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IMF warns on euro zone bond market

A top IMF official has warned that the rally in euro zone bond markets risks ending in disappointment, with investors now lending to governments at rates that assume the region's return to full health will be glitch free.

Investor optimism on Europe has risen on signs the region's recovery is gathering momentum after years of economic and financial crisis which left the single currency project close to collapse.

José Viñals
Saul Loeb | AFP | Getty Images
José Viñals

The optimism has triggered a fall in the price of borrowing for the region's governments, including Greece, with Athens recently securing yields of less than 5 percent for a 3 billion euro ($4.16 billion) five-year bond issued last month.

José Viñals, the director of the IMF's monetary and capital markets department, told the Financial Times the sale was "certainly very good news in terms of Greek authorities getting back into the market". But he cautioned against a "fall into complacency" in Athens and elsewhere, advising officials across the bloc that it was "very important that policy delivers on all fronts".

"We are seeing a lot of what I would call 'pricing to perfection' in financial markets, by which I mean pricing outcomes which are really quite good. There is a danger that if outcomes are not perfect, there is room for disappointment."

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Mr Viñals said he believed that the euro zone governments' 10-year borrowing costs would rise as rates in the US increased. Tapering by the US Federal Reserve would push up yields across the bloc, with the European Central Bank's forward guidance that rates will remain ultra-low for "an extended period" only likely to affect short-term rates.

"It's hard to say [if this will happen this time], but on the basis of historical evidence one can say that when long-term interest rates have risen significantly in the US this has been followed by long-term rates rising significantly elsewhere, particularly in other advanced economies and in Europe," he said.

In Frankfurt last week for a European Central Bank (ECB) and European Commission event on financial stability, Mr Viñals said one of the most important reform efforts in the region was the ECB's health check of the euro zone's biggest lenders, its so-called comprehensive assessment, which runs from now until October.

The exercise was set to show that the bloc's banks were in better shape than investors thought. "If this conversation had taken place two or three years ago, I would have told you European banks had a lot of catching up to do. Fortunately, the situation today is much, much better," Mr Viñals said. "There has been a very significant increase in capitalization and an enhancement of liquidity."

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The IMF official echoed calls by Christine Lagarde, the IMF's managing director, for the ECB to counter weakness in price pressures immediately to avoid what economists have labelled secular stagnation, where growth stays weak.

"The problem of low inflation is its persistence . . . If low inflation [in the euro zone] is persistent, then it becomes a problem because it is the counterpart of low growth," he said. "It is very important to escape this low inflation-low growth trap now."

It was critical governments passed reforms to counter low growth, Mr Viñals said. While he did not want to "prejudge" whether or not monetary policy makers should engage in quantitative easing, he supported efforts to revive the market for asset-backed securities.

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"One thing that is important is to recognize the [weakness in] lending to SMEs. Helping develop safer securitization is also something that would be important to help on this front," he said.

Europe also had to "finish the job" of repairing the balance sheets of businesses.

"In Portugal, Spain and also Italy, there are many corporates facing a difficult situation in servicing the debt. It's not only bad for the banks but for the economy – it stops investment and job creation," he said, adding that governments will at times need to intervene in restructuring talks "to ensure solutions that work for the economy."

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