Euroland: Heading for make or break?

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This post is a guest contribution by Elga Bartsch, Daniele Antonucci, Olivier Bizimana, Anselm Karitter, Tomasz Pietrzak of Morgan Stanley.

2011 Is Likely to Bring a Mild Moderation in GDP Growth…
The recovery will likely continue to be below-par, bumpy and brittle and can be still characterised as largely creditless, mostly jobless and very uneven. At an average 1.5%, on our forecasts, headline GDP will likely slow slightly from 1.7% last year. This would still be above the current potential growth rate, which we estimate at around 1%. And, in the light of the sovereign debt crisis, this would still be a good outcome. Nonetheless, growth will likely remain below the historical trend of around 2%. The main reasons for the mild moderation in GDP growth are the removal of the fiscal stimulus in the two largest countries, further fiscal tightening in the periphery and a deceleration in global trade growth. More generally, the recovery should stay subdued because of the ongoing need to deleverage balance sheets across all sectors and the negative impact of the financial crisis on potential output growth – i.e., the speed limit for inflation-free GDP growth over the long term. It will thus take until the second half of next year before the euro area will have even made back the output losses of the 2008-09 recession, we estimate. And it will take considerably longer before it regains a normal level of resource utilisation, thus allowing the ECB to keep rates unchanged.

…but the Recovery Should Continue to Broaden Out
In terms of the drivers of growth, the euro area has already witnessed a shift away from inventory rebuilding and rising exports towards stronger final domestic demand in the course of last year. We expect this broadening of the recovery to continue in 2011, and forecast overall investment spending growth to turn positive again, as capex keeps motoring ahead at moderate rates and construction no longer contracts sharply. Meanwhile, consumption growth should expand steadily at a subdued rate. But the aggregate steadiness masks substantial country differences between Germany and France (where spending is recovering noticeably in the former and remaining strong in the latter) and in parts of the periphery (where it is still contracting). Given fiscal tightening across the EMU, government consumption should flatline.

Alas, the Recovery Will Generate Few New Jobs
True, there are signs of a stabilisation in the unemployment rate and in payrolls too. But we expect the improvement in hiring intentions seen in the last few months to peter out soon. Our employment indicator is already pointing towards a moderation. The sluggish labour market response reflects three main factors. First, the subdued nature of the recovery and the low level of resource utilisation. Second, labour hoarding during the recession (Germany, France, Netherlands). Third, permanent job losses in construction and real estate (Spain, Ireland). As a result, wage increases will likely be moderate, thus helping keep unit labour costs low. Despite these modest underlying inflation pressures, headline HICP inflation is on the rise at the moment. Unusually cold winter weather has already pushed inflation past the ECB price stability threshold of 2% for the first time in two years. Further temporary increases driven by commodity prices and indirect tax hikes might lie ahead.

EMU Budget Deficit Narrows, Government Debt Still Rises
Recovering domestic demand, a stabilising labour market and discretionary fiscal tightening should bring the deficit from 6.3% of GDP to 4.8% in 2011, implying a discretionary fiscal tightening of about 0.8% of GDP for the euro area as a whole. Again, there are very big differences between individual countries both in terms of the level of the budget deficit and its change compared to 2010.

In Our Base Case, the ECB Continues to Gradually Withdraw its Unconventional Measures but Leave Rates Unchanged

The withdrawal of monetary policy stimulus started with the ongoing phasing-out of the LTROs with a maturity of more than three months. In our view, it will gradually switch the refi tender operations back from fixed-rate, full allotment to a variable-rate auction. The switch in the tender operations will probably happen in increments, starting with the three-month tenders and ending with the weekly operations. On the whole, the interbank market in the euro area seems to be functioning better now. However, behind the overall improvement, trouble spots are still likely to lurk – both in terms of the variance in national banking systems’ reliance on ECB funding and in terms of the variance between individual institutions within those banking systems.

