European policymakers get ahead of the curve
After months of disappointing markets with their slow response European policymakers got ‘ahead of the curve’ this weekend with an unprecedented €720 billion (bn) rescue package, just in the nick of time. In the short term, the action should be enough to reassure markets and provide another leg up for risk assets globally. However, the medium- to long-term implications are less encouraging, at least for the euro-zone. The substantial fiscal consolidation now implied across the euro-zone increases deflationary risks for the region. In addition, the new policy transfers credit risk from peripheral to core euro-zone nations. Despite a sharp rally in the euro early Monday, the prospect of weak growth, low interest rates and an erosion of ECB independence all suggest the euro will be a less attractive currency going forward.
To support fellow member states, the euro-zone governments have agreed to set up a stabilisation fund that will provide loan guarantees and bilateral loans worth up to €440 bn, with a further €60 bn provided by all EU members through expansion of an existing balance of payments facility and an additional €220 bn from the IMF. This €720 bn package is in addition to the €110 bn IMF and eurozone rescue plan previously approved for Greece, and will come with similar terms and conditions, suggesting strong austerity measures for any country that actually accesses it.
The European Central Bank (ECB) has also announced that it will buy government debt and private securities to provide ‘depth and liquidity in those market segments which are dysfunctional.’ This is the ‘nuclear option’ of buying government bonds that the market had long been clamouring for.
It is not quite quantitative easing (i.e. printing money to buy government debt), because the ECB has also said it will ‘sterilise’ any asset purchases by removing liquidity from the system elsewhere. However, it is still an enormous step for the ECB and a departure from previous policy.
Relative to the funding needs of the periphery, the package can be considered as covering the funding needs of Spain, Portugal and Ireland together up until well after the end of 2013, which we estimate at €558 bn. Alternatively, it could cover the funding needs of these countries plus Italy up to the end of 2011. We estimate the funding needs of Italy, Spain, Portugal and Ireland up until 2011 amount to €640 bn. Whichever way the numbers are split, this is a substantial package that should remove market concerns over the peripheral countries’ ability to roll their debt over and finance their budget deficits.
Markets react positively
Indeed, bond yields fell sharply for euro-zone peripheral countries on Monday following the announcement over the weekend.
Equity markets have also reacted positively to the package. The EuroStoxx 50 index was up 9% on Monday at the time of writing, after falling 11% last week.
The euro also rallied sharply early Monday, though we think this was primarily on short covering, as euro short positions had been at record highs going into the weekend. In the medium term, we think the euro will be substantially weaker than it has been over the past few years because of recent events. The damage done to the credibility of the euro-zone institutions, the prospect of weak growth, low interest rates and an erosion of independence for the ECB all suggest medium-term weakness for the euro.
In the short run, the substantial action taken over the weekend should reassure markets and support the resumption of the rally in risk assets seen in recent months. Immediate financing needs have been solved, giving time for structural reforms to take place, but this opportunity must be taken. It should also allow investors to focus more on the underlying improvement in the macroeconomic data, such as strong employment growth seen in recent months in the US and decent business confidence data in the core euro-zone countries.
Medium- to long-term impact
However, the medium- to long-term implications for the euro-zone are less encouraging. The likely fiscal consolidation that will be needed to continue to reassure markets, and outside institutions such as the IMF now providing aid, will weigh on growth for the region as a whole.
Indeed, it is not just the peripheral countries that are going to have to reduce spending and increase taxes, the larger economies such as France and Italy will also have to accelerate fiscal consolidation in order to maintain the confidence of markets. By providing such substantial guarantees and credit lines, credit risk has effectively been transferred from peripheral eurozone countries to the larger core euro-zone countries (i.e. to Germany, France and Italy).
Lower government spending and overall growth, combined with weak wage growth, increase the chances of a deflationary/weak inflation environment for the euro-zone over the next few years.
On a more positive note, it is clear that markets have forced euro-zone institutions to supervise and centralise fiscal policy. Indeed, many observers have commented that for the long-term survival of the single currency, monetary union could not be achieved without a degree of political union, at least in terms of fiscal policy.
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