TWN Info Service on Finance and Development
Investor confidence erodes over fiscal concerns
in euro area
Geneva, 16 Jun (Kanaga Raja) -- The surge in volatility in the global financial markets from mid-April to early June has been due to a rapid deterioration of confidence among investors on account of fiscal concerns over Greece and other euro area sovereigns, as well as the risk of weaker growth, the Bank for International Settlements (BIS) has said.
In its latest quarterly review, the Basel-based
central bank for the world's central banks said that investor worries
about unsustainable fiscal positions crystallized around the problems
Faced with growing uncertainty, investors cut risk exposures and retreated to traditional safe haven assets. The announcement of a significant European rescue package bought a temporary reprieve from contagion in euro sovereign debt markets, but could not allay market concerns about the economic outlook, said BIS, adding that instead, the flight from risky assets continued, resulting in additional increases in risk and liquidity premia.
According to BIS, a number of developments led investors to question the robustness of global growth. In advanced economies, investors and market commentators focused on the risk that the surge of public debt could derail the economic recovery. At the same time, rising Libor-OIS spreads reflected growing concerns that the financial system is more fragile than previously thought.
(OIS is the acronym for Overnight Indexed Swaps,
an interest rate swap historically considered less risky than the Libor
and, in the
Economic policy tightening in
The BIS review observes that over the six weeks to the end of that month, prices of risky assets fell and volatility rose. Stock markets fell in advanced and emerging markets alike, bringing global equity prices below end-2009 levels. Corporate credit spreads, which had remained broadly stable for several months, widened in late April.
Faced with significantly higher uncertainty, investors increased their demand for US Treasuries, German government bonds and gold. Implied volatilities of equity prices and credit spreads rose sharply, reaching new highs for the year.
The challenging fiscal situation and uncertainty about the growth outlook for the euro area also led to a significant weakening of the euro against other major currencies. By the end of the period, investors had become increasingly concerned about the global growth outlook and, as a result, again pushed back their expected timing for the normalization of monetary policies in the advanced economies.
According to BIS, concerns about the fiscal positions
BIS recalls that growing fears about the risk
of a credit event were first signaled in the inversion of
At the same time, the inversion also reflected the view that, if Greece managed to meet its obligations during the next few quarters, the situation was likely to stabilize to some extent, hence, resulting in lower average CDS spreads over the longer term.
Consistent with this, as worries about the creditworthiness
According to BIS, the catalyst for this sudden
loss of market confidence was Standard & Poor's 27 April downgrade
of Greek government debt to BB+ after
In the light of the Greek downgrade and escalating protests by the Greek public, the 45 billion euro EU-IMF support package announced on 11 April appeared insufficient. Market participants questioned politicians' resolve and their ability to disburse the funds. An enlarged 110 billion euro package announced on 2 May also met with skepticism. Despite the ECB's (European Central Bank) decision to suspend its minimum credit rating thresholds for Greek government bonds, prices fell to distress levels.
Euro area sovereign CDS spreads rose sharply following
the 27 April downgrade. CDS spreads on five-year Greek debt rose to
more than 900 basis points, similar to those of
By contrast, the daily movements in sovereign
CDS spreads for
During the first week of May, says BIS, the contagion
from the Greek crisis quickly spread across
With the rise of sovereign risk, market participants
focused on the exposure of different banks to Greek, Portuguese or Spanish
sovereign debt, notes BIS, adding that by the end of that week, the
impact had spread beyond
Continued policy tightening in
"In response to greater global uncertainty,
investors cut risk exposures and moved into safe haven assets. Gold
soared above $1,200 per ounce, while bond investors moved out of most
euro sovereign bonds into the relative safety of German and
According to the review, contagion from euro area
sovereign debt markets also spilled over into interbank money markets,
reviving concerns about rising counter-party risk and US dollar funding
shortages. Three-month Libor-OIS spreads in the
Highlighting the EU-IMF rescue package, BIS notes that having lived through the turmoil of 2008, policy-makers anticipated the end-game and took action to prevent a global confidence crisis. Their response took the form of a 750 billion euro rescue package announced in the early hours of Monday, 10 May. The ECB supported this move by taking the decision to purchase euro area public and private debt securities in the secondary markets to help restore market liquidity.
By early June, the ECB had reportedly purchased 40 billion euro of euro area government bonds, sterilized through the auction of one-week fixed-term deposits. Moreover, the ECB expanded its longer-term refinancing operations.
The Federal Reserve also took steps to relieve some of the US dollar interbank funding pressures by agreeing to reintroduce US dollar swap lines with key central banks. The US dollar swap lines were identical in size to those announced previously - $30 billion for the Bank of Canada and unlimited for the other four central banks involved - and were authorized up to the end of January 2011.
