Central Banks

Friday, May 25, 2012 - 08:26

EuroView: Capital Fleeing Entire Periphery, Not Just Greece

By Jack Duffy

PARIS (MNI) - The start of a bank run in Greece has captured the headlines, but it may be the run by foreign investors on the entire periphery that poses the biggest challenge to the Eurozone.

While less visible than a rush by Greeks to withdraw their passbook savings, a move by non-residents to pull deposits and dump government bonds in countries like Italy and Spain is gathering pace, according to official data and analyst reports.

In Italy, foreign investors reduced their holdings of government bonds by nearly E100 billon, or 12%, in the second half of last year. In Spain, non-residents dumped E37 billion, or 14%, of their government bonds between November and February. And by some accounts the pullback has accelerated as LTRO money has made domestic banks big buyers and foreigners even bigger sellers.

Richard McGuire, senior strategist at Rabobank, notes that if the declines continue at their recent pace, international holdings of Italian government debt will be back to pre-euro era levels by July of next year. Spain could be back to pre-euro levels by year-end 2013.

The departure of foreign investors "is pushing us toward a make or break moment" in the Eurozone," McGuire said. "The only solution to the crisis is fiscal union of some sort," he said. "This kind of capital flight, or de-euroisation, is pushing us away from that."

Fitch estimates that at the end the first quarter, foreign investors held just 34% and 32%, respectively, of Spain and Italy's public debt, down from more than 60% and around 50% in 2008.

But the capital flight is not just in government bonds. Matt King, global head of credit products strategy at Citigroup, says that from their peak bank deposits by foreigners have fallen by 64% in Greece, 55% in Ireland, 37% in Portugal, 13% in Spain and 34% in Italy.

In a research note, King noted that Italy lost E160 billion in foreign private capital in 2011, while Spain lost about E100 billion. If capital outflow reaches the same average level that has occurred in Greece, Portugal and Ireland, Rome and Madrid could each lose another E200 billion, he said.

"Capital flight will stop only once there is decisive policy intervention," King says. "The longer investors have to wait for this, the more decisive it will need to be."

The fact is that investors no longer believe that a Greek euro, or a Spanish euro, or an Irish euro is the same as a German, Finnish or Austrian euro. As a consequence, private foreign capital is draining away from the periphery and being replaced with official capital, mostly provided by the European Central Bank.

European Union leaders meeting in Brussels on Wednesday promised to take monetary union "to the next level" but did not agree on any concrete steps likely to convince foreign investors that the euro is a safe bet, even in the short term.

Steps to a possible solution could be a pan-European deposit insurance program to stop deposit flight. Or a more active and flexible role for Europe's bailout fund in supporting vulnerable banks. Or setting a timetable for the issuance of common Eurobonds once the fiscal compact treaty has been fully ratified.

But bold steps in the Eurozone only happen at moments when leaders must act to avoid a catastrophe. And while Europe may be approaching such a moment, it is not there yet.

"We believe that the crisis must get worse before it gets better," said McGuire of Rabobank. "It is only when the crisis reaches a certain point of tension that leaders are driven to look beyond their own narrow political interests."

In the meantime, as the threat of bank runs hangs over Greece and Spain, the flight of foreign capital goes quietly on. With around E900 billion of Italian and Spanish government bonds still in foreign hands, there could be a lot more selling to come.

(EuroView is an occasional column written by Market News International editorial staff. Any views expressed are solely those of the writer)

--Paris newsroom; 33142715540; jduffy@marketnews.com

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