EUROPE COMPASS
WEEKLY UPDATE FEBRUARY 4, 2013
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Balancing Bulls and Bears
The main theme of news reporting on the euro-area economy is that the worst of the crisis has passed. This theme has been fuelled by a series of data released last week:
Unemployment is still high and large numbers of firms are continuing to go bankrupt (the illustration here is for Belgium and is only available in Dutch, but the pattern holds elsewhere as well).
Overall confidence in the business sector is weak.
Bank lending to firms and households remains tight, particularly with regard to mortgages, and demand for credit is low.
Household consumption is down, particularly on the euro-area periphery.
While the service sector exhibits rising prospects, industry remains subdued and export order books are struggling.
That all looks like bad news, but it could be much worse. Unemployment is increasing at a slower pace. Banks report that they are unlikely to tighten lending conditions further. Household consumption is starting to recover. Firms are less pessimistic than they were in recent months. All this suggests that the euro-area economy may have turned the corner instead of driving off the cliff.
Now what?
Some analysts will trumpet the dawn of a new recovery in order to steal a march on rising equity prices and risk-on bond purchases in Southern Europe. Others will sound a note of caution about the underlying weakness of the euro-area economy to unexpected shocks. Both sides have a point.
Much of the euro-area crisis has been driven by the fracturing of the European financial space and the withdrawal of liquidity from the countries on the periphery. That is starting to reverse. The reduction in bond yields for Spain and Italy is part of a wider movement of liquidity out of the safe havens where it has hidden during the crisis, ECB deposits included. Now this money can be put back to work. The banks will not forget quickly the lessons of the recent past, but they will have to lend if they want to prosper. As firms and households get used to the new environment, they will start looking for ways to use whatever money the banks are willing to lend. This means that the medium-term prospects are good.
However, the challenge is to make it to the medium term. That will involve acknowledging the full cost that the crisis has imposed on European economics and finance. Italy's Monte dei Paschi di Sienna (MPS) crisis is a good illustration. The Dutch government's nationalisation of SNS Reaal (SNS) on February 1 is even better.
Problems in the net-lending countries
SNS is a reminder that net-lending countries have financial problems at least as big as those in the periphery of the euro-area. (I am careful not to say 'net borrower' with respect to Italy because its accumulated current-account deficit during the first eight years of participation in the euro was only 8% of GDP and Italy's position in the Target2 payment system was in credit until July 2011.) SNS lost money on a commercial real estate portfolio it acquired from another Dutch bank, ABN-AMRO, in 2006, as well as on loans it made to Dutch investors who used the money to develop property in Spain. The problem with SNS was loose management practices. As reporters at NRC Handelsblad explain in their extensive weekend coverage, "according to property developers, there was no bank where so much money could be borrowed so easily as from SNS property finance". Now the Dutch government -- and, by extension, Dutch taxpayers -- are left holding the tab. The nationalisation will cost 3.7 billion euros (5.0 billion dollars).
Nevertheless, Dutch Finance Minister Jeroen Dijsselbloem argues that the alternatives would have been worse. The SNS is systemically important insofar as a run on that bank could have pulled down all the rest. This argument rests not so much on the size of SNS inter-bank lending as on the fragility of confidence in the banking system as a whole. SNS was large enough to be symbolically important and the Dutch government did not want to run the risk of a banking system crisis.
That argument makes sense, but only because of the close links between national banking systems and government finances. This is the lesson that the editors at NRC Handelsblad draw from the event. It holds not only for the Netherlands, but also for Italy, Spain, Ireland and elsewhere. Moreover, the halting and partial progress towards a banking union at the European level means that this close interdependence between banks and their governments is likely to remain an important source of weakness for the European economy as a whole.
Trouble in Italy and Spain
Another source of weakness is the political context. I have written previously about the elections under way in Italy. The MPS scandal is making it a closer contest than anyone expected. Eugenio Scalfari used his column in La Repubblica yesterday to consider what would happen if Silvio Berlusconi won. That outcome remains unlikely, despite Berlusconi's promise yesterday to reimburse property taxes. Yet it is noteworthy that a Berlusconi victory has crept from outright impossibility to worthy of consideration.
Making matters worse, now we also have to contend with a party financing scandal in Spain. Prime Minister Mariano Rajoy may well be cleared of any wrong-doing. Nonetheless, the credibility of his Popular Party government in the eyes of the Spanish people will be tarnished. Will the crisis have knock-on effects for the confidence of foreign investors? So far, that has not happened; next week could be different.
ECB balancing act
With such continuing economic weakness and clear downside financial and political risks, the ECB Governing Council is unlikely to raise its policy rates or to loosen monetary conditions when it meets on February 7. ECB Executive Board member Peter Praet, in his speech at the annual Danish Top Executive Summit on January 29, made the case against raising the inflation rate used in the ECB's definition of price stability or making a public commitment that the ECB will keep policy rates on hold for an extended period of time. The speech is not hawkish in the sense of being staunchly anti-inflation, but it is conservative with respect to the use of ECB policy instruments and the pursuit of the ECB's mandate. Balancing bears and bulls in the market, the ECB is unlikely to show any inclination to change either what it is doing or how it is performing the task.
I trust you have found this weekly Europe Compass note helpful. The Europe Compass is one element of Oxford Analytica's Europe Practice, which provides analytical insight and advice on the changing political economy of Europe and the implications for corporations, investors and public institutions in all markets and regions. I invite you to contact me or anyone at our Europe Practice with your queries or concerns.
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