Liquidity Is Not The Same As Solvency
It’s more than troubling to think that the market has essentially been focused on the same underlying issues surrounding the Eurozone for over two years now. Despite the prolific liquidity facilities aimed at both the European banking system and Greece, the same fundamental solvency issues remain far from solved in my view.
The enactment of the ECB’s first three year LTRO operation in December appeased investors and their concern surrounding the European banking system. However, a by-product of ECB’s LTRO is that it has created a much greater reliance of Eurozone countries on the ECB. Notably, Spanish banks have increased their borrowings by €52 billion, from €116 billion to €168 billion post the LTRO operation; Italian banks increased their borrowings from the ECB by €42 billion in November and by €57 billion in December. Given the large increase in liquidity, and likely increase in excess reserves, it wouldn’t be too far-fetched for one to argue that those banks subsequently used a sizable portion of these excess reserves to invest in their own countries government bonds.
As a matter of fact, in January Spanish and Italian banks increased their government bond holdings by €24 billion (12% increase) and €28 billion (11% increase). While this action has resulted in a decrease in cash yields, the CDS market does not believe the current situation is sustainable highlighted by the “de-linking” of these markets since the liquidity program begin.
But whereas the market has interpreted the ECB actions as a strong signal to provide liquidity, the much more important question of long-term debt sustainability still remains.
One only has to look at Greek government yields on longer dated securities to know that the market thinks the recent bond swap will still not cure the solvency issue for Greece. Although the market seems satiated at present, it is most likely inevitable Greece will “come back to the well” again when austerity programs flounder and this time the German electorate will be less willing to fund their wayward southern neighbors resulting in an exit of Greece from the Eurozone – a risk the market appears to be ignoring at present!