Saturday, June 19, 2010

EMU−wide growth remains muted


  • Recovery? When GDP numbers for 2Q 2010 are released this summer, it should become apparent that the EMU economy posted pretty solid growth in spring. That is, however, merely a counter-reaction to the weak start to the year caused by the unfavorable weather, and does not reflect the underlying trend. GDP growth will remain subdued, since the impulses from fiscal programs and the inventory cycle are running their course.
  • Risks! GDP growth risks for the coming year are even tilted to the downside. The inevitable consolidation of the public-sector budgets will act as a drag. Nevertheless, we keep our central macro picture unchanged, primarily because of the recent slide of the euro. It is acting like an automatic stabilizer (pages 4-5).
  • Growth pattern. This does not, however, prevent the up-to-now brisk export growth from slowing down given the global economy’s stamina problems. This will weigh on investment activity, and ultimately also on employment (pages 6-7). Exports remain the only major growth pillar, while final domestic demand is expected to clearly lag behind.
  • ECB. While the EMU debt crisis does little to change our underlying macro picture, the repercussion effects on monetary policy are quite considerable: It is pushing the start of the ECB tightening cycle farther out into the future. The central bank will leave its key interest rate unchanged for a longer period – provided governments forge ahead with their budget consolidation. We do not expect the first ECB rate hike before end-2011.
  • Further topics:
    – Weekly Comment: Spain as a lynchpin (page 2).
    – Switzerland: SNB on hold for some more time (page 8).
    – Commodities: The bear is on the loose (page 10).
    – Data outlook: Purchasing managers become more cautious (p. 14).
    – Market outlook: Only a breather for the euro (page 21).

Spain: The Lynchpin

Spanish policymakers seem to perform better under pressure than Spain’s football team so far: yesterday’s debt auction went well, Finance Minister Salgado confirmed that bank stress tests will be published on an individual institution basis, and the government has pushed through by decree a set of labor market reform measures. Labor markets reforms were an opportunistic defensive play, not elegant, but effective – it is on bank stress tests that Spain will need to show the same combination of confidence and technical skills that had made its football team the World Cup favorite. By announcing its intention to publish the results, Spain has raised the stakes and investors' expectations – now it will need to show that it is up to the challenge. If its transparency effort is successful, it could provide the crucial incentive for other countries to follow suit, allowing Europe to finally clear the air on the health of its financial system – ECB’s Governing Council member Noyer recently also expressed support for publishing bank-by-bank stress tests. Moreover, greater confidence in Spain’s financial system could in turn bolster market optimism on the country’s ability to repair its public finances. Separately, ECB’s Noyer and Liikanen warned that fiscal tightening might weigh on Europe’s recovery – while accelerated fiscal consolidation could limit the pace of growth, I remain convinced that current fears are out of proportion with the moderate consolidation currently envisaged at the eurozone-wide level. Indeed, the ECB’s June Monthly Bulletin unambiguously emphasizes the benefits of high-quality fiscal consolidation. Spain is now the eurozone’s lynchpin: if Spain fails, the eurozone’s wheels will come off, derailing the continent’s recovery and its financial system. But if Spain pulls through, it could help turn sentiment around, particularly if its example prods other countries to take further steps on financial system transparency and structural reforms. Yesterday’s marked positive reaction on the EUR following the Spanish debt auctions confirms the extent to which the market’s assessment of the eurozone hinges on developments in Spain.
Spain’s labor market reforms are signaling that the government has the determination to pursue growth-enhancing reforms in the face of social resistance. As my colleague Tullia Bucco noted yesterday, the measures approved do not go to the heart of the problem, in that they fail to dismantle the rigidities imposed by a complex collective bargaining system with agreements negotiated at both the provincial and sectoral level. Nonetheless, the measures do achieve a meaningful reduction in firing costs, which could eventually open a exit from the current two-tier labor market – which suffers from the same insider/outsider distortions plaguing many other eurozone countries.
Regarding the bank stress tests, Spain could be the weather vane for the eurozone’s banking system: it is widely acknowledged that Spain’s banking system is characterized by a sharp dichotomy between the ailing savings banks (“cajas”) heavily exposed to the real estate sector and the more resilient large institutions. Uncertainty on the state of health of individual financial institutions has contributed to exacerbate concerns about the banking system as a whole, compounding concerns on the state of public finances. As a consequence, Spanish banks have reportedly run into significant funding difficulties, which have forced them to rely to an increasing extent on ECB financing. Spanish authorities have insisted that the overall scale of the problem is limited; if that is the case, publication of the stress test results should be highly beneficial to the truly solid institutions, which could quickly regain market trust and consequently easier access to market liquidity and funding. To be successful, Spanish authorities will need to be bold, releasing a sufficient level of detail including the assumptions used and sensitivities of the calculations, to allow investors to reach a confident assessment of worst-case scenarios as well as a baseline case – this was the strategy successfully adopted in the US. Moreover, Spanish authorities will need to stand ready to move quickly to deal with any institutions that might be revealed as unviable.
ECB officials yesterday highlighted the risks emanating from financial sector stress and fiscal consolidation. While financial sector developments are crucial, I continue to believe that concerns on the possible recessionary impact of fiscal consolidation are excessive. The ECB June bulletin, citing the EC Spring forecasts, shows that the eurozone’s aggregate fiscal deficit will widen further to 6.6% of GDP this year from 6.3% in 2009, and decline by just half a percent of GDP next year, to 6.1%. The cyclically-adjusted budget balance (both overall and primary) is also projected to deteriorate further this year before recording a moderate improvement in 2011, when about half of the projected improvement in the fiscal balance will be driven by an acceleration of growth. Admittedly, the forecasts do not yet incorporate the additional measures announced over the last few weeks; however, bear in mind that many of these measures have been planned to underpin existing budget targets, and the most ambitious efforts have been launched in the smaller countries, and should therefore have only a moderate impact on the eurozone’s overall stance. With growth recovering and expected to approach potential next year, this can hardly be characterized as a reckless and suicidal consolidation.
Indeed, the ECB’s June Monthly Bulletin unambiguously emphasizes the benefits of high-quality fiscal consolidation. In a Box on “Fiscal consolidations: Past experience, costs and benefits”, ECB staff argue, “Although fiscal consolidation may imply costs in terms of lower economic growth in the short run, the longer-run beneficial effects of fiscal consolidation are undisputed.
Moreover, such short-term costs will tend to be rather limited for countries with precarious fiscal starting positions and must be weighed against the costs of greater adjustment efforts the longer the fiscal correction is postponed. By contrast, the early announcement and implementation of credible and ambitious consolidation plans, focusing on the expenditure side and combined with structural reforms, will strengthen public confidence in the sustainability of public finances, reduce risk premia in interest rates and thus support macroeconomic and financial stability. Given the substantial increases in government debt ratios, there is an urgent need to accelerate the correction of fiscal imbalances in many euro area countries to restore sound public finances, which are a necessary support for monetary policy in its task of maintaining price stability”.

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