Saturday, December 27, 2014

27/12/2014: Geography of the Euro Area Debt Flows

The debate about who was rescued in the euro area 'peripheral' economies banking crisis will be raging on for years to come. One interesting paper by Hale, Galina and Obstfeld, Maurice, titled "The Euro and the Geography of International Debt Flows" (NBER Working Paper No. w20033, see puts some facts behind the arguments.

Per authors, "greater financial integration between core and peripheral EMU members had an effect on both sets of countries. Lower interest rates allowed peripheral countries to run bigger deficits, which inflated their economies by allowing credit booms. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. The result has been asset-price bubbles and collapses in some of the peripheral countries, area-wide banking crisis, and sovereign debt problems."

The causes explained, the paper maps out "the geography of international debt flows using multiple data sources and provide evidence that after the euro’s introduction, Core EMU countries increased their borrowing from outside of EMU and their lending to the EMU periphery."

So braodly-speaking, core euro area economies funded excesses. Hence, in any post-crisis rescue, they were the beneficiaries of transfers from the 'peripheral' economies and taxpayers.

Some details.

According to Hale and Obstfeld, "one mechanism generating the big current account deficits of the European periphery could be summarized as follows: after EMU (and even in the immediately preceding years), compression of bond spreads in the euro area periphery encouraged excessive borrowing by these countries, domestic lending booms, and asset price inflation. We further argue that a substantial portion of the financial capital flowing into the European periphery was intermediated by the countries in the center (core) of the euro area, inflating both sides of the balance sheet of the large financial institutions in the euro area core."

So, intuitively, lenders/funders of the asset bubbles should be bearing some liability. And it would have been the case were the funds transmitted via equity or direct asset purchases (investment from the Core to the 'periphery' in form of buying shares or actual real estate assets). Alas they were not. "These gross positions largely took the form of debt instruments, often issued and held by banks. Thus, EMU contributed not only to the big net deficits of the peripheral countries, but to inflated gross foreign debt liability and asset positions for nonperipheral countries such as Belgium, France, Germany, and the Netherlands – countries that all experienced systemic banking crises after 2007."

Debt, as we know it now, has precedence over equity when it comes to taking a hit in a crisis, and debt is treated on par with deposits. Hence, "the tendency for systemically important banks to increase leverage in line with balance sheet size …implied a substantial increase in financial fragility for these countries’ financial sectors."

In the short run, prior to the crisis, leveraging up from the Core into the 'periphery' had a stimulative effect on asset bubbles. "Four main factors contributed to the suppression of bond yields in the European periphery after the introduction of the euro.
- First, the risk of investing in the European periphery declined with the advent of the euro due to investor assumptions (perhaps erroneous) about future political risks, including the possibility of official bailouts.
- Second, transaction costs declined and currency risk disappeared for euro area investors investing in the periphery countries.
- Third, the ECB’s policy of applying an identical collateral haircut to all euro area sovereigns, notwithstanding their varied credit ratings, encouraged additional demand for periphery sovereign debt by euro area financial institutions, which, moreover, were able to apply zero risk weights to
these assets for computing regulatory capital. The EU’s recent fourth Capital Requirements
Directive continues to allow zero risk weights for euro area sovereign debts, even though the borrowing countries cannot print currency to pay their debts.
- Fourth, financial regulations in the EU were harmonized and the euro infrastructure implied a more efficient payment system though its TARGET settlement mechanism."

Crucially, all four factors combined to reinforce each other giving "…core euro area financial institutions a perceived comparative advantage in terms of lending to the periphery, and this would also likely have affected financial flows from outside to both regions of the euro area.

In line with the above, the authors find:
- "...strong evidence of the increase in the financial flows, both through debt markets and
through bank lending, from core EMU countries to the EMU periphery."
- "… that financial flows from financial centers to core EMU countries increased, but predominantly due to increased bank lending and not portfolio debt flows.
- "In addition, …evidence from the syndicated loan market that is broadly consistent with the core EMU lenders having a comparative advantage in lending to the GIIPS."

Net conclusion: "The concentration of peripheral risks on core EMU lenders’ balance sheets helped to set the stage for the diabolical loop between banks and sovereigns that has been at the heart of the euro crisis."

Authors quote other sources on similar: “German banks could get money at the lower rates in the euro zone and invest it for a decade in higher yielding assets: for much of the 2000s, those were not only American toxic assets but the sovereign bonds of Greece, Ireland, Portugal, Spain, and Italy. For ten years this German version of the carry trade brought substantial profits to the German banks — on the order of hundreds of billions of euros ... The German advantage, relative to all other countries in terms of cost of funding, has developed into an exorbitant privilege. French banks exploited a similar advantage, given their major role as financial intermediaries between AAA-rated countries and higher yielding debtors in the euro area.” (From Carlo Bastasin, Saving Europe: How National Politics Nearly Destroyed the Euro, Washington, D.C.: Brookings, 2012, page 10.)

Charts below summarise flows from Core markets to 'peripheral' markets

CPIS is stock of portfolio debt claims from CPIS data in real USD:

BISC is stock of total international bank claims from consolidated BIS data in real USD:

BISL Flow is valuation-adjusted flows of total cross-border bank claims from locational BIS data in real USD:

And conclusions: "Not only did peripheral countries borrow more after EMU; in addition, financial institutions in the core of the euro area expanded their balance sheets to facilitate peripheral deficits, thereby increasing their own fragility. This pattern set the stage for the diabolical feedback loop between banks and sovereigns that has been such a powerful driver of the euro area's recent crisis."

So next time someone says that 'periphery' is to be blamed for the causes of the crisis, send them here. for in finance, like in dating, it takes two to tango…

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