How seriously can investors take Draghi's assurances?

How seriously can investors take Draghi's assurances?

31 August 2012

ECB president, Mario Draghi, has repeatedly claimed that the
central bank will do everything necessary to save the euro. Nothing has been
formally agreed yet, but the ECB is expected to announce a new government
bond-buying programme following next week’s meeting of its Governing Council.
To have a significant impact on Italian and Spanish borrowing costs, the latest
effort must be big enough to dispel the convertibility risk that lies behind
the extreme polarisation of government bond yields across the eurozone:
investors are loath to hold Spanish and Italian debt because they fear that the
two countries’ membership of the currency union might be unsustainable.
Unfortunately, the ECB is highly unlikely to do enough to convince investors
that membership is unequivocally forever, not least because the Bundesbank
opposes any open-ended commitment to cap borrowing costs.

Spain, Italy and the periphery of the eurozone face
unprecedentedly high real borrowing costs, which are preventing a recovery in
investment and hence economic growth. Without a return to growth, they will
fail to dispel investor fears over the sustainability of their public finances
and the solvency of their banking sectors. The Italian and Spanish governments
argue that their high borrowing costs largely reflect convertibility risks and
that the ECB should do as much as necessary to address these fears. The
eurozone’s members that currently benefit from exceptionally low borrowing
costs – Germany, Austria, Finland, the Netherlands and to a lesser extent
France – maintain that very high Italian and Spanish borrowing costs largely
reflect these countries’ failure to reform their economies and strengthen their
public finances. There is merit in both these positions, but much more to the
Spanish and Italian argument than the opposing one.

Opponents of open-ended ECB action argue that Italian and
Spanish borrowing costs are not actually that high. Interest rates have just
returned to levels seen in the run-up to the introduction of the euro, when
investors distinguished properly between the countries that now share the euro.
High borrowing costs are needed to focus minds and instil discipline. Were the
ECB to take aggressive action to bring down borrowing costs, it would create
so-called moral hazard; countries would be free to delay reforms in the
knowledge that they will not be punished for it by having to pay high borrowing
costs. According to this argument, it is a positive development that investors
are now differentiating so strongly between the risks of lending to various
governments. After all, the failure to do so in the run-up to the crisis contributed
to the under-pricing of risk across the eurozone and reduced pressure on
governments to reform their economies.

In nominal terms Italian and Spanish borrowing are indeed
comparable to the levels of the late 1990s. But it is real cost of capital
(that is, adjusted for inflation), that is crucial, and not the nominal cost.
Both countries face much higher real borrowing costs than they did in the
run-up to their adoption of the euro. Moreover, it is erroneous to compare the
present with the late 1990s. Italy and Spain are at very different points of
the economic cycle now than they were then. In the late 1990s both economies
were growing, in the Spanish case rapidly, whereas now they face slump and
mounting risk of deflation. Countries facing depressions and rapidly weakening
inflation typically face very low borrowing costs: investors invest in
government bonds for a want of profitable alternatives. This is what we see in
the UK and US; borrowing costs remain at all-times low despite the extreme
weakness of both countries’ public finances and poor growth prospects.
Investors certainly need to differentiate between eurozone governments, in
order to ensure that risk is correctly priced. The Italian and Spanish
authorities acknowledge this. But the current spread between the yield on
German government debt and that of the Italian and Spanish governments wildly
exceeds what is required to make sure investors differentiate appropriately.

The polarisation of borrowing costs has politically
explosive distributional effects: Germany is borrowing and refinancing its
existing debt at artificially low interest rates. According to the German
Institute for the World Economy, investor flight from the government debt
markets of the eurozone’s struggling members to Germany has already saved the
German government almost €70bn. Other countries face ruinously high borrowing
costs, which are simultaneously increasing the scale of their reform challenges
and narrowing their political scope to make the necessary reforms. The longer
Italian and Spanish borrowing costs remain at such elevated levels, the greater
the economic damage to those economies will be and the harder it will become
for the two countries’ governments to shore up the necessary political support
for further reforms.

Why have government borrowing costs across the eurozone
diverged so much? The principal reason for the size of the spread between the
periphery and Germany is convertibility risk. Investors believe that there is a
chance that Italy and Spain will ultimately be forced out of the currency union
and are thus demanding a hefty premium to insure against this eventuality. This
feeds the convertibility risk by weakening countries’ fiscal positions and
raising private sector borrowing costs (government bond yields set the cost of
capital for the private sector). With private and public consumption in both
Italy and Spain set to remain depressed for years to come, economic recovery
requires stronger investment and exports. But borrowing costs are crippling and
credit scarce. In a vicious cycle, the steep fall in the value of Italian and
Spanish banks’ holding of government debt, combined with mounting bad debts as
a result of recessions made worse by punitive borrowing costs, are forcing the
banks to further rein in business lending. 

The ECB’s latest programme of bond purchases will be big
enough to ensure that Mario Draghi does not lose face. But it will not be big
enough to dispel convertibility risk and hence demonstrate its credibility as a
lender of last resort. And it is this credibility problem, rather than the
relative ‘credibility’ or otherwise of member-states policies, that is the
principal reason for the unsustainably high borrowing costs faced by Italy and

Simon Tilford is chief economist at the Centre for European Reform.