Imagine you have a mountain of spare cash: would you invest it in euro zone government bonds right now? If you are a large Japanese investor, the answer is “maybe not”.
Last week Barclays Capital, the British investment bank, produced the latest part of a long-running survey of Japanese bond investors, which tries to determine attitudes towards dollar and euro bonds.
This revealed that a hefty two-thirds of Japanese investors quietly fear that the latest 750 billion euro aid package will have “not much” impact on the euro zone’s woes – up from a mere third of investors that expressed skepticism two weeks ago (when the package emerged).
Unsurprisingly, those same investors are getting cold feet about euro bonds: at the start of the year almost 80 percent of the survey’s respondents preferred euro debt to dollar debt, but that proportion is now below 30 percent.
Japanese investors are not just worried about debt issued by the peripheral economies of Portugal, Italy, Ireland and Greece; they seem pretty uneasy about German bonds too.
This is a striking straw in the wind. Japan’s institutional investors are powerful in global markets since they command vast funds. As they are also conservative and publicity-shy, it is often hard to know what they are doing.
If this survey is correct, it could also point to the direction other Asian investors are taking. For example, it appears that China’s powerful sovereign wealth funds started raising their purchases of euro zone bonds last year in an attempt to reduce their high exposure to dollar risk.
But there are widespread rumors that the Chinese are also getting cold feet – not in the sense that they are actually selling those euro holdings, but rather that they are refraining from buying too much more euro debt. Everyone is trying to work out what is happening with the economies of Portugal, Greece and others, said one senior Chinese finance official last week: “There is anxiety. The situation is not clear.”
It will not be easy for the euro zone countries to quell that concern. One of the issues spooking Asian investors is the sluggish nature of growth in Europe. Another is the unpredictable nature of policymaking (as shown by Germany’s unilateral clampdown on short sales last week).
But the third – and perhaps more subtle – issue is the uncertainty about how to assess the riskiness of individual euro zone bonds. The key issue at stake, as Credit Suisse pointed out in a recent research note, is that in the eyes of the capital markets the functioning of the euro zone has had uncanny echoes of the collateralized debt obligation instruments that banks were flogging in the days of the credit boom.
Think for a moment about how a CDO works: essentially, it is a financial product that allows bankers to pool a diverse collection of loans (such as mortgages). Most crucially, it is usually claimed that the total bundle of loans is safer than any individual credit. To use banking jargon, what a CDO does is provide “credit enhancement”, turning dodgy debt into something that looks safer.
Hence the fact that during the credit boom, mortgage bonds with a triple B credit rating were used to build CDOs with a triple A stamp (the logic behind this was that diversified portfolios of mortgage should expose investors to less risk).
On paper, the euro zone does not look exactly like a CDO, since euro zone governments have never tried to “bundle” their debt. Instead, governments have continued to issue separate national bonds. But ever since the euro was created, investors have priced euro zone bonds in roughly the same way; thus the weak countries have enjoyed a “credit enhancement”.
But faith in the financial alchemy of this single currency has spectacularly crumbled, just as faith in those CDOs fell apart. As a result, it is tough for anyone to know how to price euro zone debt. While that is unlikely to prompt Asian investors to sell existing stock, it does mean they are likely to pause before making new purchases.
That is not good news for any European government needing to sell its bonds; nor, for that matter, for financial markets as a whole.