Foreign holders of Greek and Portuguese debt have seized on emergency intervention by the European Central Bank to exit their positions, leaving eurozone taxpayers exposed to the credit risk.
By Ambrose Evans-Pritchard, International Business Editor
Published: 6:57PM BST 17 May 2010
Euro,dollar - Banks dump Greek debt on the ECB as eurozone flashes credit warnings Photo: AFP/Getty Images
The Bank of New Mellon said its custodial data showed a "sharp acceleration" of net sales of debt from the two countries after the ECB began purchasing €16.5bn of bonds from southern Europe and Ireland in bid to halt market panic. "It rather suggests that investors leapt at the opportunity to clear their balance sheets of intolerable risk," said Neil Mellor, the bank’s currency strategist. "This leaves the ECB itself in an unpleasant situation since it now faces a deterioration in its own balance sheet."
While ECB action has greatly reduced bond spreads on peripheral eurozone debt, it has not yet stabilized the broader markets. The euro fell to a four-year low of $1.2260 against the dollar in early trading. Jean-Claude Juncker, the head of the Eurogroup, said on Monday that this risks becoming disorderly. "I'm not worried as far as the current exchange rate is concerned: I'm worried as far as the rapidity of the fall is concerned."
Crucially, there are still serious strains in the interbank lending market. Hans Redeker, currency chief at BNP Paribas, said the LIBOR-OIS spread in Europe used to gauge credit stress is flashing danger signals, hovering near levels seen during the Lehman crisis.
The ECB’s strategy of draining liquidity to offset the stimulus from the bond purchases risks making matters worse. "They are using one-week deposits for sterilisation and the effects of this to make short-term funding more expensive. This will force banks to sell assets to shrink their balance sheet and risks causing a credit crunch," he said.
Mr Redeker said the ECB is pursuing a contractionary policy to assuage concerns in Germany that Club Med bond purchases will stoke inflation. "They have read the German press and it made their hair stand up on their necks. The reality is that a deflationary cycle is developing in Euroland and the ECB will eventually have to start quantitative easing," he said.
Dominic Wison, market chief at Goldman Sachs, said talk of an EMU break-up were overblown but echoed concerned about strains in the short-term money markets. "The LIBOR-OIS spreads widened consistently through the week. Ongoing pressures on funding have not yet been quieted. As we saw in 2008 and 2009, those stresses – if they do not subside – are generally toxic for markets," he wrote in a client note.
A report by RCB Capital Markets said German banks have yet to come clean on 75pc of their combined exposure to €45bn of Greek debt. The state-owned Hypo Re has revealed holdings of €7.8bn, equal to 243pc of its tangible equity. Commerzbanks’s subsidiary Eurohypo holds €3bn, or 77pc, of its tangible equity.
RBS said that some German banks may face risks if there is a voluntary debt restructuring by Greece, since this would not trigger debt insurance contracts on credit default swaps. This would leave them facing much larger debt write-downs than they bargained for.
Analysts say austerity measures across southern Europe are causing the euro to weaken further because they will dampen growth and may lead to protracted slumps, forcing the ECB to delay rate rises.
Italy is next in line for a fiscal squeeze, preparing €25bn of belt-tightening over the next two years. Leaks in the Italian media say Rome plans to freeze public sector wages, limit recruitment, and delay retirement.
The goal is to build a "primary" budget surplus (before interest costs) of 1pc of GDP in 2011 and 2.5pc in 2012 in order to demonstrate discipline to the bond markets. Finance minister Giulio Tremonti, who has been praised for his iron control of spending, aims to establish an ample margin of safety to secure Italy’s place in monetary union.
Italy’s impressive efforts – following austerity packages in Ireland, Greece, Portugal, and Spain – show much Britain has to do to avoid being left behind by other countries in what amounts to a beauty contest over deficits and sovereign debt in global markets.