EBRD

Transition Report 2012 INTEGRATION ACROSS BORDERS

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Chapter 3

Box 3.1 Financial fragmentation in the eurozone

The crisis in the eurozone has been characterised by a fragmentation of European financial markets. In a reversal of earlier trends, financial conditions are diverging and increasingly driven by country-specific effects. From 1999 to 2008 the deepening financial integration in the eurozone was seen as evidence that monetary union was promoting economic convergence in Europe. The introduction of the single currency gave rise to a highly integrated money market and led to convergence in interest rates for governments and firms. The prospect of declining borrowing rates and stable, homogeneous conditions in a shared financial market made joining the eurozone seem an attractive proposition. However, the integration that was perceived to be a structural consequence of economic and monetary union has proved fragile in times of crisis, as evidenced by the growing dispersion of interest rates, the variation in banks' funding costs and the decline in cross-border lending.

The divergence in sovereign yields between the eurozone core and periphery has been mirrored by the developments in interest rates for firms and households. Charts 3.1.1a and 3.1.1b show the evolution of borrowing costs for governments and corporates in major eurozone economies.3 Interest rates across all categories of loans had been converging until the 2008 Lehman Brothers collapse, after which there was a sharp increase in dispersion. The onset of the sovereign debt crisis has been marked by a further divergence in lending rates. The market's more differentiated assessment of sovereign risk has translated into adverse funding conditions for banks in the periphery, while core countries have benefited from a "flight to quality" and access to relatively cheap funding. On the asset side, increased sensitivity to corporate risk has also contributed to the dispersion in borrowing costs, with banking sectors in some countries exposed to a higher share of risky borrowers. The result has been a divergence in lending rates and an impaired transmission mechanism for monetary policy, with ECB cuts to policy rates failing to ease retail lending rates in the periphery (see ECB 2012a).

Source: ECB statistical data warehouse.
Note: The chart shows the 10-year government bond yields of the five largest eurozone economies (on the left axis) and their coefficient of variation – COV (on the right axis).

Source: ECB statistical data warehouse.
Note: The chart shows the interest rates on loans to corporates with a maturity of less than one year for the five largest eurozone economies (on the left axis) and their coefficient of variation – COV (on the right axis).

As financing conditions have diverged, markets have become more fragmented. The cross-border share of total money market loans has fallen from 60 per cent in mid-2011 to around 40 per cent in early 2012 as banks report giving added weight to country risk when assigning credit lines.4 The eurozone interbank market is increasingly segmented, with banks reducing their claims on the periphery and transferring assets to perceived safe havens and Germany in particular. Countries experiencing outflows have generally also seen declining credit stocks (see Chart 3.1.2) and weak or negative deposit growth.

Chart 3.1.2 also shows the effects of financial retrenchment on the EBRD's countries of operations. While banks have reduced their exposures across the region, some countries have been hit much harder than others. In Hungary and Slovenia – both countries with domestic vulnerabilities; refer to the Country Assessments at the end of this report – outflows in the last quarter of 2011 and first quarter of 2012 exceeded 5 per cent of GDP, and were accompanied by a sharp contraction of credit (see Chapter 2). In contrast, countries perceived to be more stable, such as Poland and the Slovak Republic, saw relatively mild outflows over the same period (with inflows in the first quarter of 2012) and stable credit growth. The variation in credit growth in central and south-eastern European countries has been increasing steadily since the beginning of 2011. In this sense, financial fragmentation has begun to spill over from the eurozone into the rest of Europe.

Source: Bank for International Settlements (BIS), ECB statistical data warehouse and national authorities via CEIC Data.
Note: Data on external bank claims are from the BIS locational statistics. The chart shows foreign exchange-adjusted changes.


3 The variation in Charts 3.1.1a and 3.1.1b would be even greater if Greece and Portugal were to be included. The charts show that divergence has occurred even in the five largest eurozone economies, where the risk of insolvency has been less acute.

4 According to the results of a March 2012 survey of banks in the ECB Money Market Contact Group, "75 per cent of the respondents said that they apply different haircuts to the assets in repo operations depending on the geographic origin of the counterparty" (ECB response to media request, "Indicators of market segmentation", 8 August 2012).

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