Are we heading for another Euroland crisis?

Part 1 

Despite the gloomy news on Euroland surveys, European crises tend to start when global growth decelerates, not bottoms, and we expect global PMIs to edge up in coming months – and we also expect that if Spanish bond yields rise, Spain will sign the Memorandum of Understanding (MoU). Furthermore, if European tensions mount again, we can believe that Germany will speed up the approval of the use of the ESM for the direct recapitalisation of banks (or at least put a framework in place that means that they are willing to do this in 2014, in way that allows investors to regard the FROB  (Fondo de Reestructuración Ordenada Bancaria or Fund for Orderly Bank Restructuring, a banking bailout and reconstruction program initiated by the Spanish government in June 2009) balance sheet expansion as being only temporary.

One key part of the puzzle is the prospect that the ECB has turned fundamentally more dovish (with the periphery probably outvoting the core) and that its triple target of reducing convertibility risk, improving the monetary transmission mechanism and maintaining price stability may well result in more aggressive action. Reducing the convertibility risk may even mean taking three-year bond yields in Spain and Italy down to 1% to 2%.

There is execution risk, but the Outright Monetary Transactions (OMT, see http://ftalphaville.ft.com/blog/2012/09/06/1148831/omt/ for background) look sustainable for the next 18 months because there is a stick (the actuality of high 10-year bond yields) and a carrot (very low T-bills) and the yield curve in effect acts as an enforcement mechanism.

Politics is of course important, with tough decisions for Spain on the MoU, and in the case of Finland and Germany, national parliaments activating the ESM, and providing cover for the ECB. There have been positive developments, with Mrs Merkel’s popularity at a three-year high and she supports the Draghi plan, while the opposition SPD are in favour of Eurobonds. Meanwhile, most of the Euroland periphery are implementing policies that are close to being consistent with an IMF programme and the IMF has explicitly said this for Ireland, Spain and Portugal. In this regard, it is apparent that despite the news headlines, the political pain threshold of the periphery is much higher than we had thought: 67% of Greeks still support the euro despite GDP, by the end of this year, forecast by the IMF to be down 26% from its peak, Latvia has stayed pegged to the euro despite a 21% fall in GDP and Ireland has so far seen a 10.4% decline in GDP. We can add that the Dutch election suggest that euro scepticism is less pervasive than many fear.

As for the peripheral economies themselves, the three-month annualized current account balance in the five PIIGS has now turned positive for the first time since the beginning of the crisis, and this matters not only because it shows that the periphery is regaining competitiveness (although the bulk of the improvement is down to sharply falling imports), but also because income from a current account surplus can, to some extent, offset the impact of modest capital flight.

Against this backcloth, a Greek exit looks unlikely (less than 20% probability) at least for now – and that means until after the German elections (likely in September 2013), after the OMT is started, after a banking union has been established (one that includes a deposit guarantee, resolution and regulatory regime), and after Greece has been seen, once again, not to implement the Troika proposals.

As a key issue, when all is said and done, Greece’s exit from the euro would look unhelpful for both Greece and broader Europe for the next year at least, but withdrawal over the longer term may happen and may be manageable.

Part 2

Although the Euro project may be ‘safe’ for now, major challenges to the Euro do clearly lie ahead, reflecting the problem that the underlying economies remains deeply imbalanced and an important part of the endgame may materialise in 18 months’ time, when the ECB has accumulated, under its OMT programme and its repos with the peripheral European banking system, very large holdings of peripheral European bonds.

At that point, peripheral European politicians may likely consider the option of not fulfilling the politically painful reform conditions attached to the OMT.

The ECB maintains that, in this case, it would stop any purchases or even sell existing holdings back into the market.

However, we can wonder whether this is a credible stance to adopt, given that this approach would involve the risk of large capital losses in the case of a default or an exit from the euro by the country in question.

Looking ahead, we can muse that at that stage, one of two outcomes is likely.

First, the ECB may relent and support the non-compliant country’s bond market despite the recognised non-compliance. In that case, we might reasonably expect a backlash from the public of the core economies, especially Germany.

Secondly, the ECB may not relent. In that case, it would withdraw OMT support from the country in question and, if necessary, refuse to accept that country’s bonds as collateral for its repo operation. The impact of withdrawing the repo facility could be severe, because the loan to deposit ratios are c150% of GDP in the periphery. Yet, in this case it would have to accept either default within Euroland, or exit from Euroland of the country as two possible consequences, and if it does not adopt one of these approaches, it can be seen to lack a credible threat.

The OMT in effect allows the can to be kicked down the street, and means that crisis can be averted for the next 12 to 18 months – and it need not be that a broad market and financial crisis necessarily rears its head once more at that point, because a Greece exit might be manageable once the OMT, and banking union are set up. That said, the scale of the challenges suggests that a Spanish exit would be unmanageable for the euro, and therefore the problems cannot be ignored.

In terms of where we have got to, our guesstimate would be that roughly 60% of the solution to the crisis in Europe is now in place. That leaves an unhealthy 40% to go.

The critical issue is that policies need to be found to foster growth.  Expansion of the European Central Bank’s balance sheet via the OMT should help significantly in this regard, by both weakening the euro and mutualising debt.

Other measures that might reasonably be seen to be required are more EIB/project bonds, and the 28^th June summit had €120bn of these, i.e. 1.2% of GDP.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla