Research Dept. News
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Monthly Report, num 354 - February 2012
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Financial markets
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Monetary and capital markets
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A new year, the same old problems
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The global financial scenario starts the new year dependent on familiar risks.
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The year has started with investors keeping an eye on the same issues that had set the tone for financial markets last year. Top of the list are the familiar fiscal imbalances of the main western economies, particularly the euro area where these problems are occurring within a far-reaching institutional crisis. Second is the threat of a slowdown in economic growth in the emerging countries. Third is the still weak pulse of the United States' economy and the doubts raised by its economic policy in an electoral year. Fortunately, since the last few weeks of December signs have been glimpsed of a possible change in the European scenario which might give rise to a more stable phase in global financial markets. Should the measures adopted by the ECB and the euro area's fiscal treat agreements actually turn out to be successful, investor confidence would recover, making it easier for higher risk assets to appreciate in the medium term. But in the meantime, and pending the results of the different actions taken by the world's central banks and government leaders, the dominant sentiment in financial markets continues to record a high degree of uncertainty and confusion.
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Central banks make an effort to boost economic growth
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Monetary authorities attempt to safeguard growth in their economies.
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The slowdown in the pace of growth for the world economy is a fact that has been gradually confirmed since the second half of last year. The delicate financial situation affecting the main developed economies is combined with a progressive slowdown in production in the emerging countries, as well as lower foreign investor flows to these economies. All this has hampered international growth prospects. An examination of the latest data shows an economic scenario in which, while the euro area appears to be entering a period of recession, in the United States growth is stabilising at a moderate rate, as well as signs of a gentle deceleration in the growth of the large emerging economies. Within this context, monetary authorities play a crucial role. Most central banks have adopted strategies that prioritize economic growth over price stability, aiming to restore the confidence of financial markets in their actions.
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The Fed's monetary measures are having the desired effect on long-term interest rates.
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In the case of the United States, the Federal Reserve (Fed) has once again decided to extend the expansionary profile of its monetary strategy in order to underpin a recovery that is still slow. As has been the case since the third quarter last year, the main economic indicators are gradually improving. Specifically, household consumption and corporate investment are progressing well, giving some hope of the economic recovery continuing. However, as emphasized time and time again by the Federal Reserve Chairman himself, Ben Bernanke, the economic situation is still looking very vulnerable, as suggested by the lack of activity in some key production areas, particularly the housing sector. Bernanke also stressed the persistence of a high number of risks hovering over the economic recovery, a large proportion of these originating in the euro area's sovereign debt crisis. The monetary authority also pointed out the favourable trend in the net creation of jobs which, although upward, is still at a level that historically corresponds to economic situations dominated by fragility. Based on these data, the Fed has repeated its proposal to boost job creation, albeit without threatening price stability, and to this end it is defending the maintenance of interest rates at their currently minimal levels (0%-0.25%), as well as continuing with exceptional monetary measures. Of note among these measures is the reinvestment of the accrued interest and principal from notes and mortgage-backed securities that have matured, as well as its programme to extend the maturity of government bonds on the Federal Reserve's balance sheet. This action, known as Operation Twist, is actually having the desired effect on long-term interest rates. Specifically, the Fed purchasing bonds with long maturities while selling short-term bonds is pushing down interest rates and thereby reducing financing costs for the private sector (particularly mortgages). Although the Fed authorities have not given any firm announcement regarding the possibility of implementing a new package of quantitative measures (which would be a third round of quantitative easing), the authority is at great pains to stress its total flexibility in adopting decisions that facilitate sustained economic growth.
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The ECB sees some signs of economic stabilization in the euro area.
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In the euro area, the European Central Bank (ECB) kept its official interest rate at 1% at its meeting in January. According to the bank's president, Mario Draghi, this decision was taken based on the data obtained from surveys that have started to show some signs of the region's activity stabilizing. However, this evidence is tenuous and set within a highly uncertain context, where there is a still a high risk of the economy performing less well than expected. This risk has two facets. On the one hand are the financial risks resulting from worsening tension in the euro area's credit markets. And, on the other, there are economic risks, closely related to the slowdown in world economic growth and structural imbalances (the need for fiscal adjustment). However, although it is true that the risks to growth and inflation for the area as a whole are markedly downward, the possibility of further cuts in the official interest rates by the central bank might come up against the relatively good tone of the German economy.
