Eurozone contagion fears broke new ground in recent weeks with news of Portugal’s downgrade and rising Italian yields. In this interview, Lorenzo Pagani, portfolio manager and head of the European government bond and European rates desk at PIMCO, discusses the worsening eurozone sovereign debt crisis and how policymakers need to do more to stem the crisis.
Q: The eurozone debt crisis, which moved from Greece to Spain and now potentially Italy, has reached a critical juncture. Is the EU’s current approach working?
Pagani: The approach taken so far by European Union (EU) policymakers has been reactive at best, characterized by single steps forced by certain events. We believe this approach has been driven by the need to buy time without the will to fully commit the necessary political and economic capital needed to solve the problem. As a consequence, we now find ourselves facing a much bigger problem. The crisis has moved from Greece to Spain and to Italy in recent weeks, but the tools set up to address the crisis appear limited in scope and size to deal with the problem at hand.
As an example, the European Financial Stability Fund (EFSF) still has only around €250 billion of effective lending capacity, despite previous agreements by EU policymakers to increase it to its nominal capacity of €440 billion (which we feel would still be too small if Spain or Italy were to require support).
Uncertainty is currently very high. We believe the situation is definitely worse now compared to one year ago and the EU policymakers’ strategy – or lack thereof – seems to be one key reason for this. In addition, polarized policy debate has resulted in conflicting headlines, which only serves to further confuse an already uncertain situation.
Q: How might policymakers bring the situation under control?
Pagani: There must be a change in the strategy; single steps should be substituted by a comprehensive solution, and purely reactive behavior should be substituted by pre-emptive actions. We are currently lacking a clear vision about how to move from a single currency union for a group of heterogeneous countries with no fiscal union, toward a broader political and fiscal union that can survive in the long term. The recent widening of Italian credit spreads indicates that the markets are beginning to doubt EU policymakers’ willingness to realise this vision. Time may be fast running out.
Q: Some market participants are proposing the eurozone issue common bonds, or so called Eurobonds, as part of the solution. Do you think this is a plausible solution to the eurozone’s debt crisis?
Pagani: Proposals to issue joint Eurobonds explicitly guaranteed by EU members as a way of financing part of the debt of each member country would be a clear indication of the willingness to move towards a fiscal union. We believe the market would respond positively to such a decision.
Q: Italian credit spreads suffered unexpected widening in recent weeks; what do you think caused this?
Pagani: We still think that Italy’s fundamentals are intact and differ significantly from Greece, Ireland or Portugal. For example, our research has shown Italy to have a much smaller fiscal deficit compared with Greece, Ireland or Portugal and a much higher savings rate. It also has a smaller external deficit while its debt stock has a higher proportion of domestic ownership and longer weighted-average life. In addition, Italy’s banking sector is less leveraged than that of Ireland’s and Portugal’s. At this stage, we believe the recent widening in Italian credit spreads is driven by technical factors rather than deterioration in Italy’s fundamentals.
Italy tended to be considered the natural alternative for investors looking to underweight peripheral eurozone. As a result, most investors were overweight Italy, and the recent combination of events (i.e. disagreement among EU policymakers on the Greek issue, rating agencies’ action on Portugal, internal political wrangling in Italy) has triggered a bout of risk aversion among foreign investors that has caught domestic investors by surprise, inducing a widening of spreads.
Q: Given the resurgence of eurozone peripheral sovereign debt worries in recent weeks, how does PIMCO assess risks associated with further interest rate increases by European Central Bank?
Pagani: The European Central Bank (ECB) has tried to make a distinction between liquidity policies and monetary policy. It began the process of normalizing interest rates, but the recent turmoil in peripheral eurozone is likely to encourage the ECB to keep rate increases on hold for the time being. Conversely, we do not expect the ECB to cut interest rates at this stage unless the crisis gets significantly worse.
However, it is important to note that the ECB has other and arguably more effective means to address the effects of the peripheral crisis. For example, it could use its balance sheet to deploy a form of quantitative easing (QE) to help bridge a shift toward greater fiscal union.
Q: What, if any, impact would you say the European bank stress test results have had on European markets?
Pagani: The summary results show that only eight out of 90 banks failed the EU-wide stress test in 2011 with a combined capital shortfall of just €2.5 billion. At first glance this seems like a good result, but upon closer scrutiny this looks to us like the result of benign assumptions rather than the makings of a really solid banking system. The assumptions of this year’s stress test were tougher than last year’s, but they still seem to be describing a mild recession while ignoring the implications of a wider sovereign debt crisis. To be able to restore confidence in the banking system, we believe stress tests must be very conservative in their assumptions. In summary, this seems to be another missed opportunity for EU policymakers to restore lost confidence.
Nonetheless, this year’s stress test was instrumental in providing additional transparency on banks’ exposure to sovereign debt. Market participants with the necessary analytical resources, like PIMCO, can now conduct their own stress tests and apply the results to their investment processes.
Q: How could a downgrade of U.S. Debt impact European investors?
Pagani: Any potential U.S. credit downgrade within the next month is likely to be linked to the U.S. government’s failure to increase the debt ceiling, which could trigger a technical default. This would likely cause a significant increase in global risk premiums and volatility, and could amplify the problems within the European peripheral economies.
Q: How do PIMCO’s views on the European debt crisis translate into investment strategy?
Pagani: PIMCO’s outlook has been to underweight peripherals since the onset of the crisis. Our analysis reveals significant credit differentiation between sovereigns within the periphery.
In our view, Spain and Italy both face significant adjustment challenges and remain vulnerable to further technical contagion, but owing to their better initial conditions, we would consider Spain and Italy given their perceived relative value against other credit and global alternatives.
A comprehensive policy response from EU policymakers that results in greater fiscal integration - such as a common eurozone bond or a large scale asset purchase program - would encourage us to turn more positive on peripheral credit.
Thank you, Lorenzo