Wednesday, 13 June 2012

Graph(s) of the week: Italian and Spanish bond yields

As expected, the Spanish bank bailout effect was so short term that it didn’t provide any momentum at all. I expected it to end right after the Greek elections this weekend, but it went down even quicker than that – one week, that’s how long the markets were optimistic about the bailout. But is this all that surprising? Not really. It’s just another good proof of the (in)effectiveness of ECBs policies (*even though the bailout was officially made by the ESM, I explain in the comments why I consider them the same thing). When banks hoard cash and deposit it overnight at the ECB or use it to buy government bonds with record low yields to hedge against any possible risk, then it’s obvious that the hands of the monetary authority are tied. 

Spanish 10-year government bond yield
Source: Bloomberg, 13/06/2012
Italian 10-year government bond yield
Source: Bloomberg, 13/06/2012
Perhaps the investors are realizing this, which could be why the Italian bond yields surged today as well. So obviously, the contagion wasn't stopped. It is very likely that it was, in fact, encouraged as investors realized the ineffectiveness of the bailout to turn things around. They have witnessed moves like these too many times in the past year and not once did they prove good enough to stop further contagion. Markets demand stability. The ECB can only provide it for a couple of months (or days). But political incentives can either maintain it for quite some time, or destroy it in a matter of minutes. Europe has experienced both these scenarios. 


One other point from the graphs is the difference in yields between Italy and Spain since December and January. While back then it was the risk of Italian default that was driving up the yields in Spain and threatening a euro break-up, now it's the other way around. What happened? 

To remind ourselves, in November Italian bond yields went up to over 7% signalling a possible Italian default and a potential bailout triggering mass turmoil in Europe. But what happened since clearly stressed out the different paths undertaken by Italy and Spain. While both governments pledged to reform, and both are still considered credible on that promise, Spanish yields went up significantly and returned to their pre-December levels (as seen in the first graph above). On the other hand Italy has experienced a slow decrease of yields only responsive to outside shocks like the Greek elections and the Spanish bank bailout. 


So what are the main causes of diverging paths in Spain and Italy since December, even though both countries started with reforms and both received help via the LTRO? Why are foreign debt holders massively running away from Spain, completely reversing the previous trend as shown in the figure? The obvious answer is that one is more successful than the other in undergoing reforms, and that Spain's serious banking problems sent investors panicking (again). 

According to the Germans at least, Italy has been very successful: 
"German Finance Minister Wolfgang Schaeuble said Italy “has made remarkable progress in the last six months” under Prime Minister Mario Monti.
Italy will have the highest primary surplus in the euro region next year if budget policies are implemented, Schaeuble said in Berlin today. At the same time, there is scope for more growth-friendly measures, he said."
Even though much, much more could be done in Italy as many have accused the Monti government of being too political for a technocratic government. But this is understandable since they are forced to make concessions in order to get support for policies in Parliament. Then again, whose fault is that, the vote-buying self-preserving Italian politicians or the reformist technocratic government?

So the only option left is to forgo short-term solutions and deficit financing and stick with the reforms which will restore competitiveness. Italy is far from being safe but that's precisely why it needs to continue reforming. Spain should take note. The ECB at this point can do more harm than good.  

3 comments:

  1. I though the bailout was made by the ESM, not the ECB?
    So the failure of the bailout isn't really monetary policy, it's a failure of fiscal policy

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    Replies
    1. Yes, sorry about that, I seem to think of these two as the same thing, while they're obviously not. One is a monetary policy tool, the other a fiscal policy tool funded by the member states.

      I should clarify what I meant in that sentence - I was referring to the ineffectiveness of flooding the banks with more cash when all they do with it is use it to either buy government bonds, or deposit the money overnight at the ECB. They are unwilling to accept any risk whatsoever. And who can blame them? One one hand they have learned a lesson, but on the other, the regulators didn't as they are still steering bank investments and setting up too high capital standards making banks even less inclined to take any risk.

      So, what I generally mean when I equate the policies from the ECB and the ESM aimed at banks is that they are both equally inefficient. I see no point in trying to amend the banking system by pushing more money to the banks, when they are already too conservative with it. Simply giving them more money won't make them lower their interest rates and increase lending. Not now when there's so much uncertainty in the eurozone economy.

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    2. Btw, thanks for pointing that out, I've changed that line in the first paragraph to explain this.

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