According to BIS, asset price movements immediately following these announcements initially suggested that the contagion from the Greek crisis had been halted. Euro sovereign credit spreads narrowed sharply, the euro appreciated, and global equity markets rose. Conditions in European money markets improved with the spread between EONIA and Eurepo rates narrowing, particularly for Italian government bonds.
US dollar liquidity conditions eased, the euro-dollar basis swap spread narrowing by 10 basis points. Broader credit spreads also improved, with a sharp fall in European corporate CDS indices, says the review, pointing out also that the safe haven flows of the previous week reversed, lifting German bund and US Treasury bond yields while weakening gold and the Swiss franc.
However, the relief in markets turned out to be temporary, as investor confidence soon deteriorated on worries about the possible interactions between public debt and growth. Peripheral euro area sovereign bond spreads widened, despite bond purchases by national central banks. The euro also weakened, with volatility jumping sharply against other major currencies.
As confidence dropped, investors also scaled back their appetite for risky assets, including carry trade positions targeting currencies of commodity-exporting economies, such as the Australian dollar, the Norwegian krone and the Brazilian real. These had appreciated over the previous months on expectations that their economies would particularly benefit from a global economic recovery.
Despite the overall negative tone, government
bond auctions by
While investors sought to understand the rapidly
changing situation in the euro area, a number of financial regulatory
initiatives added to an already complex situation, says the review,
pointing as examples, EU finance ministers agreeing on
Later the same day, the German financial regulator
BaFin surprised markets by unilaterally announcing immediate restrictions
Then, on 20 May, the US Senate passed its financial reform bill, containing a number of measures designed to limit risk-taking by large banks.
According to BIS, as doubts mounted about the prospects for global economic growth, market participants pushed out the expected timing of monetary tightening in the major advanced economies.
"Such revisions in policy expectations in part reflected communication by these central banks that rate hikes were not anticipated in the near term, as well as investors' concerns that volatile market conditions could derail the nascent economic recovery. A further reason for the change in market expectations about monetary policy was expected fiscal consolidation in a number of countries and its possible contractionary effects."
Against this background of heightened uncertainty, says BIS, market participants focused on the deteriorating financial market conditions while often ignoring positive macroeconomic news.
"Similar positive news in the
According to the review, while European policy-makers introduced new support initiatives, a number of other monetary authorities continued to withdraw exceptional support measures. As planned, the US Federal Reserve completed its purchases of agency mortgage-backed bonds at the end of March. Although the Fed is no longer buying bonds, there are signs that its significant holdings of public sector bonds continue to help keep bond yields low.
While the decline in confidence further postponed the normalization of monetary policies in most advanced economies, other countries took steps to tighten policy from April onwards.
According to BIS, the Bank of Canada raised interest
rates by 25 basis points on 1 June. Moreover,
Market participants expected more policy tightening across a range of emerging market economies, although uncertainty about the pace of tightening increased.
On the one hand, many of these economies are facing rapid economic growth, currency appreciation and the risk of overheating in asset and property markets. On the other hand, the growth and inflation outlook has been complicated by the high volatility in commodity prices and the unpredictable effects on economic activity of the euro sovereign debt crisis, concluded BIS.
In another section of the review highlighting international banking and market activity, BIS finds that the integration of European bond markets after the advent of the euro has resulted in a much greater diversification of risk in the euro area.
As of 31 December 2009, banks headquartered in
the euro zone accounted for almost two thirds (62%) of all internationally
active banks' exposures to the residents of the euro area countries
facing market pressures (
Together, they had $727 billion of exposures to
At the end of 2009, they had $958 billion of combined exposures ($493 billion and $465 billion, respectively) to the residents of these countries. This amounted to 61% of all reported euro area banks' exposures to those economies.
According to BIS, French and German banks were
most exposed to residents of
French banks were particularly exposed to the Spanish non-bank private sector ($97 billion), while more than half of German banks' foreign claims on the country were on Spanish banks ($109 billion).
German banks also had large exposures to residents
Government debt accounted for a smaller part of euro area banks' exposures to the countries facing market pressures than claims on the private sector.
The joint foreign claims of banks headquartered
in the euro zone on the public sectors of
These two banking systems had sizeable exposures
to the public sectors of
The largest non-euro area holders of claims on
the above four public sectors were Japanese and
In terms of the banks' Tier 1 capital, the combined exposures of German, French and Belgian banks to the public sectors of Spain, Greece and Portugal amounted to 12.1%, 8.3% and 5.0%, respectively, of their joint Tier 1 capital, said BIS. +