Lessons we learned in 2011
By Patrick Artus
We believe financial market trends in 2011 have shown us four important characteristics of their functioning: liquidity crises can have a serious impact on solvent economic agents, be it eurozone banks or countries; the correlation of risks generated by the cross-holding of assets is very dangerous, especially banking risk and risk related to non-financial companies; the dollar and the U.S. Treasuries remain the safe-haven asset irrespective of the U.S. economic and financial situation; lastly, the correlation between all risky asset markets is huge during crises, to the point where practically only one risk factor remains.
We knew - and this became clear in the aftermath of the Lehman bankruptcy and once again during the eurozone crisis that banks could be faced with a liquidity crisis, especially with a serious funding problem, in the interbank market as well as in the bond market. These bank liquidity crises require a central bank to play the role of lender as a last resort to the banks, as the Federal Reserve, the Bank of England and the ECB have done: the central bank lends to the banks as long as they cannot raise financing normally in the financial markets. (**not sure what it means**)
But as we have seen, which is new and surprising, that solvent countries could also be faced with a liquidity crisis. Spain and Italy are solvent, they can rapidly reduce their fiscal deficits and these two countries now have trade surpluses for industry. Yet, since July 2011 they have been faced with a dramatic liquidity crisis and therefore with a surge in interest rates, from 3 percent to over 6 percent for 10-year interest rates. This explains the debate on the need for the ECB to play the role of lender not only for banks but for countries as a last resort. For now the ECB has been doing the job only for modest amounts, and it needs to do it without encouraging governments to avoid cleaning up their public finances.
The second message from 2011 in the financial markets concerns the dangers of cross-holding. In Europe there has been a high correlation between sovereign risk, banking risk and risk related to non-financial companies. It is very dangerous, because when sovereign risk perception increases, the funding costs of banks and of the economy increase, growth slows down, and the public finance situation deteriorates further. This correlation is mainly due to the banks’ holdings of national government debt. At the end of September 2011, the eurozone banks held 140 billion euros in eurozone government debt. Cross-holding of assets is therefore dangerous if it is not essential for the financing of the economy.
The third message concerns the dollar's role. The financial situation of the United States is poor: fiscal deficit and public debt have sharply risen due to the high level of deindustrialisation. Despite this poor financial situation, all increases in risk aversion, after the Lehman bankruptcy and once again in 2011 with the eurozone crisis, have driven investors back to the dollar, which explains its appreciation and the capital outflows from emerging countries. These capital flows primarily return to the markets for the U.S. Treasury bonds, which accounts for the very low level of their interest rates: in December 2011, 2 percent for the 10-year interest rate, 0.2 percent for the 2-year interest rate.
The last message is that the correlation between all asset markets can lead to global financial contagion during crises. This occurred in 2011 that the perceived seriousness of the eurozone crisis had an impact on the prices of all risky assets including non-European assets. This concerned equities of the OECD countries, emerging-country assets, exchange rates and, as we have already seen above, bank debt and corporate debt.
This correlation between returns on risky assets is so high during crises that only one risk factor and practically only one risky asset remain: investors no longer have any options to diversify their portfolios between risky assets and the risks accumulate, which obviously increases the financial fragility. Our observation of the financial markets in 2011 has therefore shown us that they are violent: liquidity crises appear even in solvent countries; there is a dangerous correlation between risks (sovereign, banking, corporate) due to cross-asset holdings; a sudden return to the dollar when risk aversion increases; lastly, an extremely high correlation between the returns on all risky assets during crises, which removes the ability to diversify the risks.