more hesitant about lending to creditors in distressed economic environments than they are when conditions are sound.
In the euro bloc, politicians and central bankers would do far more to promote recovery if, instead of examining artificial and probably unworkable methods to rekindle lending, they were to encourage genuine resolution of distressed bank credits in problem economies.
This would enable wholesale winding-up of businesses or asset portfolios that are never likely to make a return. Unfortunately, promoting euro area-wide resolution of failed enterprises is not a subject that engenders political popularity and therefore is unlikely to appear on any summit agenda any time soon.
In the highly restrictive environment for bank credit, we are unlikely to see a return of cross-border financial integration sparked by the early apparent success of monetary union. Up to the trans-Atlantic financial crisis in 2007-08, banks and other lenders built up enormous stocks of financial assets in other euro area countries on terms that turned out recklessly to underestimate the true level of risks.
This tendency was encouraged by the European Central Bank on the grounds that the so-called ‘financial channel’ for ironing out differences in economic output and financial strength across the euro bloc provided a source of build-in stability. This theme was repeatedly hammered out by Jean-Claude Trichet, the ECB’s president between 2003 and 2011. Unfortunately financial integration turned out to be the prelude to considerable instability, the opposite of what was hoped for.
According to the ‘financial channel’ theory expounded by Trichet, which relied on academic research carried out above all in the US, the relatively small amount of fiscal redistribution throughout the euro area via the European Union budget (which makes up a mere 1% of EU GDP) would not hinder the financing of economic adjustment, as long as private sector financial institutions took up the strain.
This was the mechanism behind the build-up of cross-border claims and liabilities in the first decade of monetary union that led to the progressively increasing domino-like vulnerability of European banks as the sovereign debt crisis gained in intensity in 2009–10.
ECB statistics show how much has changed. In a speech in Athens last month, Vítor Constâncio, ECB Vice-President, gave probably the best ECB analysis to date of the precise way that the crisis unfolded in Europe. Increases in private debt, not public debt, lay behind the worsening imbalances in the peripheral states, he said – countering the reasons for the unleashing of the crisis often given by Trichet. In the first seven years of monetary union, private debt increases were especially pronounced in Greece (217%), Ireland (101%), Spain (75.2%), and Portugal (49%).
The steep rise in public debt, on the other hand, began only after the financial crisis. ‘A particular aspect of the process of financial integration in Europe after the introduction of the euro was a major increase in cross-border bank activity. Exposures of banks from non-stressed countries to stressed countries more than quintupled between the introduction of the euro and the beginning of the financial crisis.’
Constâncio said European rules on free movement of capital, the objective to create a level-playing field for different banking sectors, and the belief in the efficiency of supposed self-equilibrating financial markets made containment very difficult. ‘No one ever predicted that a sudden stop, characteristic of emerging economies, could occur in the euro area. As a result, the inflow of relatively cheap financing turned into a huge credit boom in the countries now under stress.’
The result was that private sector creditors withdrew their loans. ECB figures show that total exposure of banks from ‘non-stressed’ to ‘stressed’ countries is now back to around 25% of GDP in stressed countries and 12% of GDP of non-stressed countries, back to levels pertaining at the start of monetary union in 1999. This was after both ratios peaked at roughly double current levels in 2007.
Separate figures drawn from ECB data show that, in euro area banks’ overall portfolios of debt securities, cross-border holdings of euro area government securities and covered bonds are now down to about 22% of the total, slightly higher than the 20-21% level when monetary union started in 1999, against a peak of 40% in 2007.
Overall, though, governments are still heavily indebted. The burden of financing has been shifted to the official sector. Which explains why, in the case of Greece, the prospect of Official Sector Investment (OSI) in any further debt restructuring fills the authorities with dread, especially in Germany ahead of the September parliamentary elections.
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