The European Central Bank (ECB) has signaled the end of its asset purchase program and even a possible rate hike before 2019. After more than 2 trillion euros of asset purchases and a zero interest rate policy, it is long overdue.
The massive quantitative easing (QE) program has generated very significant imbalances and the risks far outweigh the questionable benefits. The balance sheet of the ECB is now more than 40 percent of the eurozone GDP.
The governments of the eurozone, however, have not prepared themselves at all for the end of stimuli. They often claim that deficits have been reduced and risks contained. However, closer scrutiny shows that the bulk of deficit reductions came from lower cost of government debt. Eurozone government spending has barely fallen, despite lower unemployment and rising tax revenues. Structural deficits remain stubborn, and in some cases, unchanged from 2013 levels. In other words, the problems are still there, they were just hidden for a while, swept under the rug of an ever-expanding global economy.
Savings Illusion
However, that illusion of savings and budget stability will rapidly disappear as most Eurozone countries face massive amounts of debt coming due in the 2018–2020 period and wasted precious years of quantitative easing without implementing strong structural reforms. The recent troubles of Italian banks are just one precursor of things to come.Taxes rose for families and small and medium-sized enterprises, while current spending by governments barely fell, competitiveness remained poor, and a massive 1 trillion euro in nonperforming loans raises doubts about the health of the European financial system.
The main eurozone economies face more than 2.1 trillion euros in debt maturities between 2018 and 2021. This, added to lower tax revenues due to a global economic slowdown and rising spending from populist demands, creates an enormous risk of a large debt crisis that no central bank will be able to contain. Absent of structural reforms, the eurozone faces a Japan-style stagnation or a debt crisis.
The ECB warned in 2014 that “many euro area countries did not take advantage of the favorable economic conditions prior to the crisis to build up a fiscal buffer for future downturns.” This is happening again, but much worse, as average debt to GDP has soared to almost 90 percent and government spending as a percentage of GDP remains above 40 percent.
Higher Yields
Where would bond yields be if the ECB was not the largest purchaser of eurozone bonds? We do not know for sure, as there is no discernible market demand at these levels. At the peak of QE in the United States, the Federal Reserve never bought 100 percent of newly issued Treasuries.Today, the ECB program buys more than three times the net issuances. This means we have no clue of what the real market demand for eurozone sovereign bonds is and what yields would be demanded by investors to compensate for the risk of highly indebted governments.
What we know is that yields would be a lot higher. I estimate a minimum of 1.2 percent above current yields would be needed to reflect the inflation expectations.
Of course, the eurozone nations would not feel the whole increase in expected yields. At the peak of the euro crisis, Spain’s average cost of debt was 3.4 percent or almost 300 basis points below to where yields of the standard issue bond rose. But the return of yields to normalized levels will likely affect confidence as the placebo effect of QE vanishes and reality returns. If they persist long enough, they will feed through the average cost of debt as well.
No single country in the eurozone except Germany, maybe the Netherlands, is ready for the end of QE.
Eurozone governments have wasted all the benefits of QE in higher current spending and kept structural deficits.
Now the tide is turning. Even if the ECB decides to delay the end of QE, the reality is that sovereign yields and credit default swaps have been quietly rising. Not just due to the Italian crisis, but due to the evidence of unsolved issues coming back to the surface in Europe.
The worst part of this is that governments in Europe will likely decide to increase taxes to try to tackle rising deficits.
The combination of the already clear slowdown with higher taxes, stubbornly high spending, and rising deficits, as well as interest rates, can be a perfect storm for Europe that will likely bring back the ghost of the crisis.
Europe decided to tackle the crisis by hiding imbalances under a massive wave of liquidity, and governments abandoned all reforms to bet it all on monetary policy. Now, the reality is likely to show its face abruptly. And none of the governments in Europe are ready, because they are not even aware of the extent of the problem.
