Jean-Claude Trichet’s shot against inflation may end up inflicting collateral damage on Europe’s most cash-strapped economies.
Primed to raise its benchmark interest rate this week for the first time in almost three years, President Trichet’s European Central Bank again faces the conundrum that its monetary policy rarely suits all 17 members of the euro area, where the kaleidoscope of growth ranges from record expansion to recession paired with a sovereign-debt crisis.
The upshot may be that the normalization of rates from a record low of 1 percent will disproportionately hurt Spain, Greece, Portugal and Ireland, while failing to nip inflation threats in Germany. Such uneven fallout risks exacerbating the two-speed European recovery and dealing further damage to the bonds of so-called peripheral nations. Credit Suisse Group AG is warning investors away from the region’s stocks and banks partly because of concern the ECB is making a policy mistake.
“As the ECB continues to tighten, it increases the risk that the sovereign-debt crisis comes back,” said Gavyn Davies, chairman of London-based hedge fund Fulcrum Asset Management LLP, which oversees about $1.5 billion in assets. “It will manifest itself with the troubled economies moving into slower growth rates, and the fiscal arithmetic will worsen again.”
Trichet and his 22 fellow policy makers convene in Frankfurt April 7, a month since he surprised investors by signaling an increase in the ECB’s key rate by a quarter of a percentage point as inflation accelerated to 2.6 percent in March, the fastest in more than two years. The yield on German 10-year government bonds, the European benchmark, rose for an eighth day, approaching the highest level in almost 15 months.
In enacting the first rise since July 2008, policy makers would be focusing on their primary goal of price stability rather than secondary mandates to support growth. They’d also be taking the lead over the Federal Reserve in starting to withdraw emergency lending rates.
Belgian Guy Quaden, who retired March 31 as one of the longest-serving ECB council members, said “a cautious increase” won’t hurt the region’s economic recovery because “both growth and inflation have become again significantly positive.”
Even so, the weakness of the periphery and its banks mean “the ECB simply cannot raise rates too aggressively without breaking up the euro zone,” said Simon Maughan, co-head of European equities at MF Global Ltd. in London. A Bloomberg News survey predicts the central bank will lift its main rate to 1.75 percent by year-end, based on the median estimate of 31 economists.
Record Debt Burdens
Economies from Ireland to Spain are buckling under record debt burdens and the bursting of property bubbles, even as Germany expanded 3.6 percent last year, the strongest pace in two decades. In forecasting euro-zone growth of 1.6 percent this year, the European Commission predicts expansion of 2.4 percent in Germany, three times the anticipated rate for Spain, where unemployment is above 20 percent, the highest in the region.
The situation is a “precise reverse” of the period before December 2005, when the ECB last began raising rates, said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. Then Germany was weak, with growth of 0.8 percent that year, while the Irish and Spanish economies expanded 6 percent and 3.6 percent.
“We were in a world where rates were much too accommodative for the periphery and much too tight for the core,” Kounis said. “Now, the situation is the same, only the countries are different. It’s a problem with their one-size- fits-all policy.”
The ECB has set its benchmark at 1 percent since May 2009. Spain, Portugal, Ireland and Greece, which are responsible for about 17 percent of euro-area gross domestic product, would need an average rate of minus 4.6 percent under the Taylor Rule, according to estimates by Credit Suisse equity strategists including London-based Luca Paolini. Germany, which accounts for almost a third of GDP, requires a rate of 4.5 percent, they say.
The Taylor Rule, devised by Stanford University economist John B. Taylor, is a measure of where rates should be set given inflation and growth projections.
Paolini and his colleagues recommend investors in continental European stocks stay 5 percent “underweight” the level suggested by benchmark indexes, in part because the ECB could be making a “policy mistake” if an April increase marks the start of a series of moves. In a March 9 report, they also cut their view of European banks to “benchmark” from “small overweight” and said low leverage and loan-to-deposit rates at Italian banks such as Intesa Sanpaolo SpA should help them outperform Spanish rivals.
“For the Irish, Greek, Spanish and Portuguese banks, rising interest rates are negative,” said Carlos Egea, a strategist on Morgan Stanley’s peripheral sovereign and bank trading desk in London. “They’re positive for the Italians.”
