Return of the Eurozone doom loop?
Financial markets could be excused for having been caught by surprise by Silicon Valley Bank’s (SVB) recent collapse. After all, who was to know that the country’s 16th largest bank would have taken on so much interest rate risk by buying on an unhedged basis massive amounts of long-dated U.S. Treasury bonds? Who also was to know that the Federal Reserve would raise interest rates at the fastest pace in more than 40 years and engage in aggressive quantitative tightening to regain inflation control?
After SVB’s failure, and with memories of the 2010 Eurozone sovereign debt crisis still alive, it would be inexcusable if markets are caught by surprise by renewed European banking system troubles later this year. After all, the Italian and Spanish banks are holding an unusually large amount of their countries’ government bonds amid questions about those countries’ public debt sustainability.
In addition, the European Central Bank (ECB) is raising interest rates at a very rapid pace and has shifted from a policy of massive quantitative easing to one of quantitative tightening to get inflation back under control.
During the 2010 Eurozone debt crisis, the ECB fretted about the so-called “doom loop,” whereby some of its member country banks held excessive amounts of their countries’ government bonds. The fear was that any sell-off of those bonds that might be occasioned by a loss of confidence in those governments’ ability to repay their debt would cause those bond yields to rise sharply. That in turn would deliver losses on the banks’ bond holding and raise questions about their ability to meet deposit withdrawals. It also would lead those banks to restrain credit at a time of economic weakness, which would only deepen any economic recession.
If in 2010 there was reason to be concerned about a Eurozone doom loop, we should be even more concerned today given the European banks’ larger government bond holdings. Whereas in 2010 Italian and Spanish government bonds constituted around 5 percent of those countries’ banks’ balance sheets, today those numbers are over 10 percent for the Italian banks and around 7.5 percent for the Spanish banks. This must be of particular concern considering that the Italian economy is around 10 times the size of Greece’s and its government bond market is the third largest such market in the world, after the United States and Japan.
Another reason to be concerned about a return of the Eurozone doom loop is that the ECB is no longer providing substantial support to the Eurozone government bond market. Until recently, the ECB was buying very large amounts of Eurozone government bonds in general and those of the Italian government in particular. Indeed, over the past two years the ECB is estimated to have bought as much as EUR 250 billion in Italian government debt, which more than covered that government’s net bond issuance. Now that the ECB is no longer a buyer, the question arises as to who will be buying the bonds to cover the more than EUR 600 billion in the Italian government’s gross borrowing needs this year?
To be sure, the Italian and Spanish banks can in principle hold their respective governments’ bonds till maturity, provided that their depositors do not lose confidence and begin to withdraw deposits on a large scale. But an important lesson from SVB’s recent failure is that, especially in today’s digitized world, it could be a big mistake to count on such deposit stability.
All of this highlights the substantial risks that the ECB would be running if it continues along its current hawkish monetary policy stance. It also underlines the importance of the Fed being ready for another round of the Eurozone sovereign debt crisis.
American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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