The European sovereign debt crisis 2.0

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

In June, the EU member states published their consumer price index (CPI), which shows that prices have increased significantly since the figures published in June. Spain recorded a 10.8% rise in the CPI, closely followed by Belgium with a 10.4% rise. Austria and Portugal saw their CPIs rise by 9.3% and 9.1%, while Germany and Italy saw increases of 8.5% and 8.4%. The CPI in France rose 6.1% from its June figures.

To combat rising inflation, the European Central Bank (ECB) raised its three key interest rates by 50 basis points. The interest rate of the main refinancing options and the interest rates of the marginal lending facility have been increased to 0.50% and 0.75%, making it the first time that the ECB has raised rates since 2011.

ECB President Christine Lagarde said higher interest rates will push prices down and help the ECB reduce inflation to 2%. However, Lagarde’s plan will only work “in the absence of further disruptions”, with energy costs stabilizing and supply bottlenecks easing.

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

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

Economists have warned that the energy deficit could close factories and bankrupt small businesses that cannot afford the cost of electricity.

energy cost europe germany
Annual energy price in Germany from 2012 to 2022

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

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

The EU’s push for green energy has also caused many countries to decommission their coal-fired power plants and switch to natural gas or renewable energy sources such as solar or wind. This was felt most in Germany, where local government efforts to decrease reliance on polluting energy sources could backfire. With few other countries as dependent on Russian gas as Germany, the country must now deal with the pushback from 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 PPI affects producers and consumers: rising production costs make local manufacturers less competitive and destroy their margins. Rather, consumers bear the rising cost of the final product. The ever-growing CPI and CPI even prompted German unions to call for an 8% statewide pay rise, a move many economists have warned could further exacerbate inflation.

europe germany ppp
Germany PPI from 2002 to 2022 (Source: The Daily Shot)

Meanwhile, the ECB’s attempts to combat inflation in its southern member states have resulted in further damage to the euro.

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

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

The bank said that the financial fragmentation between these items forced 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 10-year Italian government bond yield (BTP) and the 10-year German bond yield (bunds). The purchase of bonds managed to reduce this difference to 183 basis points, but it rose again to 229 points in a month because the political instability in Italy called into question the economic stability of the country.

The importance of the BTP-Bund spread lies in the position of Germany. Historically, German debt has been considered a risk-free benchmark against which all EU debt was compared. However, skyrocketing inflation and a looming energy deficit for the winter have the potential to shake Germany’s ranking as a risk-free benchmark for sovereign debt in Europe and introduce more volatility in the secondary bond market.

10-year bonds Europe Italy
10-year yield on Italian government bonds (Source: TradingView)

Numerous banks and institutions question both the effectiveness and legality of the ECB’s intervention in Italy. Aggressive bond purchases shut down any attempt to stabilize inflation in the country.

Meanwhile, rising bond yields could cause EU members to default and go into hyperinflation. Since all EU members share the same currency, a hyperinflated euro in one member state could cause the rest to experience similar volatility.

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

The second largest currency in the world by market capitalization, the euro has lost 16% of its value against the US dollar since the beginning of the year. It has also fallen below parity against the US dollar for the second time this year.

europe eur usd parity
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 exacerbate the increase in energy and food prices.

Historically, people have flocked to hard, scarce assets in times of recession, choosing tangible investments like commodities, land, and real estate. If a recession hits Europe with full force, we could see a inflow 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 governments of Russia and Iran to introduce cryptocurrencies as a means of payment could lead other countries to follow suit. Greater adoption could eventually lead to large regional gas and power producers requesting cryptocurrency payments if the euro remains on its current path.

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