The ECB's
willingness to supply Eurozone banks with cheap long-term funding,
coupled with the US Federal Reserve's willingness to supply ECB with
enough dollars to plug the hole left by financial institutions'
capital flight from Europe (Eu135bn in December alone!) makes it
likely the Eurozone can avoid financial implosion this year.
But it is
unlikely to avoid recession. All three main ratios underpinning the
business cycle point towards recession: nominal GDP growth is now so
slow that asset turns and return on capital are falling – which
usually triggers a downturn in the investment cycle. Europe's terms
of trade have deteriorated back to their 2008 lows. And the pace of
bank deleveraging, which has been the most gentle of headwinds during
the last five years, is picking up dramatically. Falling returns on
capital, rock-bottom terms of trade, and accelerated deleveraging
dictate a private sector recession. And that's before the impact of
tighter public sector budget discipline is taken into account.
Nor is it easy to
expect an early exit from this recession, since the underlying
problems of competitiveness within the Eurozone are ignored entirely
by the current attempts to 'save the Euro'. Yet these issues will
eventually be addressed in one way or another. The bullish view is
that eventually Germany will reconcile itself to very rapid nominal
GDP growth, including a bout of inflation and a current account
deficit rather than watch deflationary forces consume southern
Europe. This may, in the end, be correct. But it won't be in 2012.
For more than a year
now the world has worried that the Eurozone's financial problems are
so extreme that they must inevitably drag the region into recession,
and possibly much of the rest of the world with it.
Mainly these concerns
are correct: the introduction of Euro-financing to countries who's
productivity growth cannot begin to keep pace with German
productivity growth has opened up huge gaps in competitiveness within
the Eurozone which had been masked only by enormous build-ups of
Eurozone debt. In the process, the nominal GDP of the weaker
countries soared extraordinarily compared with the GDP of the core
Eurozone countries, primarily Germany, and also compared to other
developed economies. The chart below shows how it happened.
Now this debt financing
is no longer available, and the underlying competitiveness issues
widely understood, the Eurozone as currently constituted is living on
borrowed time. By my calculations, even if labour productivity in the
peripheral countries of the Eurozone had kept pace with Germany's,
the scale of 'internal devaluations' needed in these countries to
restore their intra-Eurozone competitiveness are simply impossible to
achieve. Greece needs a devaluation of around 55%, Spain 50% and
Ireland 45%. On the other hand, the scale of 'internal devaluation'
needed by Portugal (18%) and Italy (10%) seem plausible.
Sooner or later, these
devaluations will be made, either by massive and economy-shredding
deflation in the peripheral countries (which surely could not be
achieved without intense political disruption), serious and sustained
inflation in the core countries (distinctly unwelcome to Germany), or
through these countries accepting and external devaluation through
exiting the Eurozone.
These choices seem
obviously to most observers outside the Eurozone, but they currently
elude the imaginations of Eurozone politicians and policymakers. And
in the short-term, they continue to believe they are faced primarily
with a liquidity problem (which can be resolved in the medium term by
various 'rescue' expedients) whilst in the medium term the most
visible aspect of the problem – the build-up of government debt –
can be addressed by cutting public spending, closing fiscal deficits.
I expect they will
continue to believe this even if Greece defaults and devalues later
this year. Greece can yet be declared a 'special case', and the
policy of liquefy the Eurozone banks whilst tightening the fiscal
austerity screws will be maintained.
In
the short term, it remains a reasonable expectation that continuing
major infusions of extra liquidity can indeed prevent the underlying
economic incompatibilities of the Eurozone from degenerating into
uncontrollable financial crisis. For the ECB, even after taking into
account the huge new lending of long-term money to Europe's banks at
cheap rates (Eu489bn in three-year money in late December, with more
to come later this year), still remains only modestly leveraged by
central bank standards, with a total assets/equity leverage ratio of
around 33x. That ratio could rise to around 45x before it would stand
comparison with either the US Federal Reserve or the Bank of Japan.
But
postponing financial catastrophe is not the same thing as fending off
recession, and my three main cyclical indicators – return on
capital, terms of trade, and leveraging trends - all point to
recession in the Eurozone this year. There are three main indicators:
return on capital is already falling; terms of trade have fallen back
to 2008 levels and area likely to fall further if commodity prices
continue rising; and bank deleveraging still has a long way to go.
Beyond that, the ECB's new largesse is perversely also having the
effect of accelerating the deleveraging process by making buying
Eurozone sovereign bonds a much more attractive business for banks
than the risky business of lending to the private sector.
By my estimate, the
Eurozone had recovered about half the return on capital it lost
during the financial crisis in 2008, unlike the US where the recovery
was far quicker, and where ROCs are now at their highest level since
2000. Worse, it seems that ROC peaked in 3Q11 and almost certainly
fell marginally again in 4Q11. When asset turns (sales/total assets)
begin to fall one can expect investment spending to fall in sympathy
– although this may be delayed by other factors which disguise or
delay the underlying deterioration.
But there are only two
disguises available in the medium term: either operating margins
(indicated by international terms of trade) can rise, or financial
leverage (indicated by bank loan/deposit ratios) can rise. Right now,
neither of those tactics are available: whilst the Eurozone's terms
of trade were steady throughout most of 2011, they are just about as
bad as they were in 2008 at the height of the commodities boom. And
whilst bank loan/deposit ratios have fallen consistently throughout
the last five years, the fall has been so gentle it has merely
allowed the ratio to drift down from a peak of 117% in 2007 to 104.4%
now. Compare that to ratios elsewhere: 82% in the US; 96% in the UK;
68% in China and 70.6% in Japan and it is clear that the European
banks still have a lot of deleveraging to do, and probably at a
rather more rapid pace than during the past five years.
Indeed, one can see
this more rapid pace emerging since December. Ironically, it is also
hastened by ECB's determination to prop up Eurozone sovereign bond
markets by making huge amounts of liquidity available to Europe's
banks. The banks face a practical question: why take the risk of
lending to the private sector when you have the choice both of taking
the ECB's money and buying sovereign bonds, or alternatively, of
simply putting the money back on deposit with ECB?
And that's what's
happening: when ECB auctioned Eu 489bn of cheap three-year money in
mid -December, the banks used that funding partly to lengthen their
debt maturities, so the absolute rise in ECB lending came to only
Eu214 billion. As more short-term debt has matured and not been
replaced, the gross new lending has fallen to only Eu 122.25bn.
Meanwhile, what have the banks done with the money? Overwhelmingly,
they have re-deposited it back to the ECB: since mid-December,
financial institutions' deposits with ECB have jumped by Eu307bn. In
other words, the impact of the ECB's supply of cheap money to the
Eurozone banking system has been, very perversely, to leave the ECB's
net supply of credit to financial systems down by Eu 184.8 bn. In
fact, the ECB's net supply of credit to financial institutions is now
at its lowest point since the crisis began.
It is quite possible
that in the next few months the ECB will become a net holder of
deposits from Europe's banks. And, not surprisingly, at the same
time, European bank lending, and European monetary aggregates are
slowing very sharply.
In conclusion: the
upside potential in Europe this year is limited to avoiding
full-scale financial crisis. Even so, we should expect a year of
unrelieved recession for the Eurozone as a whole, and on current
policies there is no real reason not to expect this
financial/economic stalemate to drag on throughout 2013 as well.
Bond yields, naturally enough, are unlikely to rise. However, as
precautionary savings ratios rise, we should expect the private
sector savings surplus also to rise, which – if the Japanese
example is anything to go by – also suggests we should not expect
any collapse in the Euro (whatever this currency turns out to be).
No comments:
Post a Comment