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The Deepening Recession in Europe
May 4, 2009
This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, www.cumber.com. He can be reached at Bill.Witherell@cumber.com.
In its latest, very gloomy “World Economic Outlook” (available at www.imf.org) the International Monetary Fund revised sharply downward its economic growth projections for the euro area, to – 4.2% for the current year, followed by -0.4% in 2010. The most recent OECD projections for the region, published in March (available at www.oecd.org) are almost identical (-4.1% and -0.3%). The European Central Bank’s forecast for this year is a much more optimistic -1.7% decline, with recovery taking hold towards the end of the year. There admittedly have been some positive signs (“green shoots”) such as a surprisingly strong rise in purchasing managers indices for the euro area and a revival in French business confidence. On the other hand, however, the German Finance Minister recently indicated “The downwards dynamic is not letting up.” While we do not fully share the pessimism of the IMF and the OECD with regard to the global economy, we do agree that the euro area is in the midst of a deep and probably prolonged recession.
These projections by the international organizations as well as the above mentioned surveys were done before governments and health authorities around the globe went on alert for a possible influenza pandemic. While the swine flu outbreak is centered in Mexico, suspect cases have been identified in a number of countries around the globe, including in Europe. There is still great uncertainty as to how serious this threat will become and its effects on markets. If the euro zone avoids a pandemic outbreak, the weakest economies would still be hit by any global increase in risk aversion that this threat could cause. Should the euro area countries be hit hard by the flu, the IMF projections would likely prove to be optimistic.
The euro area (or eurozone) consists of the sixteen European countries that have accepted the euro as their currency: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The central bank responsible for monetary policy in the euro area, the European Central Bank (ECB), has been acting as if it believed its own more-optimistic projections, that is, its latest, restrained 25-basis-point cut of the repo rate in April leaves that rate at 1.25% (in comparison with the US discount rate, which was reduced to 0.5% four months ago, and the UK repo rate, which was reduced to 0.5% a month ago). The actual market overnight interest rates, however, have been driven down below US and UK levels due to the liquidity resulting from the ECB’s liberal lending to banks. The ECB has also been very reluctant to engage in so-called “quantitative easing” through buying assets (commercial paper, bonds) directly to boost liquidity in markets, an approach that has been used by the US Federal Reserve and a growing number of other central banks. The ECB is likely to take some further, probably modest, actions this week. Thus far, an unwillingness to take prompt and effective action in the face of the severe recession has left the ECB appearing to be reactive and behind-the-curve.
Financial-sector problems in the euro area are continuing to unfold. It is striking that although the US has been the epicenter of the global financial crisis, the economic contraction in the euro area is more pronounced and problems in the euro area banking systems also appear to be more severe, with corrective actions generally being too little and too late. The IMF calculates the capital injections needed by euro area banks are at least $350 billion, far above the estimated $275 billion for US banks. While US banks are estimated to have so far recognized about 50% of the toxic assets on their books, euro area banks are far behind in this process, having recognized only about 20%.
While some of the toxic assets relate to real estate loans, others relate to lending to Central and Eastern Europe. Some of the latter states, such as the Baltics, have seen their fortunes change from being the fastest-growing economies in Europe to now having to seek assistance from the IMF. Latvia, for example, received $10 billion from the IMF in December and is anticipating a GDP decline of some 13% in 2009. Hungary also has received IMF support, and Romania is requesting the same. Austrian banks have been the most active in extending loans to the region, followed by Belgium, Germany, Italy, and Sweden; and the Central and Eastern European subsidiaries of these Western European banks have suffered significant deterioration in their financial condition.
This grim story evolving in the eurozone is to some considerable degree a result of the constraints imposed by a single-currency regime covering sixteen quite diverse economies. During the present decade, three of those economies, Greece, Spain and Ireland, experienced prolonged booms, with pronounced overheating and resulting wage and price inflation, along with booms in property markets. Over the same period, economic growth, job creation, and wage growth in Germany and France have been very restrained. Evidently a one-size-fits-all monetary policy can not adequately address the diverse situations of these economies.
Further aggravating the situation, the absence of any euro area discipline with respect to external borrowing has permitted the three booming economies to borrow excessively abroad, and their current account deficits have reached levels that raise solvency concerns. Since the usual adjustment mechanism of changes in exchange rates is not available, severe depression of domestic demand (deflation) is unfortunately the probable adjustment path in Greece, Ireland and Spain.
Turning the above situation around would require very significant new supportive action by the ECB and/or the IMF. Possibilities include a large IMF rescue package, direct support by the Germans and the French, and having the stricken euro area nations issue bonds that are purchased by the ECB (monetization of this debt). There are difficult political and budgetary obstacles to such measures, and continued policy inaction is probably the most likely situation going forward.
The implications for international investors are that euro area equity markets are likely to underperform relative to global markets for some time, and over the medium term the euro-US dollar exchange rate is likely to weaken as the more-rapid recovery of the US economy becomes apparent. Among the euro area countries, we expect the best relative performance from the equities of German, French, Dutch, and Belgian firms. At Cumberland, our International and Global Multi-Asset Class ETF portfolios have underweight positions for the euro area.
Bill Witherell, Chief Global Economist, email: bill.witherell@cumber.com. |