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Moreover, the ECB is basing its aid on a series of unconventional measures whose aim is to reduce the difficulty of Europe's banks in securing funding, and consequently the difficulties for the real economy. Among these measures, of note are the unlimited liquidity lines at a fixed interest rate provided by the ECB since last year. The two liquidity tenders approved at the last meeting in December are an outstanding example, with a three-year maturity. According to the ECB, the result of the first tender, held towards the end of 2011, was a success in terms of demand from Europe's banking sector, and its effects are helping to improve banks' funding conditions and to restore investor confidence. These results will probably be reinforced by the next injection of liquidity at three years, planned for February.
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The three-year liquidity tender eases funding conditions for Europe's banks.
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In terms of the ECB's direct involvement in stabilizing and resolving the euro area's sovereign crisis, the authority is still firmly committed to ensuring the debt markets function correctly, thereby restoring investor confidence. In order to carry this out, the ECB has continued to resort to purchasing the bonds of euro area countries in difficulties. Purchases made to date total 217 billion euros, with this process speeding up over the last few months due to rising credit tensions related to Italy and Spain.
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Looking at the monetary scenario for the emerging countries, of note is the shift that most authorities have started to make in their monetary policies. The gradual slowdown in global business indicators, which started in the summer, has led to the restrictive tone of their monetary policies being severely out of synch with the trends in the real economy. Given this situation, and with the aim of avoiding a sharp slowdown in real growth rates, the central banks of these economies have decided to change the direction of their policies towards a less restrictive profile. For example, in January, and continuing the sequence of interest rate cuts starting in August 2011, Brazil's central bank approved a new cut in the official interest rate to 10.5%. China and India have also applied less restrictive measures, among others.
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The Euribor falls due to increased liquidity in Europe's financial system.
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In such an environment, interbank market rates have continued to reflect, in the form of fluctuations, the variations in the financial and monetary scenario on both sides of the Atlantic. Interest rate movements were downwards in January. In the United States, the Libor interest rate in dollars halted its upward trend started in the summer thanks to the tentative easing of uncertainty in Europe's financial situation. While, for its part, the Euribor interest rate accumulated another drop for all maturities. In addition to the effect of the ECB's cut in the official interest rate in December, there is also the impact of the large liquidity tender held by the European authority with a three-year maturity, significantly reducing tensions in this market.
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Stability reigns supreme in the government bond markets
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Yields of the public debt of the most solvent countries remain exceptionally low.
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Continuing the tone of the last few months, the internal rate of return (IRR or yield) for the public debt of the main economies - the United States and Germany - has been stable, therefore remaining at historically low levels. This debt market performance is the result of the attitude shown by investors given the highly uncertain scenario still being perceived in the euro area, pushing up demand for low risk assets in detriment of other riskier options. In the case of the United States, this can be seen in the trend of the yield on 10-year bonds. For the third consecutive month, their yield has been below 2%, the result of several aspects. In addition to the aforementioned unstable financial situation in the euro area is the overwhelming presence of the Fed in secondary debt markets (buying up bonds via Operation Twist), as well as the perception that, in this election year, the political bodies will be forced to tackle medium and long-term budget adjustment.
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Investors see German debt as the safest European asset.
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In the case of the euro area, German debt has performed in a similar way to that of the United States, albeit with some nuances. The yields on 2 and 10-year maturities (0.21% and 1.86% respectively) have continued to fall due to the abundant liquidity injected by the ECB and the downgrading suffered by various countries in the region; specifically the downgrade in the credit rating carried out by Standard & Poor's for several economies, of note being France, Italy and Spain. Although this action had already been partly assumed by investors, the change in rating has strengthened the leadership of German debt as the best quality European asset. Evidence of this is that, for several sessions, German one-year bonds offered negative interest rates for the first time in their history.
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Advances in the euro area are facilitating new bond issuances from countries in southern Europe.
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Investor sentiment is divided when it comes to those countries negatively affected by the sovereign debt crisis. On the one hand, the advances made in creating a fiscal pact for the euro area, the promise of rigorous action by the new governments in Italy and Spain and the satisfactory outcome of the ECB's big liquidity tender (LTRO) are factors that have helped to cheer up many investors. The relative improvement in the uncertain environment has allowed Italy and Spain's risk premia to relax, also contributing to the success of recent long-term debt tenders carried out by both countries. But, on the other hand, incessant doubts regarding Greece's capacity to meet its commitments with its creditors and the declared incapacity of Portugal to achieve its fiscal deficit targets have once again heightened scepticism among another large group of investors. As a result, the risk premia of these two countries have risen.
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The euro's exchange rate continues to fall
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Several factors weaken the euro's exchange rate against other currencies.