Ideally, the ECB Would Want to See Financial Stability Issues Being Addressed before Embarking on a Tightening Cycle

If needed, however, the bank could also raise interest rates before it is has completely phased out all unconventional measures (see EuroTower Insights: Executing the Exit, November 11, 2009). But despite the current inflation overshoot, we expect the ECB to stay put for the whole of 2011. Yet, in the light of the improving growth backdrop globally, rising headline inflation and potentially also rising inflation expectations, we see an increasing risk that the ECB cannot afford to wait until 2012 for its first rate hike. In the absence of an early ECB rate hike, however, the monetary policy backdrop would argue for steeper curves, led by a sell-off in longer maturities. We expect 10-year Bund yields to rise from 2.9% at the time of writing to 3.4%.

Risks to Growth Outlook Are Broadly Balanced, Non-Quantifiable Uncertainty Remains Elevated
Potential upside surprises to growth could stem from stronger-than-expected global growth momentum, from a more pronounced weakening in the euro’s exchange rate, and from positive effects on confidence as governments address the sovereign debt crisis. Possible downside surprises to the growth outlook could stem from limited credit availability due to weak balance sheets (both of lenders and of borrowers), from a further rise in the already elevated energy and commodity prices, and from renewed bouts of financial market tension – pushing funding costs higher and causing liquidity to dry up. In addition, the volatility/uncertainty created by the sovereign debt crisis itself could cause hesitation in investment spending. Finally, a global inflation scare could cause bond markets to sell off broadly.

The Main Source of Uncertainty, However, Is the Unknown Policy Response to the Sovereign Debt Crisis
Over and above the usual quantifiable uncertainty that forecasters face about some of the key external macro parameters driving their estimates (such as FX, commodities, global growth, etc.), there is an unusual degree of qualitative uncertainty around the euro area estimates this year. This uncertainty stems from the unknown policy response to the sovereign debt crisis. This policy response could potentially introduce a step-change in the institutional framework governing the euro area and the sovereign debt crisis. If and when such a step-change could occur depends crucially on whether market tensions in the periphery escalate, we think. A step-change in the policy response – e.g., a move towards a closer fiscal federation or a decision to jointly issue euro bonds – would likely trigger a non-linear reaction from market participants and economic agents alike as a new set of rules are being brought in.

Policy-makers face two challenges this year: First, the recovery is still very uneven between countries. Second, tackling the sovereign debt crisis that would otherwise continue to meander around the euro area.

#1 Rebalance the euro area and prevent imbalances in the future. On our estimates, growth discrepancies within the euro area already peaked last year at an unprecedented spread of 7.6pp, with growth ranging from +3.7% in Germany to -4.1% in Greece. In the course of this year, we expect the rebalancing process to continue as activity in the periphery recovers and moderates in the core. But it will probably be quite a while before any convergence shows in indicators such as unemployment, capacity utilisation or government debt. In addition to the unprecedented discrepancies in growth, the euro area is also undergoing a massive country rotation. This adjustment process, painful as it is, is key to the functioning of the euro area – especially in the light of the macro imbalances that have built up in the past.

Present imbalances largely reflect the start of the euro. Much of the past growth divergence (and thus the current correction) reflects a one-off after the start of the EMU when the (initially) poorer periphery was catching up with the core, when investors were diversifying their portfolios away from the low-return core, and when the periphery converged to the lower core interest rates. The resulting rise in current account deficits and surpluses largely reflected a desirable rise in capital mobility, we think. However, an oversupply of bank funding, inadequate risk management and excessively low interest rates in the core have contributed to a build-up of imbalances and resulted in an inefficient allocation of the capital flows.

Current account balances are at the heart of rebalancing. The two aspects of the current account – the trade flows on the one hand and the capital flows on the other- underscore the fact that any intra-euro area adjustment cannot be one-sided. If the core countries are to reduce their current account surpluses by boosting domestic spending, they will also provide less excess savings to the periphery. Looking beyond the annual flows, data on foreign assets and liabilities show that financial integration has advanced considerably since the start of EMU. Persistent current account deficits and surpluses meant that surplus countries have built up net foreign assets, while the deficit countries piled up net foreign debt. Servicing this debt means that a rising share of domestic income will go to foreigners.

