The European sovereign debt crisis 2.0


Despite their best efforts, governments in European countries have so far been unable to curb inflation this year. Russia’s invasion of Ukraine was the spark that finally ignited the crisis that had been looming since the outbreak of the COVID-19 pandemic in 2020.

In June, EU Member States released their Consumer Price Index (CPI), showing that prices have risen significantly from the figures released in June. Spain recorded a 10.8% increase in the CPI, with Belgium just behind its 10.4% rise. Austria and Portugal saw their CPIs increase by 9.3% and 9.1%, while Germany and Italy recorded increases of 8.5% and 8.4%. The CPI in France rose 6.1% from its June figures.

To fight against rising inflation, the European Central Bank (ECB) raised its three key rates by 50 basis points. The interest rate on the main refinancing options and the interest rates on the marginal lending facility were increased to 0.50% and 0.75%, making this the first time the ECB has raised rates since 2011.

ECB President Christine Lagarde said rising interest rates will put downward pressure on prices and help the ECB bring inflation down to 2%. However, Lagarde’s plan will only work “in the absence of further disruptions”, with energy costs stabilizing and supply bottlenecks diminishing.

So far, the rapid fall in real rates is only a problem for the eurozone. With winter fast approaching, energy prices are starting to rise significantly in the EU, with some countries actively planning for intermittent blackouts throughout the fall and winter.

In Germany and France, next-year prices per megawatt-hour have risen 10-fold since last year, with other countries bracing for increases that could exceed 1,000% by the end of the year. winter.

Economists have warned that the lack of energy could close factories and bankrupt small businesses unable to afford the cost of electricity.

electricity cost europe germany
Annual electricity prices in Germany from 2012 to 2022

Although many believe that the end of the war in Ukraine will end the energy crisis in Europe, there are many other factors at play that could prolong the crisis well beyond the war.

Europe’s dependence on Russian natural gas has ended nuclear power generation in the region. This reduction in the use of nuclear energy has hit France the hardest, as 31 of its 57 nuclear reactors are shut down due to emergency maintenance. Since the start of the year, France has imported energy for a record 102 days. In comparison, the country imported no energy between 2014 and 2016.

The EU’s push for green energy has also prompted many countries to turn off their coal-fired power plants and switch to natural gas or renewable energy sources such as solar or wind power. This was felt most in Germany, where local government efforts to reduce reliance on dirty energy sources could backfire. With few other countries as dependent on Russian gas as Germany, the country now has to deal with the backlash of rising energy prices and its effects on the economy.

Germany’s producer price index (PPI) rose 33% in July and is expected to rise as winter approaches. Every increase in the PPI affects producers and consumers – rising production costs make local manufacturers less competitive and destroy their margins. On the other hand, consumers bear the increased cost of the final product. The continued growth of the PPI and CPI has even led German unions to demand an 8% statewide wage hike, a move that many economists have warned could further exacerbate. inflation.

europe germany ppi
Germany’s PPI from 2002 to 2022 (Source: The Daily Shot)

Meanwhile, the ECB’s attempts to fight inflation in its southern member states have caused even more damage to the euro.

In July, the ECB revealed its new plan to cap borrowing costs in Italy, Spain, Portugal and Greece by buying up the countries’ government bonds if their debt yields rise too much. Data released earlier this month revealed that the ECB deployed 17.3 billion euros to buy bonds from southern members of the EU. The debt was purchased using funds from maturing debt in its existing bond holdings. Official statistics show that the ECB’s net holdings of German, French and Dutch bonds have fallen by 18.9 billion euros over the past two months.

To facilitate its aggressive bond buying, the ECB divided the EU into three categories: donors including Germany, France and the Netherlands, and recipients including Italy, Spain, Portugal, Greece and neutral countries.

The bank indicated that the financial fragmentation between these categories compelled it to activate these purchases. When the ECB announced the plan, the BTP-Bund spread hit a two-year high of 250 basis points.

The BTP-Bund spread is the difference between the yield of Italian 10-year government bonds (BTP) and German 10-year bonds (bunds). Bond buying managed to reduce this spread to 183 basis points, but it rose to 229 points in one month as political instability in Italy challenged the country’s economic stability.

The importance of the BTP-Bund spread lies in Germany’s position. German debt has always been seen as a risk-free benchmark against which all EU debt was compared. However, soaring inflation and the impending energy deficit expected this winter could upset Germany’s ranking as the risk-free benchmark for sovereign debt in Europe and introduce more volatility into the secondary bond market.

europe italy 10 year bonds
10-year yield on Italian government bonds (Source: TradingView)

Many banks and institutions question both the effectiveness and the legality of the ECB’s intervention in Italy. Aggressive bond buying put an end to any attempt to stabilize inflation in the country.

Meanwhile, rising bond yields could cause EU members to default and enter hyperinflation. With all EU members sharing the same currency, a hyperinflated euro in one member state could lead to similar volatility in others.

This makes the ECB the buyer of last resort for the majority of the European bond market, as the central bank will fight to prevent its members from defaulting. The ECB will have to print more money to fund these bond purchases if the debt on its existing bond holdings does not mature in time. However, increasing the rate of printing new euros will do little to curb rising inflation in Europe.

The second currency in the world in terms of market capitalization, the euro has lost 16% of its value against the US dollar since the beginning of the year. It also fell below par with the US dollar for the second time this year.

parity eur usd europe
EUR/USD parity from January 2022 to August 2022 (Source: TradingView)

If the Federal Reserve continues to raise rates and the ECB continues to buy European debt, this downward trend could continue in the coming months and further aggravate the rise in energy and food prices. .

Historically, people have flocked to durable and scarce assets during recessions, choosing tangible investments like commodities, land and real estate. If a recession hits Europe hard, we could see an influx of money into the crypto market, especially Bitcoin. Bitcoin’s reputation as a safe-haven asset could make it attractive both as a long-term investment and as a store of value. Recent efforts by the Russian and Iranian governments to introduce cryptocurrencies as a means of payment could inspire other countries to follow suit. Increased adoption could eventually lead to major regional gas and energy producers demanding cryptocurrency payments if the euro remains on its current path.


Comments are closed.