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The banks and the government have joined the dance to save each other

Călin Rechea (translated by Cosmin Ghidoveanu)
English Section /

The banks and the government have joined the dance to save each other

Italian finance minister, Giovanni Tria, recently said that the yield of government bonds is not justified by the fundamental aspects of the budget and it is expecting a drop in them, in order for "the negative effects on the banking system to be avoided".

The statement presented by Bloomberg was made at the meeting of the Finance ministers of the G20 group and represents the first clear recognition of the phenomenon, known as the "loop of destruction", by the new Italian authorities.

How is the phenomenon manifesting itself? Banks buy government bonds without having to allocate additional capital (author's note: government bonds always have a zero risk weight), and financial institutions will see losses due to the drop in the market value of the securities in their portfolios, amid rising financing costs.

The next step is usually the forced sale of the government bonds in order to fit within the new risk limits, which lead to new increases in interest rates and further degradations of the government's fiscal position.

"We are hoping the spread will drop once there is a better understanding of the structure and the spirit of the budget", Giovanni Tria continued.

The Italian finance minister was obviously referring to the difference between Germany's and Italy's borrowing costs, which have recently reached a 5-year high, of over 310 basis points (see chart 1), as keeping them below the 400 basis points level is considered of crucial importance.

It is hard to believe that the "spirit of the budget" will convince banks and investors, especially if the European authorities prove inflexible and will insist on the deficit staying below 2% of the GDP, significantly below the proposal of the Italian government, of 2.4% of the GDP.

Unfortunately, the Romanian government also seems to be resolutely going down the "amorsării" of a "destruction loop", through its budget and fiscal policies. Of course, the danger is much greater in the case of Italy, a significant pillar of the Eurozone.

In Romania as well, the spread between the return of 10-year bonds compared to Germany's and US' similar securities has recently grown to a 5-year high, and the "redresările" seen in the beginning of 2017 took place among a significant upward trend.

Pressures on the borrowing costs have increased so much in October 2017, that all the auctions for government bonds have failed. Then, the government was looking to borrow 2.44 billion lei.

In October 2018, the situation has radically changed, as the NBR has launched the repo operations, by which it grants liquidity to the banks, in August 2018.

After the first four auctions, the government borrowed 2.27 billion lei, as the amount scheduled in the prospectus was 1.795 billion. According to the prospectus, the government scheduled the drawing of 4.695 billion in October 2018, amid a maturity of over 8 million lei next month.

In the last auction of last week the issue RO1720DBN072 with a 3 year maturity, a coupon of 2.3% and a maturity in October 2020 has been reopened.

The amount raised, including in the additional session, was about 1.028 billion lei, while the scheduled amount was 575 million.

Upon first sight, the auction can seem like a resounding success, but the "enthusiasm" needs to be significantly tempered, because the median return was 4.07%, by 17 basis points over the yield of the similar auction one month ago and 177 basis points above the coupon.

The real problem of the median term borrowing costs is reflected in the evolution of the yields for the bonds with the RO1720DBN072 ISIN of the first auction, of August 2017, until now.

More than a year ago, in August 2017, the government was borrowing 575 million as part of the RO1720DBN072 issue, at a median yield of 1.88%. The next month, the same amount was borrowed at a yield of 1.91%.

Then came the shock of October 2017, when the call for bids failed, and in the auction of November 2017 the "surprise" came: out of the scheduled amount of 575 million, the government only raised 265 million, at a yield of 3.45%.

The median return for the auctions of the RO1720DBN072 issue was 3.39% after the failure of October 2017 until the next failure, of May 2018.

A new "success" for RO1720DBN072 was encountered in July 2018, when the government borrowed 381 million lei, amid a scheduled amount of 300 million, for a return of 4.4%.

Since then, the median return for these bonds with an initial maturity of 3 years is 4.04%.

The number of government bond auctions failed reached a record of 16 in 2017, and in 2018 the number of "failures" stopped at 10 after the first five months of this year.

Judging by what the evolution of the government bond auctions of the last two months, it seems that a "truce" has been signed between the government and the banks, in which banks offer bigger amounts, and the government is "offering" higher yields, so that it doesn't cross over the threshold of the acute phase of "the destruction loop".

How much longer can this "dance" continue, with its constantly rising price for taxpayers? Not much longer, as we will have some unpleasant surprises when it comes to the economic rise and the budget deficit, and the liquidity on the international markets will continue to drop.

"Central bankers are under pressure, as populists are looking for easy solutions", Reuters writes about the new dynamic of relations between governments and central banks, an issue which has been discussed in the annual meeting of the International Monetary Fund and the World Bank.

There, Mario Draghi, the president of the ECB said that "central bankers are being asked to change the interest rates, cancel the debts, buy bonds directly and other things".

But isn't that what major central banks have been doing, with the exception of canceling debts, over the last ten years?

While they decry the threats to their sacrosanct independence and are feeling threatened by the wave of populism, shouldn't central bankers accept at least part of the blame for the new state of things?

Haven't things come to this point precisely because of the ultralax monetary policies, marked by the printing of money and even by interest rates?

And before accusing the populists of wanting cheap money to fulfill their electoral promises, shouldn't it be acknowledged that the irresponsible politicians who preceded them have wanted the same things?

This is the international contest in which the Romanian banks and the government of the country seem to have joined in the "dance" to rescue each other.

"As long as the music is playing, you need to get up and dance", was saying, in the summer of 2007, Charles Prince, executive director of Citigroup, told Financial Times.

And Citigroup "danced" until the autumn of 2008, when it fully benefited from the federal program for the saving of Wall Street.

In 2012, Sheila Bair, former president of the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits in the US, said that "I often wonder if we would have had the massive bailout programs, had Citi not been in trouble", according to James Freeman and Vern McKinley in the book "Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi".

How long will the music play this time?

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