Greece, where government debt is set to rise to 156 percent of GDP by 2014, will face an additional debt-service charge of 1.6 percent of GDP if market borrowing costs gain 1 percent on the back of the ECB raising rates, Paolini estimates.
Davies at Fulcrum says there is also the risk that investors again push up what they charge troubled economies to borrow relative to what they demand from Germany. With investors speculating Portugal soon will follow Greece and Ireland in seeking a bailout, its bonds sank last week, with the two-year yield topping the rate of the nation’s 10-year debt for the first time since 2006. Irish 10-year yields traded at the highest since the birth of the euro.
A jump in government bond sales while rates are rising also may make it harder for Europe’s most indebted nations to fund themselves. Euro-region nations will sell 147 billion euros ($209 billion) of bonds this quarter, net of redemptions, up 24 percent from the third quarter, analysts at HSBC Holdings Plc estimate.
While Andrew Bosomworth, Munich-based head of portfolio management at Pacific Investment Management Co., said too much tightening “could derail what is so far a very fragile recovery,” he told Bloomberg Television March 29 that failure by the ECB to raise rates would leave a “considerable risk that inflation expectations will get out of control.”
Import prices in Germany are rising at the fastest pace in 29 years, and inflation expectations, as measured by the difference in yields between five-year German nominal bonds and similar-maturity index-linked debt, have tripled to 2.25 percent since August, breaching the ECB’s limit on March 23.
The central bank last month revised its 2011 euro-area inflation forecast to about 2.3 percent from 1.8 percent. It also boosted its forecast for expansion to about 1.7 percent from 1.4 percent.
Trichet may be sending a “clear signal” to European governments that the ECB is unwilling to keep easing debt-market tensions for them, putting pressure on them to solve the crisis and restore fiscal order, said Thomas Mayer, chief economist in Frankfurt at Deutsche Bank AG. Countries have “had enough time to realize that a common monetary policy cannot be tailor made for everybody,” he said.
The ECB has committed to providing banks with unlimited liquidity for maturities as long as three months through the second quarter. That will restrain the euro overnight index average, or Eonia, which serves as a benchmark for many private borrowing costs, said Julian Callow, chief European economist at Barclays Capital in London. Eonia was 0.588 percent April 1.
Households in the weaker countries nevertheless may suffer from tighter borrowing costs at the same time economic output could be restrained by budget cuts the International Monetary Fund calculates will help the euro area’s fiscal deficit shrink to 4.6 percent of GDP this year from 6.4 percent last year. Private-sector leverage levels in Spain, Portugal and Ireland now run more than 210 percent of GDP, about 100 percentage points more than in Germany, Credit Suisse calculates.
More than 83 percent of homes in Spain are owned, twice the share in Germany, and two out of five are burdened with an outstanding mortgage or housing loan, Eurostat data show. How the debts are financed also poses a hurdle. Variable-rate mortgages account for almost 100 percent of new lending in Portugal and about 85 percent in Spain, compared with 15 percent in Germany, according to the Brussels-based European Mortgage Federation. In Ireland, 85 percent of outstanding loans have flexible rates.
As the ECB raised its key rate by 150 basis points starting in December 2005, borrowing costs for households rose by more than 100 basis points in Spain, Ireland and Portugal and only about 50 basis points in Germany, an ING Groep NV gauge shows.
With real disposable income declining in peripheral countries as a result of tax increases and spending cuts, even a small increase in market rates may be enough to boost foreclosures and sap credit availability. Irish and Greek banks last year had nonperforming loans equivalent to more than 10 percent of their totals, with Spain’s rate about 6 percent, said Giada Giani, an economist at Citigroup Inc. in London.
Banks in those countries will be hit most by higher interest rates as long as the ECB provides unlimited liquidity, keeping market rates below its benchmark. Financial institutions lent money to each other for 0.781 percent interest for a week today, less than the 1 percent charged by the ECB in its main refinancing operation.
While a couple of rate increases this year “are unlikely to have catastrophic effects on peripheral euro-area banks, they would definitely add more pressure to their already fragile situation” and risk “exacerbating economic divergence among euro member states,” Giani said.
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