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Friday, May 17th, 2013

You Can’t Fight Fundamentals Forever…
posted by Brian Biggs

The Maastricht Treaty, the cornerstone of the Eurozone as we know it today, sets out some straightforward criteria for membership of the single currency area.  A strict inflation target, low government debt and deficits, a prudent pre-euro exchange rate – taken together this package of economic requirements became known as the “euro convergence criteria” and is meant to bring a country’s economic structure in line with an ideal EU average prior to joining the euro.  In practice, many of the Eurozone’s founding or early members fell short of these criteria, either through outright falsification before joining or ignoring their self-set rules subsequently.  Indeed, joining the euro, the European Commission recognises, allowed many macroeconomic imbalances to remain or even worsen.

One area where the Eurozone did manage to achieve convergence is in government borrowing costs.  The Maastricht Treaty, economists argued, had the effect of minimising currency risk premiums among future Eurozone countries over time, and effectively disappeared with the introduction of the euro.  Countries enjoyed investor faith in the euro, which was viewed as a hard currency.  If this is the case, then it stands to reason that if investors were to lose faith in the euro as a hard currency, or that economic fundamentals had not come into line sufficiently to minimise currency or default risk, then borrowing costs should rise.  Unsurprisingly, this is what happened.

Figure 1: Annual average yield on 10-year sovereign bonds, 1995-2012

Source: United Nations, Bloomberg, Europe Economics

In fact, those countries that benefitted the most from joining the euro are precisely those countries that are now seeing their yields rise.  In order, Greece, Italy, Spain, and Portugal saw their borrowing costs fall the most between 1995 and 1999.  Finland, France, Germany, and the Netherlands also witnessed yields on their sovereign debt come down, but less than the GIPS group. 

Core countries benefitted from the reduction in risk premiums brought on by the euro, but it also appears their fundamentals were more in step with what investors prefer, as yields on their debt since 2008 have fallen as well.  That, or they’re the “cleanest dirty shirts” for investors that can’t get out of their euro exposure.

GIPS countries, on the other hand, borrowed at lower rates almost exclusively due to the risk premiums effect of the euro.  As Eurozone members, they allowed their fundamentals to go haywire and drift substantially in the wrong direction away from the Eurozone average.  Now they are, literally, paying for it.

Figure 2: Change in annual average yield on 10-year sovereign bonds

Source: United Nations, Bloomberg, Europe Economics

The hope of the Maastricht Treaty was that economic management principles imposed on countries before joining the Eurozone would minimise differences among national economic structures, allowing for a well-functioning currency union.  Instead, differences persisted, but were largely papered over — by euros.  The sovereign debt crisis exposed lingering differences and began to pull yields of distressed countries towards their pre-euro levels.  Rates on GIPS sovereign debt have fallen recently, thanks in part to economic reforms, and in part to the Draghi Put.  But you can’t fight fundamentals forever.  In the long-term, distressed Eurozone sovereigns, if they wish to remain in the single currency area, will need to continue to bring their economic fundamentals in line with their non-distressed peers to borrow at affordable rates.


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