Four ways to boost growth

Lead indicators (PMIs) are consistent with Euroland’s GDP contracting by 1% and the outlook is set to deteriorate further with fiscal tightening of 1.75% of GDP this year. Spain could face fiscal tightening of c7% of GDP in the second half of the year, with fiscal tightening having only been imposed from late May onwards, due to the election in Andalucía. France is likely to have to find supplementary fiscal tightening of €10bn to meet its fiscal target of 4.5% of GDP this year. Recently, the EU commission suggested that the French budget deficit next year would be 4.4% of GDP , against the required 3% official target, although EU Commission numbers are based on existing policy and do not take into account new policy expected in July. There are also looks likely to be more wage deflation to come in the periphery. Wages in peripheral Europe will have to fall by another 3% to 14% and with a loan-to-deposit ratio of 120% and leverage still above the 20-year average, there is still scope for a contraction in credit, and European credit could contract by between 3% and 10% as banks scale back cross border business.

There look to be four key means of boosting growth – currency devaluation, printing money, specific growth measures and funding, and debt mutualisation.

On currency devaluation, as a matter of history, each 10% off the euro adds c1% to nominal GDP growth (and 0.7% to real GDP growth). As a helpful twist, given the export profiles of the individual countries, a weak euro disproportionately helps growth in the core relative to the periphery. As a result, a weaker euro is likely to lead to more growth and inflation in the core (i.e., Germany), which would reduce the amount of wage deflation required in the periphery for the latter to regain competitiveness relative to the core.

The euro could weaken as a result of printing money, loss of confidence in Germany’s credit quality due to bail-outs for the periphery, concerns on the risk an imminent breakup of the Euro, which would leave the ECB suffering losses of around €300bn-€400bn, and the economic numbers certainly suggest that the euro should be weaker. Yet the euro has shown remarkable resilience, perhaps as a result of

repatriation of dollar assets by banks as they sought to meet their Basle 3 capital ratios targets. In the case of French banks, there was c€180bn of dollar repatriation.

As to how the ECB could ‘print money’, there could be direct or indirect methods. Direct action would include quantitative easing (QE) and may be expected given that the ECB is mandated to keep inflation close to but below 2% and deflation is a real risk. Indirect measures can include renewed LTROs, which can help growth by driving down bond yields in the periphery.

On the challenge of growth measures, there is the possibility of increasing EIB capital (proposals speak of €10bn) which could translate into increases in lending of €60bn. The EIB reckon this could lead to a €180bn increase in total lending, as each €1 of EIB money tends to attract an additional €2 of private money. In addition, the EU are setting aside €230m which they say could mobilise up to €4.6 billion of private investment, and this could be seen as a pilot exercise.

Turning to debt mutualisation, the key issue is the speed at which this could be done. There are lot of potential schemes, but to make such plans work, Euroland will likely need banking union, allowing direct recapitalisation of banks and proper deposit guarantee. Such a move would allow the ECB to increase support and realistically the ECB may need to step up for a €2tn 5-year LTRO or a deposit guarantee by year-end.

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

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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