A strange inversion has occurred. Usually it is the financial markets that are twitchy, fretting about this and that, while the central bankers dollop out the calm. Now it is the other way around, with central bankers sounding off in increasingly alarmist tones, while the markets have managed a decent enough rally. Who is right?
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Well, we cannot know, but it has at least become clearer why the central bankers are so worried: they think there may be a run on Italian sovereign debt, and if that were to happen they are concerned that they would not have the firepower to stop it. The markets, by contrast, have become increasingly confident that the European authorities will indeed be able to stitch together some sort of deal by the end of this month that will at least patch things for a bit. Bank shares came off yesterday in response to downgrades, but European equities are still close to a two-month high.
Central bankers have lined up over the past week to get on the record how dangerous the present situation is: Mervyn King, Jean-Claude Trichet and Mario Draghi have all made similarly dire statements. Of these, the views of Dr Draghi carry the greatest significance as he steps over as governor of the Bank of Italy to become president of the European Central Bank next month. "We must," he said, "act fast. The sorts of interest rate rises seen over the last three months, if protracted, could lead to an uncontrollable spiral."
The potential domino sequence of just such a spiral is caught in the first graph. The figures, from an analysis by Fathom Consulting, have been derived from CDS spreads that show how the markets are calculating the risks of default. The chances of Greece defaulting are now close to 100 per cent. If that were to happen there would be a 60 per cent chance that Portugal would follow; then if that were to happen, a 70 per cent chance that Ireland would follow, and sequentially on through Spain, Italy and France.
My own feeling remains that Ireland is less likely to default than these numbers would suggest. But the mood running against Italy is strong, as you can see from the next graph, which shows the premium on Italian 10-year debt over German debt. The spread is now more than 4 per cent, whereas it was less than 1 per cent even 18 months ago. Again, you can question this and argue that in reality the chances of an Italian default are being overstated. But whether or not that is true, the plain fact remains that the Italian bond market is the third largest in the world after the US and Japan. It would be beyond the ability of Germany to rescue Italy by underwriting its debt, even in the unlikely event that it were prepared to do so. You can understand Dr Draghi's concern.
The more immediate issue is what will happen to the banks. There is a medium-term capital problem. When Greece defaults some will need to raise more funds to bring their ratios back to an acceptable level. If other countries follow, that would mean more capital still, and there is a legitimate debate as to whether they should mark all their sovereign debt to market. Should they adjust their books to fit every short-term panic that washes over the markets, or should they be allowed to take a longer-term perspective? There ought in common sense to be a middle way between making the banks hostage to short-term market fluctuations and allowing them to pretend that borrowers (including countries) can repay their debts when clearly they can't.
You can see the reasons why a number of bank ratings have been downgraded in recent days, including the two part-nationalised British banks, Royal Bank of Scotland and Lloyds. But this seems to me to be a rather mechanical response because in practice both those banks carry a British sovereign guarantee. In theory at some future date they might be allowed to fail, but in practice that is not going to happen. In any case, regulators that demand that banks raise more capital have to acknowledge that this will mean that those banks will lend less than they otherwise would and have to charge more for their loans. A safer banking system is a more expensive banking system.
However, quite aside from the medium-term issue of raising new capital, there is the immediate one of funding day-to-day activities. The entire eurozone banking sector is being dragged down by the loan of sovereign debt, as you can see in the bottom graph. Ignore the technicalities, and just see the spread shown there as a measure of stress. For most of the past year the experience of euro and dollar markets has been similar. In the past month, however, the two deposit markets have diverged widely. Dollar deposit markets are still functioning reasonable smoothly. The euro market is not, as banks worry about lending to each other. We are not yet seeing the sort of meltdown that occurred in 2008, but some banks are struggling. In the short term they can go to the ECB for funding, but that is not sustainable in the long term. There was a note yesterday from the fund managers F&C suggesting that Dexia, the Franco-Belgian bank that has just required a rescue, might be "the canary in the mine". Other banks are teetering.
So why, you might reasonably ask, given the funding difficulties of European banks and these dire warnings from the central bankers, are share markets reasonably sanguine? The short answer is that the markets seem to have decided that when push comes to shove the European high command will sort it. They reckon that notwithstanding the vicissitudes of Mr Berlusconi, the turmoil in the Slovakian parliament, the limited room for manoeuvre for Angela Merkel, and all the rest, some sort of deal will be done. So Europe may well have some sort of mild recession through the winter, but core Europe at least will have a reasonable recovery thereafter.
The markets are also saying something else. This is only Europe and Europe was always going to be a slow growth zone. The latest data from the States, while not great, is not awful. The much-needed slowdown in China is happening, but need not turn into anything more sinister. And the rest of Asia continues to grow too. So Europe is a regional problem, not a global one. Unfortunately for the UK, we still depend on continental markets, and there is not much in the short term we can do about that. But those in Britain who would like to see a realignment of trade policy towards faster-growing regions will see this recent experience as strong support for their aims.