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One of the consequences of the economic and financial scenario over the last few months is the high degree of volatility seen in the foreign exchange markets. Although the range of fluctuations in the short term is tending to narrow, there are several factors that point to this trend perhaps continuing throughout the first part of 2012. Particularly the repercussions from the euro area crisis, the aggressiveness of the monetary measures taken by some central banks and the disparate macroeconomic data between different countries and regions. It is precisely the conjuncture of these elements that has helped the dollar-euro exchange rate to rise, once again, in favour of the US currency over the last few weeks. The dollar's cumulative appreciation since the record low in May 2011 (1.482 dollars per euro) has risen to almost 13%.
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The euro has also lost value against other currencies. This is the case of its exchange rate with the Japanese yen, which reached 99.65 yen per euro, this being the highest value for Japan's currency in twelve years.
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The credit wheel is starting to turn again
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The relatively improved outlook for the euro area's crisis reactivates corporate credit markets.
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With the start of the year, credit markets have recovered part of their rhythm lost towards the end of 2011 due to rising tensions regarding Europe's sovereign crisis. The ECB's huge three-year liquidity tender at a fixed interest rate and the fiscal agreements reached at the European summit on 9 December marked a turning point in the evolution of the risk premia for the large countries on the periphery of the euro area (Italy and Spain). This situation has meant that the interest rates of the main issuing countries have continued to fall during January, a circumstance that has also been passed on to the rest of the corporate bond sectors. The fall in spreads has been relatively significant, both in the investment degree tranche and also in high yield. Technical factors related to portfolio recomposition have had a favourable effect on the value of investment grade corporate bonds. The downgrade experienced by various sovereign issuers has merely reduced the supply of top quality securities. The expansion in the balance sheets of central banks has also led to a fall in the securities available for institutional investors. This situation has also meant that many of these investors have opted to move their funds towards other issuers providing larger returns and greater risk, such as high yield.
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Corporate bond markets continue to offer attractive yields.
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The area that has benefitted the most from the incipient situation is the private debt of Europe's banking sector. After the sector had been penalized for the last two years with a sharp rise in its risk premia, the liquidity facilities provided by the ECB, the relative improvement in the outlook of the crisis and the effort being made by financial institutions to strengthen their solvency have led to an increase in issuances of senior debt and covered bonds (mortgage-backed securities) by institutions in countries from the central core of the euro area.
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Global stock markets start the year with gains.
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For their part, the emerging markets' corporate bonds have remained very active in spite of the uncertainty related to Europe. Efficient management by the monetary authorities in order to avoid a sharp slowdown in economy, as well as the improvement in the credit rating of government and corporate bonds for some of these economies, are boosting the flow of foreign capital and thereby increasing corporate bond issuances.
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New stimuli for equity
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Corporate earnings in the United States are boosting the main stock market indices.
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The stock market year has started with gains for most international stock markets. The relative improvement in the risk of systemic contagion of the European crisis, the favourable economic growth figures for the United States and the measured expansion of monetary policy in developing countries have been the main aspects dominating investor mood in January. Although it's true that investor sentiment indicators in these markets, as well as capital flows towards equity, are still at levels typical of situations of high economic and financial instability, it is still the case that risk aversion has fallen relatively since the last few weeks of December.
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But in addition to these factors of great relevance for developments in the stock markets, from a sector and company point of view another series of equally relevant aspects is also converging. We are referring, firstly, to the corporate earnings season for the fourth quarter of 2011 in the United States. To date, 14% of the S&P 500 companies have published their earnings figures. Although the consensus of analysts estimates that there might be some reduction in the number of pleasant surprises (companies that report higher than expected earnings) as a consequence of the US economic slump in 2011, key indicators such as earnings per share are beating the record for the same quarter the previous year. The technology sector is key in this respect. This situation, together with the improved economic data for the United States, has made the US stock markets more stable. Secondly, from a sector point of view, it's worth noting the flow of news regarding Europe's banking sector. In the last two years, Europe's banks have been most heavily penalized by investors due to the high exposure of their balance sheets to the region's sovereign debt. But recent events have become somewhat more favourable. The increase in liquidity provided by the ECB and the acceptance of a wider range of assets as collateral for loans, the request by Germany and France to make the sector's accounting regulations more flexible and the advances being made in the euro area in the fiscal area are, as a whole, having a positive effect on the share prices of European banks, even offsetting the impact of the rating downgrade of various euro member states.
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Share prices for Europe's banking sector take a break.
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In the medium term, the consolidation of these factors and the continuity of current trends should help pave the way for a new phase marked by higher yields and a return of investment. Nevertheless, in the short term, aspects such as threats to the private sector's participation in restructuring Greek debt and possible new episodes of contagion continue to make the outlook for the stock markets highly uncertain.
