BlogSpot - (Finally) Green shoots in Europe
Positive news are emerging in Europe, translated in financial markets by stocks at new highs, credit spreads at record lows near 50bp in investment grade and 275bp in high yield. Barclays Capital identifies a number of green shoots: strong February reports on consumer confidence and composite PMIs, solid activity data from Germany and France, a brighter EC economic sentiment survey. Alberto Gallo (RBS Silver Bullet) highlights three support to growth: (i) monetary policy, (ii) slightly more flexible fiscal policy (allowing some structural investments outside the 3% budget ceiling and extending deadline to reach deficit targets) and (iii) progress on structural reforms (e.g., Italy’s Jobs Act and competition reforms).
Monetary expansion and the coming QE: The potential effectiveness of QE, in particular the portfolio rebalancing channel, is limited in Europe according to Alberto Gallo (RBS Silver Bullet) as capital-poor banks get charged higher risk weights for other holdings (corporate bonds or loans), pension funds and insurers have conservative risk limits, and credit markets are segmented. Citibank is worried that QE may be deflationary and that central bank easing is just shifting demand from one place to another, not augmenting it—resulting in continued lack of investment. They explain it by global overcapacity, which central bank easing actually increase, without liquidity spreading to the real economy.
Bond hoarding—The ECB is faced with the logistical challenge of finding enough bonds to buy—the result of a supply shortage, as fixed income net issuance across the Eurozone has only averaged around €340 billion over the last four years, according to Tyler Burden (Zero Hedge). At the individual country level, net supply less-Q€ will be negative for Germany, France, Italy, Belgium, Netherlands, Austria, Finland, Portugal, and Greece in 2015. Reuters notes that is there are not a lot of willing sellers—caused by the ultimate easy money paradox according to Burden, with (i) one deflation-fighting policy stymying another (for example, the negative deposit facility rate eliminated one option for investing proceeds after asset sales) and (ii) sellers of EGBs expose themselves to the very real possibility that proceeds will have to be reinvested at lower rates—not feasible for some sellers like insurers, from a regulatory perspective. The Wall Street Journal also reports that top-rated bonds are in short supply, especially German bonds, which account for over a quarter of the total purchases. Germany's net issuance this year is a mere €15bn, while the overall target for German bonds for the entire programme until March 2016 is €215bn—making it substantially different from the US QE. Alberto Gallo (RBS Silver Bullet) confirms that investors have moved to bond hoarding behavior, and highlight reinvestment risk, when most European core yields are now in negative territory (see the QE infinity trap; and Bond Vigilantes). Pia Huttl and Silvia Merler, in a Bruegel post, finds that pre-QE measures, in particular the TLTRO, have had almost no impact on the ECB balance sheet size—based on an update of the Eurosystem liquidity database. Solutions include (i) a fiscal move with European sovereigns realizing that they are paid to borrow and agree on a credible investment plan, (ii) changes in the market structure, with the creation of new products able to bridge demand for yield in investment grade bonds with demand for financing from real economy borrowers, or (iii) a loosening of the 25% single issue cap, or extend the purchases to government agencies.
The announcement of a Green Paper on Capital Markets Union could answer the need for new financial instruments but will take time. Jon Danielsson et al. (VoxEU) reflect on its aim to revitalize Europe’s economy by creating efficient funding channels. The main hurdle is overcoming difficult regulatory challenges—i.e., diverse tax regimes and national legislation. Karel Lanoo (CEPS) calls for targeted measures to overcome fragmentation, through enhanced enforcement, strengthening of the European supervisory authorities, enhanced disclosure and comparability of financial information and the mobilization savings in EU-wide investment funds. Dominic Elliot writes that what is needed to encourage non-bank financing is a cross-border insolvency regime and tax incentives for investors willing to contribute equity to SMEs. Howard Davies, in Project Syndicate, is critical of the CMU project and suggests that the biggest impact on market structure will come from ever-rising capital requirements, making bank credit more expensive and encouraging borrowers to look elsewhere. Solutions here include the creation of a sovereign-sponsored ABS market, developing alternative sources of funding (bonds, mini-bonds and crowdfunding)—but all take time.
Fiscal flexibility—With the release by the Commission of its decisions on EU countries’ budgetary plans (see press release), EuroIntelligence highlights the fiscal flexibility (about 0.25% of GDP) to countries that undertake structural reforms—due to a flexible interpretation of the rules by the Commission, the exceptional circumstances for passing the 2015 Italian (and Belgium) budget and the extension of the time frame for France to get the deficit down to 3%. In VoxEu, Marco Buti and Nicolas Carnot propose a rule of thumb to govern fiscal expansion, that would promote overall fiscal neutrality in the Eurozone, with moderate consolidation in France and Spain, lower consolidation in Italy, and moderate (optimal) stimulus in Germany.
Structural reforms—the publications of the OECD’s Going for Growth 2015 and the Winter Economic Forecast of the European Commission provide insights on progress and areas of improvements. Going for Growth shows that the reform effort has slowed down substantially in the EU, especially in program countries. Alessio Terzi, in Bruegel, looks at Italy and suggests that a reform window is opening, with stronger growth, thanks to lower oil prices and the weak euro (see Padoan’s speech), providing support for structural reforms: their short-term negative impact will be cushioned by an expanding aggregate demand. Terzi suggests to move beyond current efforts on the Jobs Act (reviewed by EuroIntelligence, with a few important parts: the scrapping of Art 18 of the 1970 Worker's Statute that essentially ruled out any form of dismissal, the replacement of temporary work contracts with a single contract that gives workers greater protection) and a restructuring of the banking sector, towards taxation, competition, judicial, and SOEs reforms.
Guntram Wolff and André Sapir (Bruegel) look at medium-term solutions for Europe—the establishment of institutions to prevent divergences of wages from productivity. They propose the creation of a European Competitiveness Council composed of national competitiveness councils, and the creation of a Eurosystem of Fiscal Policy (EFP) with two goals: fiscal debt sustainability and an adequate area-wide fiscal position, with no additional risk-sharing.
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