To understand what’s currently happening, the key factor we need to properly appreciate is the markedly high profitability of Eurozone sovereign debt to banks at present, if governments do not default. Yet a new feature of the current episode in the long-running Eurozone soap opera is that even the governments of the core countries (Germany and France in particular) have stopped denying that all is well. They may insist that “normality” – with a strong and apparently well-established single currency – will return. Nevertheless, they accept that much has gone wrong relative to their original expectations, and that the Eurozone’s break-up is no longer a remote and hypothetical contingency. Here I’m about to play the devil’s advocate and assume that the Eurozone remains intact (except perhaps for Greece’s departure, which could happen anytime, perhaps even over the Christmas break). I need to make two points. First, if the Eurozone survives, banks that buy Eurozone government bonds funded at today’s inter-bank rates will make fabulous returns for their shareholders. Secondly, the ECB has again changed tack on its policy towards lending to the banking system. It appears ready to extend credit (at rates not much above current inter-bank rates) for an extended period to any Eurozone bank that knocks on the door and complies with current regulations. I am as sceptical about the long-run viability of the single currency experiment as anyone, but it must be conceded that rapid, large-scale expansion of ECB lending to Eurozone banks (of, say, 250 to 500 billion euros) could give the single currency a breathing space of another six months to a year. Although its problems would not have been solved, some market participants and media commentators might delude themselves in early 2012 that a great advance had been made, with much cheering, flag-waving, playing of music by brass bands (which in this context means the brokerage commentariat), etc. (And big rises in equity markets.) At any rate, I will explain the nature of the escape-valve available to the ECB and, at a further remove, to EU/Eurozone officialdom as a whole.
The profit opportunity for banks taking a contrarian view on peripheral Eurozone sovereign debt
The rate of return on equity to banks to be earned from investment in Club Med/PIIGS sovereign debt is at present extraordinarily high, assuming that
a.) they can fund the purchases at inter-bank rate plus a modest margin, and b.) the sovereign debt repays in full at maturity in euros. The explanation here is simple, that the gearing inherent in bank balance sheets implies very high returns on any safe assets with a clear and wide profit margin. Thus when the yield on two-year Italian government paper is given as, for recent example, 5.70%, while the two-year asking euro inter-bank rate is 1.45%, what happens?. Assuming that the bond is held to maturity, the return on 100,000 euros borrowed in the market at, say, 2.00% (i.e., with the bank charged 55 basis points over inter-bank when it borrows from other banks) and re-invested in the two-year Italian government bond is obviously 3,700 euros (i.e., 5.7% minus 2.0%, multiplied by 100,000). That sounds fine, although not particularly special. (3,700 euros on 100,000 is of course 3.7%.)
Now think about a bank, with all its gearing. Assume that a bank is operating on an 8% equity-capital-to-assets ratio, which would be high by the standards of recent decades. So the 3,700 euros is not a return on 100,000 of euros, but on 8,000 euros. (The precise calculation depends on how the bank’s management allocates capital to balance sheet risk. Under the Basle rules no capital is in fact required against government bonds. In reality banks know that even sovereign debt is not entirely safe in a normal monetary jurisdiction, although – absent war, civil disorder and totally delinquent politicians – it is over 99.9% safe against the risk of default in nominal terms. Sovereign debt is nowadays certainly not safe in that 99.9% sense in the Eurozone. The implied rate of return on the banks’ equity capital (i.e., 3,700 divided by 8,000 multiplied by 100) is 46 ¼%. (The dealing and administrative costs with large blocks of government debt are negligible and can be ignored for simplicity.) Whatever one’s view on banks and banks’ bonuses, a prospective return on equity of almost 50% would be mouth-watering.
My point here is straightforward. If the Eurozone’s banks could borrow freely in the inter-bank market, and if they were 100% certain both that the Eurozone would continue indefinitely in its present form and that (Greece excepted) Eurozone sovereign debt would repay in full in euros, they would be crazy to miss the opportunity. It would be almost obligatory to borrow in the inter-bank market and to build up large holdings of ClubMed/PIIGs (or at any rate PIIS, with Greece cut out) sovereign debt. The upward surge in European government bond yields over the last two years is a function of: banks’ extreme difficulties in accessing funds in the inter-bank market, markets’ lack of confidence in the Eurozone’s integrity, and, their additional lack of confidence in peripheral Eurozone government’s ability and willingness to redeem their debt in full even in an intact Eurozone.
Let me clear that Greek solvency cannot be restored. The German government’s insistence on private sector acceptance of a 50% value haircut on Greek sovereign debt was damaging in that it undermined investors’ beliefs that all Eurozone sovereign debt was safe. However, there was – and remains – little doubt that Greece cannot and will not wholly honour its obligations to private sector creditors. There are no good, or at least, happy answers here.
Tim Congdon is the founder of International Monetary Research Ltd.