Progress in high-income Europe reduced financial market tensions during the first quarter of 2011
Market concerns about fiscal sustainability in Europe, although still present, declined in the first quarter of 2012, in the wake of major policy initiatives, including: cross-party agreement to fiscal consolidation plans; the passage of far-reaching structural policy reforms; the successful restructuring of Greek debt; agreement of pan-European fiscal rules and firewalls, and a significant easing of borrowing conditions by the European Central Bank (ECB) in the context of its Long-Term Refinancing Operations (LTROs).
As a result, the risk premia required of high-spread economies declined from 7.2 to 4.1 percent in the case of long-term Italian bonds and from 5.7 percent to 4.6 percent in the case of Spanish bonds. CDS rates for high-spread economies also declined, losing about 92 percent of the increases observed since July 2011.
As market concerns eased, other financial market indicators also improved. Equities in both developing and high-income countries recovered much of the value lost during the second half of 2011, rising by some 14 percent between mid-December and mid-May (figure 1) and bonds spreads declined (figure 2). European bank funding pressures also declined – in part because of access to cheap ECB money. Interbank and central bank overnight rate spreads (a measure of the perceived riskiness of private banks) declined sharply.
Figure 1. Equity markets recovered during the first quarter of 2012, before weakening in May
MSCI Equity Index, Jan 2011=100
Source: World Bank
Figure 2 Emerging market bond spreads were declining in the first quarter, before widening in May