Implications of Euroland recession

Our concerns on Europe GDP are:

• Lead indicators (Purchasing Manager Index surveys) are already consistent with minus 1% real GDP growth (v 1.4% yoy currently);
• Banks are likely to reduce risk weighted assets (RWAs) by €1trn-€1.5trn (owing to new capital requirements and inadequate recap), which is equivalent to a fall in RWAs by 9%-14%, and banks account for 84% of corporate borrowing/lending;
• Fiscal tightening of 1.2% of GDP is likely to be stepped up, with rumours that Italy is looking for another 1.6% of fiscal tightening in 2012/13 and France last week announced additional fiscal tightening of 0.8% of GDP over the next 5 years;
• It looks likely that to restore competitiveness labour costs in Spain and Italy, which together represent 29% of European GDP, need to fall 5% to 10%, but hey have yet to start falling. The knock on effects of such a reduction on overall levels of economic activity would be significant. Just as a first order issue, wages are half of nominal GDP.

A key problem is that the more growth disappoints, the more fiscal revenues targets are missed, which in turn leads the perceived need for more fiscal tightening. Thus, a balanced budget in Italy by 2013 is likely to require an additional €25bn of tightening. This will likely then cause credit quality to deteriorate and we may expect increased political pressure in parts of Europe to leave the euro.

Additional talk about leaving the euro is counterproductive: Merkel’s CDU voted to allow euro states to leave the euro; the Party of Freedom in Holland has announced the creation of a commission to examine whether the Dutch should return to the guilder. These developments only accelerate capital flight from peripheral Europe, which is important given that there are still for example €187bn of deposits left in Greece, and loan to deposit ratios are high:

145% in Spain, 120% in Greece. We may suspect that even if the ECB were to fund the deposit shortfall, banks in the periphery would reduce their loans as banks can’t rely indefinitely on central bank funding as well as having a maturity mismatch (the duration of their assets is longer than ECB funding).

In terms of what may lie ahead, the ECB’s balance sheet looks to be the main focus. If the ECB bought Italian bonds off French banks, then French banks deposited the money they received with the ECB,
then ECB balance sheet would have grown, the ECB would be taking the credit risk of Italy, the French banks would be receiving a much higher credit rating of the EU, but there would be no literal ‘printing of money’ as the increase in purchases would have been sterilised.

These developments would likely cause the euro to weaken, and perhaps materially. Yet, given progress to date, it is hard to see the ECB accepting rapid balance sheet expansion or QE, which could include purchase of bunds) until there is clearly a recession and the risk of deflation. Currently the ECB forecast 2012 Euroland GDP growth of 0.8%).

Without the euro, peripheral European currencies would have depreciated by a third, with therefore, all other things being equal, c10% loss to euro GDP, with peripheral Europe accounting for a third of euro GDP. This would have been similar to the cost of an average banking crisis. Thus far, crisis-related write-offs have been 2% of GDP since 2007, partly due to the sub-prime crisis, and therefore another 8% hit has to occur via write-offs or more realistically via a 8% weaker euro. In passing, US exports to Euroland are 2% of GDP and so if the year-on-year growth rate in US exports to Europe fell from 15% to 0%, then there would be c0.3% hit to US 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

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