Critical stage for Euroland
0The situation in Euroland is moving to a critical stage.
The ECB believes that the answer to the crisis has to be political (i.e. fiscal union with clear rules) and that currently the only ‘enforcement’ mechanism is the threat of a funding crisis.
Governments continue to move much more slowly than either markets or the deterioration in the European economic outlook.
Investors may still be too sanguine on some of the issues facing Europe. Thus, wages need to decline by 8% to 15% in the periphery just to get competiveness to the right current level, but the position would deteriorate again absent fundamental reforms.
This challenge is made worse by private sector leverage of 230% of GDP in Spain and Portugal, which is likely to result in government debt to GDP of around 100% and 145% by 2014.
A cocktail of bank de-leveraging, fiscal tightening, and wage deflation in the periphery is aggravated by deposit flight and a dollar funding crisis. If unchecked, the situation is likely to result in GDP next year that is materially worse than the emerging consensus that there will be a recession.
Of course the problems built up over and extended periods, and the to set the past imbalances right, there is a required loss of around €1trn – and it is far from clear how that loss will be allocated.
On paper, the solutions are either growth and/or mutualisation of debt. It’d seem that the only way to get growth is via a much weaker Euro (€/$1.10), possibly via the ECB expanding further its balance sheet. The mutualisation of debt would work as Euroland total government debt and deficit is below the US, and perhaps the most realistic solution is a move to a partial Eurobond bond (guaranteeing debt up to 60% of GDP), as this would allow the ECB to become more aggressive (possibly by turning the EFSF into a bank or, more realistically, the ECB lending to the IMF which in turn lends to national governments);
Meanwhile, the deterioration in the economic environment is so severe that the ECB will likely be forced to do Quantitative Easing. Catalysts for this could be Euroland PMI new orders falling below 35 (consistent with -3% GDP growth), Euroland M3 growth turning negative (currently +3.1% y/y) or OATs yields rising above 5% (a level that threatens France’s funding sustainability). Ultimately, we think the ECB will blink but not until Q1 and after it has exhausted conventional policy and probably after more of a crisis.
That said, we still believe the chance of the Euro break-up is small (c10%), largely because the direct cost of a break-up is c€600bn to the core, and the indirect cost is likely much higher.
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
