December 23, 2011
The European debt crisis accelerated into December, creating huge swings in investor sentiment and raising fears that the euro currency union could unravel. Since November, the crisis has led to the ouster of leaders in Greece and Italy and the election of a new government in Spain, prompted Standard & Poor's to place the credit ratings of 15 euro countries on review for possible downgrade, and forced many European banks to turn to the European Central Bank (ECB) for emergency financing. On November 30, a group of six central banks, led by the U.S. Federal Reserve, announced a plan to provide cheaper access to U.S. dollar funding, sparking a relief rally in global financial markets.
A long-awaited summit of European leaders on December 9 produced a new "fiscal compact" aimed at ensuring long-term fiscal sustainability. Among other things, summit leaders agreed that governments would not be allowed to run budget deficits larger than 0.5% of gross domestic product, increased the resources of the International Monetary Fund (IMF), and moved up the creation of a new permanent bailout fund. Furthermore, the UK refused to back the new fiscal pact, damaging relations with other European countries, particularly France.
The December summit made progress toward resolving Europe's debt crisis, but it is not a game changer. One major problem with the fiscal compact is that it fails to address several deep-seated issues that contributed to the current crisis, including:
- Competitiveness. Major structural imbalances exist between stronger core countries and the weaker periphery. Peripheral economies urgently need labor market reforms and other policies to restore competitiveness since, as members of the eurozone, they cannot devalue their currencies.
- Banking system stress. European banks have been required to increase their high-quality capital, and many have been selling their sovereign bond holdings as part of an ongoing deleveraging process. This has reduced demand for sovereign debt and worsened the crisis.
- Frail economies. Output in most eurozone economies is falling, and even Germany is struggling to maintain modest growth. Fiscal austerity in this fragile environment could further slow growth and, in the process, worsen fiscal conditions.
Major complications have already emerged. There was no consensus on adopting the new fiscal compact, raising concerns that it lacks legal muscle. There is a strong chance that Ireland and possibly other countries will have difficulty ratifying the changes. Perhaps most disappointing is that the fiscal compact did not lead the ECB to intervene more forcefully in supporting eurozone debt markets.
We believe increasing the size of the IMF's resources by €200 billion was the summit's most positive outcome. Leaders at the summit agreed that eurozone members would contribute €150 billion and other European central banks would provide €50 billion to the IMF, which serves as an emergency lender for its 187 member countries. However, news reports on December 19 said that European finance ministers fell short of the €200 billion goal due to rifts between EU members, which is disappointing. There have been reports that IMF members with surpluses, like China and Japan, may provide support, but so far there have been no firm commitments.
Other summit announcements were marginally positive. Speeding up the creation of the permanent bailout fund, known as the European Stability Mechanism (ESM), to July 2012 from mid-2013 is helpful, in our view. The ESM will have capital instead of guarantees, making it a more effective vehicle for leveraging than the existing temporary fund, known as the European Financial Stability Facility. However, leaders kept the combined lending capacity of the temporary and permanent bailout funds capped at €500 billion, which was disappointing to many market participants.
We do not expect Standard & Poor's to downgrade sovereigns across the board. However, we do forsee a one-notch downgrade for France due to its high deficit and large banking sector, as well as the potential for another downgrade in 2012. Other countries, including Spain, Italy, Ireland, and Portugal, will likely be downgraded by two notches. Any sovereign downgrade would have a negative impact on banks and corporations and cause investors to further reduce their eurozone exposure.
Economic growth in Europe will likely deteriorate due to stress in the banking system and ongoing fiscal tightening. However, reports suggesting that the eurozone has a matter of days or weeks to avert a collapse are overblown, in our view. While a breakup of the eurozone is plausible, we believe we are a long way from this worst-case outcome.
We believe the eurozone is already in the early stages of a recession, based on recent purchasing managers' index readings of private sector activity. Economic activity in Italy and Spain, in particular, is rapidly weakening. In response to slowing growth, the ECB cut its key interest rate in December for the second time since November 3. Private sector forecasts for eurozone growth have come down in recent months, but we believe they are still too high. We expect eurozone gross domestic product growth to range from -0.5% to -1.0% for 2012, compared with a Bloomberg consensus forecast of 0.5%. In any event, the growth outlook depends heavily on policy actions taken by governments and the ECB over the next few months.