Lower growth expectations and higher risk premia on peripheral European assets have weighed heavily on the EUR since the sovereign crisis began in late 2009. But, as Goldman's FX anti-guru Thomas Stolper notes, we have not seen evidence of a net capital flight crisis out of the Euro area that would have led to disruptive EUR depreciation (yet). Much of the reasoning for the relative stability is the Target 2 system and the high degree of capital mobility in European capital markets which have enabled the rise in risk aversion to be expressed by internal flows (as well as repatriation). With this weekend's election (and retail FX brokers starting to panic [9]), it is clear that the interruption of these internal channels may well lead to a disorderly capital flight and a full-fledged crisis in flows. Stolper outlines four potential catalysts to trigger this chaos (which is not his base-case 'muddle-through' scenario) as we already noted [10] the huge divergence between implied vols and realized vols indicate the market is starting to price in more extreme scenarios and safe-havens (swissy) are bid.
Thomas Stolper, Goldman Sachs - What Could Turn an Orderly EUR Decline into a Capital Flight Crisis?
Euro Decline Has Been Orderly So Far...
as vol seems well-controlled, yet as we have pointed out earlier, implied vol (forward expectations of volatility) is rising very notably.
[11]
Thanks to ECB Facilities /Financial Market Integration
To understand the ‘orderly’ nature of the EUR sell-off so far, we need to look at the underlying mechanics of the EUR decline. An escalation in country risk tends to lead to higher risk aversion by both local and domestic investors.
At a first level, risk aversion is expressed by a search for ‘safety’ in cash, cash equivalents or short-term government bonds within the economy.
At a second level, risk aversion is expressed by capital leaving the country on a mass scale and within a short time-frame. It is this second level of escalation to risk aversion that is associated with a capital flight crisis.
In the Euro area context, the existence of the Target 2 facilities and the integration of Euro area financial markets has helped avoid disruptive capital flight from the region by allowing investors across the region to buy government securities issued by core Euro area countries deemed to be safer. Target 2 accommodates large-scale cash outflows from the banking system of peripheral countries to that of core countries. Financial market integration (very few controls or taxation on capital mobility) allows investors to turn their portfolios around rapidly in order to hold government securities in those countries considered ‘safe havens’ within the EMU.
Assuming that a disruptive capital flight crisis were associated with a high demand for physical cash, it is interesting to observe that we have seen no evidence of such developments in data linked to currency in circulation by the ECB (see Chart below).
[12]
The existence of ECB facilities and the integration of Euro area financial markets is a necessary, but not sufficient, condition to avoid capital flight from the region. The fact that investors can easily shift their capital within the Euro area does not mean that they will.
However, for local investors, shifting to a foreign currency involves additional risk-taking. Private investors need to be willing to take currency risk on their savings at a time of high uncertainty and risk aversion. Institutional investors are often not even mandated to take currency risk. For individual investors, the cost of converting Euros into foreign currency can be very high—and holding EUR notes may be a viable alternative for residents in peripheral countries.
As for foreign investors, they may choose to return to their base currency. But the impact from their capital flight has so far been offset by local investors repatriating capital back into the Euro area, as we have discussed in the past.
In essence, the Euro area balance of payments remains remarkably balanced compared with most other regions and countries. Moreover, even in periods of extreme stress in peripheral countries, it is not obvious that capital flight out of the Euro area will materialise in a substantial way.
Disrupting Internal Flows Could Trigger a Euro Capital Flight Crisis
At the extreme, and in the absence of a legislated true European risk-free asset, a capital flight crisis could hypothetically occur, if investors start doubting that any placement in cash or government bonds can guarantee them a return of their placement in Euros.
Barring that very extreme and highly unlikely outcome, it becomes clear from the analysis above that a EUR capital flight crisis can be triggered only if the avenues of internal capital mobility within the EMU are somehow disrupted.
So what could cause such a disruption? In principle, it could be a situation or a policy initiative that either incentivises or forces people to seek a safe return of (rather than on) their principal in a jurisdiction outside the EMU, despite the considerable FX risks involved.
Some examples we can contemplate are:
- Invalidation of the ECB’s Target 2 facilities would interrupt the (so far unlimited) capacity to shift cash within the European banking system. Even a signal that such a development could occur (upon certain conditions) in just one country in the EMU could potentially lead to a large-scale flight of deposits from the Euro area.
- Capital controls within Europe, and legislated barriers to capital transfers within European financial markets, would have a similar impact.
- Taxation by core countries on capital inflows is sometimes viewed as a disincentive for capital to migrate from the periphery to the core. Should it be applied on a large scale, it could make the relative risk-reward of assuming currency risk to safeguard return of principal more appealing.
- Negative yields on core European fixed income. It is possible to envisage that, at times of extreme tensions, nominal yields for core European bonds could decline below zero as investors could decide to pay a premium for ‘insurance’ on their capital. Sufficiently negative yields could also increase the risk-reward for local investors to assume currency risk.
This is not an exclusive list of triggers for a capital fight crisis in the Euro area. Nor are all of these examples equivalent in terms of their impact (for example, Target 2 disruptions could cause much more tension than return disincentives). But it helps illustrate the types of outcome that have the potential to derail the current Euro area investor/depositor rational bias to remain EMU-based.