What’s happening in the Euro Area?

Philippe Waechter, Chief Economist at Natixis Asset Management - Jueves, 28 de Junio

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Looking at the European situation, we feel a kind of emergency, we feel that European governments have to act rapidly, probably at the European Summit later this week (28/29 June). There are different reasons that can trigger this perception of Europe. 1.    The crisis is long and starts having a deep impact. GDP growth rate was flat in the Euro Area from the first quarter of 2011 to the first of 2012 and unemployment rate is at an historical high at 11%. With the deep recession in Italy and in Spain, and the weak situation in France and even in Germany, a higher unemployment rate can be expected if nothing is done. 

 

2.    What has happened in Greece has also changed the picture. This has introduced the possibility that one country could leave the Euro construction. It is not something that was expected. In other words, the Greek elections can let imagine that the Euro/Europe construction can be reversible. That's a important reason to avoid a Grexit.

 

3.    The plan to save the Spanish banking sector has not been a success because the risk was that, at the end, the EUR 100bn loan have to be reimburse by the Spanish people. It was not the solution expected. Moreover, technically the question of seniority of the ESM has also changed investors mind.  With low world trade growth since the beginning of 2012 and no endogenous adjustment or change in trend inside the Euro Area, a decrease in GDP can be expected for the 2nd quarter. That's what June's surveys show.  The real problem with Spain is that the Spanish economy is too large to be managed with this kind of plan. If there is a run the contagion could be important and the different firewalls built in Europe would be too small. This means that another solution have to be found. Instead, with a deeper crisis, the Euro area has no possibility to manage such a large economy (10% of Euro Area GDP).

 

These 3 issues just say that something has to be done rapidly because all the oracles have a negative message as it was just mentioned.

 

The point is the necessity to change the institutions; they have to be adjusted to a new environment even inside the Euro Area. We can see that because no one really knows how to manage asymmetric shocks inside the Euro Area. The crisis has been a succession of asymmetric and specific shocks.

 

So the Euro Area has to build a new institutional environment that will be able to adapt the Euro Area to a new situation.

 

Angela Merkel thinks that the solution is a Political Union. We can imagine 2 points associated with it. The first is that with a more centralized government, rules for each country could be stronger, avoiding a heterogeneity of behavior for each state. This is the kind of binding constraints seen in federal countries. The second advantage would be that with one central government the ECB could be the lender of last resort. In all other countries there is a kind of mutual guarantee between the central bank and the Treasury. That's why the Quantitative Easing Strategy can be put in place in the USA, in Britain or in Japan. Such a behavior is not possible in the Euro Area because there are 17 treasuries. The problem with this solution is transfer of sovereignty from each government to a central power.

 

François Hollande is on another position. He suggests that financial solidarity is the first issue and then it would be possible to make a Political Union. This means that the firewalls can be used rapidly and immediately to help the sector that needs to be saved as the Spanish banking sector. They want at the same time that this help could be direct, not going through the government as it has been done for Spain. The other point is a will to make a Banking Union to warranty the financial stability of the Euro Area. The drawback of this strategy is that if at the end there is more financial stability, governments feel that the last step, Political Union, is not a necessity.

 

The arbitrage between the two solutions is what everyone expects from this week Summit. Everyone wants new and strong perspectives for the Euro Area. That why this week is crucial.

 

There are also some other important points to manage. First, what will be the detail of the growth pact that has been proposed by France and accepted by Germany, Italy and Spain? What will be the timing and on which kind of investment?

 

One important point will also be on the role of the EFSF and the ESM the two firewalls. How will they work? Will they be able to intervene directly without going through governments? The amount that can be mobilized is around EUR 650bn (after the Spanish plan on banks). Will it be sufficient if the task of the two firewalls is to help the banking sector or countries that have solvency problems? This can be illustrated by the example given by Gavyn Davis in the Financial Times last week. The financial needs for Spain and Italy from H2 2012 to the end of 2014 are almost EUR 1500bn. It is too large for these two instruments. Another point is that if the EMS is senior compared to sovereign debt, will investors accept sovereign debt in their portfolios. The two firewalls are not big enough but making them bigger is not the solution either.

 

A solution is to give a banking license to the EMS to give it the possibility of refinancing at the ECB. But in that case, the European institutions have to give a new role to the ECB, because at the end, it will be a large part of the solution.

 

This week summit will have to determine the target of the Euro area and the role of each institution just to have a clear view on the mechanism that rules the Euro Area.

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