What does political risk in the eurozone really mean?
Over the past few decades, general elections have rarely made a discernible impact on European financial markets. We all know investors who get animated about politics at the bar after work but who are far more concerned about company profits and the rate at which they should discount them into today’s price when at their desks. Left, right or centrist, European political victories have rarely presented a game-changing force to the direction of either.
So why are investors reading the political pages of De Telegraaf and chasing their French colleagues for information on the Parti Républicain? They care for one reason only — the existential threat these elections now pose to the European Monetary Union. When we hear eurozone political risk, it’s just short-hand for the possibility that the euro breaks apart.
The disintegration of the eurozone would be one of the largest financial shocks in modern history. Currency unions have broken apart before, but none in recent decades compare with the size, global significance and level of cross-border financial integration of the eurozone. Firms and financial institutions have transacted trillions of euros on the assumption of zero exchange-rate risk. The dislocation that would ensue if this risk needed to be re-priced would swiftly give way to a sclerosis of the real economy.
Consider the great financial crisis of 2008: this was a crisis induced by a mispricing of risk first in the US mortgage markets and then international bank financing markets. It caused a great economic recession because of the dislocation to bank, corporate, household and government funding that the subsequent repricing of risk imparted.
The 2011—12 eurozone debt crisis provided a taster of what a break-up might be like for investors. As they realised some government finances and banking systems were shakier than others — and so probably didn’t deserve the ultra-low borrowing costs assigned to them since the creation of the euro — financing markets seized up and economies ground to a halt as the market scrambled to re-price the evident risks. Indeed, it would have been far worse if the European Central Bank hadn’t eventually pledged to doing “whatever it takes” to prevent investors — via the debt markets — from forcing the break up. But while the ECB can combat market forces, it can’t resist the will of the people.
The anti-EU Geert Wilders won only 13% of the vote in the recent Dutch elections. The spotlight is now on France but its two-stage presidential election process gives voters the opportunity to rally against an extremist candidate — as they did with Jean-Marie Le Pen in 2002. The core pillars of the EU are also popular in France: 80% of people view the free movement of EU citizens positively, while 68% support the euro and the monetary union. That said, we are concerned that in the Eurobarometer survey — one of the few polls to suggest the UK would vote for Brexit — the number of French respondents for whom the EU ‘conjures up a positive image’ has dipped below those with a negative impression for the first time.
We are keeping a close eye on market-based indications that political uncertainty is starting to spill over into any contagious, dislocating scramble to re-price risk. We start with government spreads — the borrowing costs French, Italian and Spanish governments have to pay relative to Germany. They have increased notably since last summer, but remain well below the eurozone debt crisis levels of 2011—12.
We then look at bank financing — the costs banks pay to fund their activities, as well as what holders of bank bonds pay to insure against default. The cost of insurance has been falling since November and is now 25—30% of the costs commanded in 2011. The cost of bank borrowing itself has fallen even further and is now just 20% of the maximum borrowing cost in 2011 and less than 10% of the costs in 2008—09 (figure 6).
Figure 6: Europe's financial markets appear relaxed
The cost of borrowing for European banks has fallen dramatically since the financial crisis
We also look at the cost of ‘basis swaps’ — short-term, supposedly low-cost funding agreements in which one institution that requires dollars matches with an institution that requires euros. These are a particularly good indicator of systemic stress. Again they remain a long way below crisis levels, but have been trending higher over the past two years and perhaps signal more cause for concern than other measures.
In aggregate, the financial markets that really matter are rather cool on the political risk that really matters. Investors should be reassured by this.