How much worse could it get?

When all is said and done it looks as if we are likely still only about half way through the adjustment needed in Euroland as a whole.

We anticipate that to solve the European problems, the ongoing challenges of de-leveraging and competiveness need to be addressed with a cocktail of austerity and growth measures, economic re-balancing, debt write-down or write-off, currency devaluation and the creation of liquidity and appropriate credit availability.

There is now a raging debate as to the effectiveness or even appropriateness in adopting austerity measures with the concern that austerity constrains economic activity and in turn this raises claims on the state whilst reducing income, thereby making matters worse not better. In truth, policy should not be all or nothing and there is a required and delicate balancing act between reining back expenditure that adds to indebtedness, and supporting growth, which may include releasing non-financial brakes on activity such as de-regulation and the cutting of red tape. In terms of specific economic measures to support growth, we realistically need to see a weaker euro, fiscal stimulus via the EIB and project bonds, as well as a further significant expansion of the ECB balance sheet.

Lead indicators such as Purchasing Manager (PMI) surveys are currently consistent with GDP growth close to -0.5%, and a weaker euro would support exports at a time when domestic demand must be expected to remain depressed – and to achieve adequate growth without adding to debt, we ought to see the development of current account surpluses in the peripheral economies. Thus far only Ireland has achieved this.

There does seem to be a general expectation that a combination of austerity, growth measures and currency devaluation is sufficient to address the problems of over-indebtedness, but realistically there are solvency issues too, and it looks likely that Ireland, Portugal and Greece need government debt restructuring. This reflects the sheer scale of their government debt to GDP ratios after adjustment for the cost of private sector de-leveraging. We do then need a ring fence for the solvent. The European Stability Mechanism (ESM) and European Financial Stability Facility (EFSF) should be able to provide €500bn (€1.1tn with IMF monies) – but to date only 5 countries have approved the ESM. This leads on to the challenge of so-called debt mutualisation or the common ownership of debt. There a range of mechanisms that can be deployed, such as Eurobond issuance, Quantitative Easing (QE), the Securities Markets Programme (SMP), and the ESM, as well as the ECB’s Long-Term Refinancing Operation (LTRO). Given the scale of the challenge, it looks that the most likely form of debt mutualisation would be a €2tn 5-year LTRO or an ECB funded deposit guarantee scheme.

Talk is one thing and action another, and the catalyst for concrete steps is likely to be one or more of significant and sustained deposit flight, dire economic conditions in the offing, evidenced perhaps by the PMI falling below 40, increased stress in short term funding with two year bond yields rising to the levels seen last November, a decision by Greece to exit the euro, and/or contagion spreading to France.

Political will is also required for some form of banking union, which would need to include a deposit guarantee to stop deposit flight and recapitalisation of the banking system as required. This seems novel to some commentators, but resolution and recovery plans have been much discussed (see   http://www.financialstabilityboard.org/publications/r_110719.pdf) – and the good news is that the global authorities do understand the risks and required actions – even if sometimes it may appear otherwise.

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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