Eurozone crisis 2.0 takes shape

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Macro Afternoon

Via the FT:

A closely watched gauge of stress in the eurozone’s financial system has climbed to its highest level since 2012, a sign that the coronavirus crisis has pushed up borrowing costs for banks in the currency bloc.

Analysts said the rise in Euribor — a measure of the interest rates that euro area banks pay to borrow from one another — is a worrying sign of “fragmentation” of the region’s money markets, with the European Central Bank’s efforts to hold borrowing costs at rock bottom failing to reach every corner of the financial system.

Three-month Euribor climbed to a four-year high of minus 0.16 per cent on Thursday. The gap between Euribor and overnight index swaps, which track interest rates set by the ECB, has reached its widest since the height of the eurozone debt crisis in 2012.

“It’s an indication of fragmentation within the eurozone,” said Antoine Bouvet, a senior rates strategist at Dutch bank ING. The figures do not indicate where the strain is coming from, but Mr Bouvet said it was likely that lenders in southern Europe were facing higher funding costs, reflecting the divergence between government bond yields in Germany and the eurozone’s “periphery”, particularly Italy. Of the 18 banks on the panel that sets Euribor, seven are based in Italy, Spain and Portugal.

There is no need to revisit the disastrous activity charts. The problem is structural not cyclical. It is Italy where spreads for government debt have been widening:

Despite the ECB:

As it uses everything it has:

The problem is twofold. The Eurozone is much more dependent on bank financing than the US is so aiding capital markets only goes do far. Most Eurozone debt is bank-based thanks to its immense exposure to the SME sector:

It is even worse in the periphery:

SME’s are harder to bail-out. So, bank equity is are under a lot of pressure:

That vulnerability is made worse by the lack of a fiscal transfer mechanism, eurobonds, which has condemned peripheral Europe to endlessly falling living standards under the Teutonic regime for balanced budgets:

So, we have angry people, dead people, and now mass unemployed people:

Italy’s fiscal needs are mushrooming to avoid an economic disaster:

From already extreme levels:

But still the Teutons won’t budge, via The Guardian:

European Union leaders have clashed over how to rescue their economies from an economic slump caused by the coronavirus pandemic and forecast to be unparalleled since the 1930s Great Depression.

Meeting via video-conference summit, as the confirmed Covid-19 death toll passed 108,000 lives across the European Economic Area and UK, the 27 leaders instructed the head of the EU executive, Ursula von der Leyen, to draft a recovery plan.

Italian prime minister Giuseppe Conte told the group that the health emergency had become an economic and social emergency, “but now we are facing a political emergency as well”.

Italy swung behind Spain’s €1.5tn plan for grants for the hardest-hit countries, funded by “perpetual” (non-maturing) bonds. French president Emmanuel Macron also threw his weight behind the idea, saying: “Europe has no future if we cannot find a response to this exceptional shock.” He said the scale of the crisis demanded financial transfers to the hardest-hit states, and not just loans.

Coronavirus delivers a ‘moment of truth’ on the meaning of the EU

But Germany, Sweden, the Netherlands and other northern countries are wary of financial transfers, preferring loans. The divide between grants and loans has superseded the previous EU split between countries seeking jointly issued EU debt and those opposed – a divide that also loosely fell on north-south lines.

Cripes, as if Italy needs more “loans”. It needs fiscal transfers. The question is, as it heals, will its people think so? Demand so, in fact. I would, if I were them. If not, then I would redominate to ensure the fiscal transfer by loan defaults in my own currency.

So, the Eurozone comes to its crucial moment. The ECB can support things only so far. At a certain point the EU has to act like a state for its members or what’s the bloody point? I see this as a zero versus one scenario. There is no middle ground.

If it comes to crisis, and Italy nominates to leave, then the northern banks will all go bust at once, and EUR survival be drawn into question. That surely suggests eurobonds remain a live option.

But if not, then there are two likely outcomes. The first is that the US dollar soars. The second is less secure but still likely: gold soars.

There is no scenario in which these tensions erupt and the Australian dollar does not crash while bank funding costs soar.

If would add a GFC to the virus crisis.

David Llewellyn-Smith

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