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The impact of bank bail-outs on national accounts
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Since the financial crisis started in 2007, there have been numerous and varied interventions by countries to bail out or restructure their financial systems. Some of the bankruptcies have also been significant, such as that of Lehman Brothers in the United States in September 2008 or the Danish Amagerbanken and Fjord-bank Mors in 2011. However, due to the risk of contagion and the role played by banks in the payment system and flow of credit to the economy, countries have allocated large amounts of public money to bail out and restructure banks in difficulty.
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To safeguard competition, all aid programmes offered to a sector or to a company by any European country must first be approved by the Directorate General for Competition of the European Commission. Since 2007, the number of approval applications for aid programmes for financial systems has rocketed. Between 2007 and 2010, European countries allocated 0.5 trillion euros in capital and liquidity aid (4% of Europe's GDP). This aid includes a wide range of measures: direct capital injections, with or without political rights; buying back toxic assets to get rid of balance sheet uncertainty or granting loans to boost liquidity. Banks have also been able to issue up to 1.1 trillion euros (9% of GDP) of debt with a government guarantee. In addition to this aid, there is also the macroeconomic policy of the European Central Bank, with its injections of liquidity and purchases of mortgage-backed securities.
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Depending on their characteristics and scope, the impact of the measures adopted in different countries has varied, both in terms of sorting out the financial system and the national accounts of the respective countries. In this respect, giving a guarantee is not the same as offering credit or injecting capital. Neither is doing this directly the same as doing it through a society set up for this purpose, as is the case of the National Asset Management Agency (NAMA) in Ireland.
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So, what has been the impact on national accounts of the state aid packages adopted over the last few years? Firstly, on countries' indebtedness. Injecting capital, buying up assets or granting credit all require large payouts by the central government which they have had to finance with more debt. According to Eurostat figures, countries' liabilities have grown by almost 644 billion euros (5.2 percentage points of GDP) as a consequence of state intervention in the financial sector. Of these liabilities, 70% are debt issues. But little of the aid has been non-refundable. That's why public assets have also grown, by nearly 563 billion euros (4.6 percentage points of GDP). Of these financial assets, 40% are shares in financial institutions.
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One initial impact is therefore on the debt to acquire assets or shares in entities, whose net figure has grown by 0.6 percentage points of GDP. Depending on how the assets acquired perform and their potential to deteriorate, the public impact of this bail-out could be greater in the future.
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But not all public aid is reflected on national balances. When this aid is given via guarantees, the impact on national accounts is different. Over the last few years, guarantees for issues of new debt have emerged as a key support measure but, to date, this has not led to any countries having to pay out money. Consequently, unlike capital measures or liquidity injections, they do not increase a country's debt. However, they do lead to contingent risks; i.e. potential risks for the future.
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Ireland is a case in point. With the first symptoms of deterioration in its financial institutions, the decision was taken to nationalize and inject capital into them. The Irish government injected 4 billion euros and 2.7 billion euros (4% of GDP), respectively, in the Anglo Irish Bank (Anglo) and the Irish Nationwide (INBS). The country's debt rocketed. After Ireland was bailed out by the International Monetary Fund and the European Union, it decided to set up NAMA to continue to sort out the system. How does NAMA work? Financial institutions sell their riskiest loans to the agency in exchange for state-backed bonds. It is NAMA that issues the bonds granted to financial institutions in exchange for assets and, consequently, no public debt needs to be issued, which would increase debt. But the country's contingent risks increase due to the state guaranteeing the bonds.
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Lastly, we should also note that countries might see a profit or loss resulting from all this aid, which would affect the country's deficit. Included under profit are payments for guarantees, commissions on loans, etc. And under losses are those of financing loans, deterioration in the assets acquired and, if applicable, the need to call on a guarantee. In this case, in the cumulative figure for 2007 to 2010, European countries have lost over 69 billion euros, increasing the public deficit by 0.4 percentage points. But the situation differs widely depending on the country. Ireland (-35.7 billion euros), Germany (-16.6 billion euros) and the United Kingdom (-15.0 billion euros) have accumulated the highest losses. However, between 2007 and 2010, France achieved a profit of 2.4 billion euros and Spain of 1.5 billion euros, in both cases slightly improving their deficit figures.
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In a nutshell, the difficult economic and financial situation that has been going on since 2007 has led many countries to bail out their banks with tax revenue. But not all measures have the same impact on national accounts, nor do they entail the same potential income or future risks, considerations which, ultimately, are also being taken into account when designing bail-out schemes.
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This box was prepared by Anna Mialet Rigau
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Economic Analysis Unit, Research Department, "la Caixa"
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