# 2 Solving the sovereign debt crisis, which seems to be heading for ‘make or break’ in the absence of a reaction. So far, our base case has been one where policy-makers continue to muddle through and the crisis meanders around the EMU as borrowing costs are still within historical norms. The renewed escalation of market tensions late last year and early this year, which could challenge market access, suggests to us that financial markets will likely test policy-makers’ resolve to “do whatever is necessary to ensure that stability of the euro zone as a whole” (EU Council, December 17, 2010).

We still believe that there is no simple backstop to the sovereign debt crisis. This is partially because the ECB’s mandate makes it very difficult – some argue impossible – for the bank to aggressively monetise government debt. At the end of the day, however, even large-scale bond purchases by the ECB would only buy extra time. Large-scale bond purchases would not add equity, notably where it is needed most: the banking sector. While the latter in principle could be provided via the EFSF, we feel that persistent market tensions will likely force amendments to the existing EFSF framework agreement. We note several concerns that have started to undermine market confidence in the rescue mechanism:

•·          First, the lending capabilities of the EFSF are perceived by the market as being insufficient to contain two small and one larger peripheral economy. While we believe that this view is too negative, the credibility of the EFSF would probably benefit from an increase in or a removal of the cap on the guarantees.

•·          Second, the interest rate charged on the Irish rescue package – which at nearly 6% is above any reasonable forecast for nominal GDP growth in the foreseeable future – has called into question whether Ireland would be able to stabilise its debt and return to a sustainable debt path in course of the adjustment programme.

•·          Third, the lengthy period it seems to take to convince a country to apply for assistance, leading to contagion in the rest of the periphery in the meantime, is causing the EFSF to be viewed by markets as reactive rather than proactive.

We think that the EFSF would benefit from a number of amendments to its the size, interest charged and the lending capabilities, either through offering flexible credit lines to sound countries (similar to the IMF’s credit lines) or through broadening the EFSF’s mandate to purchasing government bonds (see Fast Track or Slow Motion to Fiscal Federation? December 19, 2010). It is perhaps too early to expect the bulk of these changes already at the Eurogroup/Ecofin meeting on January 17-18, especially given that the EFSF has not yet started to raise funds. However, we might get some announcement in this respect already next week.

The creation of the EFSF in May 2010 can be seen as the nucleus of a fiscal union and marked the start of a euro bond. Further steps that allow the euro area to move from fixing trouble spots towards a systemic solution are likely to be discussed. This will require political leadership in Europe, notably from Germany, and could well take politicians that are ready to risk their own political future for the future of the euro to reach to a resolution. This will be particularly difficult in Germany – a country where the electorate is critical of bailouts and worried about the euro becoming a soft currency. We can only hope that a busy domestic election agenda in 2011 does not complicate the reform of the euro area governance. Germany cannot afford not to address the euro area sovereign debt crisis, we think. Over and above all the political and strategic arguments about Europe, this is because of the large amount of financial assets held in the rest of the euro area. In our view, this is a much more important argument than the German export industry benefiting from a weaker euro.

2011 will likely be a decisive year for the ECB as well. Not only does the bank aim to proceed with gradually withdrawing its non-conventional stimulus measures – notably the unlimited fixed-rate refinancing operations – but it will also likely pave the way for a tightening cycle starting in 2012, on our forecasts. The lower turning point in an interest rate cycle is difficult to manage in a normal cycle and typically attracts a lot of political pressure, as we witnessed with the last ECB tightening cycle in 2005. But it will be even harder in the current crisis environment – where banks and sovereigns could struggle to fund at reasonable rates. The crisis has already caused a politicisation of the ECB’s decisions – most evidently in the controversial decision to buy peripheral government bonds under the Securities Market Programme (SMP). This year, the debate about the reform of economic governance in the euro area, the prospect of another bank stress test, and the need to appoint a successor to Jean-Claude Trichet, whose term expires at the end of October, will add to the process of politicisation of the ECB’ decisions.

Source: Elga Bartsch, Daniele Antonucci, Olivier Bizimana, Anselm Karitter, Tomasz Pietrzak of Morgan Stanley, January 14, 2011.

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