- At the beginning of the year, we presented three debt crisis scenarios. In this document we look at the recent economic and political developments and present an update of our scenarios.
- Our main scenario is that the debt crisis will continue for a couple years and that we slowly will move towards a quasi-fiscal union. We expect the financial markets to continue scanning the systems for weaknesses and when it finds them rising yields are likely to force politicians to respond.
- Currently there are too many risk factors for things to calm down. The core countries are likely to take advantage of the high-risk environment to push through necessary reforms in the periphery countries. The response to the crisis is also likely to result in a continued gradual move towards more fiscal integration.
- The risk of a very negative scenario materialising, which would include a sovereign default and maybe even a euro area break-up, has increased but we still assess the risk to be low. The commitment among the euro leaders remains intact but the public opposition has risen.
- The main risk is a continued increase in public opposition. It is fuelled by the bailout bills in the core countries and further austerity measures in the periphery countries. The euro area has so far delivered decent growth despite the ongoing debt crisis. Looking ahead, we expect modest growth as the unwinding of imbalances in the public and private sector takes place. We expect growth of 1.7% this year and just 1.2% in 2012.
Watch list
- Fifth review of Greece by end- September.
- ECB buying through the Securities Market Programme (SMP).
- Ratification of EFSF enhancement in local parliaments by end- September.
- Recapitalisation of Spanish bank sector to be done before end- September.
- Spanish parliamentary election in November.
- French general election in spring 2012
Status on debt crisis scenarios
In January, we published Research Euroland: Debt crisis scenarios, 25 January 2011. The document contained three debt crisis scenarios. Nine months have passed and the debt crisis is even more intense now than it was then. We therefore find it appropriate to give an update on our view on the future of the euro area. The three possible scenarios outlined in January were as follows.
- Crisis contained.
- Euro bonds and quasi-fiscal union.
- Default or euro break-up.
In January we said “We believe a scenario in which the crisis can be contained to be the most likely outcome of the European debt crisis but we should expect continued high market volatility for some time”. Currently the debt crisis is moving more in the direction of scenario two.
The crisis has clearly not been contained. Portugal has received an aid programme and the euro area leaders have endorsed a second bailout package for Greece (this package still needs to be ratified in member states). The debt crisis has spread to Spain and Italy where rising government bond yields have caused the ECB to reactivate the Securities Market Programme and purchase large amounts of mainly Italian government bonds. The fiscal boundaries as set out in the Stability and Growth Pact were never enforced and the irresponsible financial policy in many countries and reluctance to enforce harsh measures has sparked and fuelled the crisis.
No quantum leap has been taken with regard to fiscal integration but step by step we are moving towards closer co-ordination and more surveillance. Agreement has been reached to give the EFSF more flexibility and increase its actual lending capacity (awaiting approval by national parliaments). The Euro-Plus-Pact was endorsed in March and, among other things, obliges countries to incorporate the EU fiscal rules set out in the Stability and Growth Pact into national legislation. It has been agreed that the ESM will be an international financial institution based in Luxembourg with a EUR700bn capital base and that it can even intervene on an exceptional basis in the primary market subject to strict conditionality under a macroeconomic adjustment programme. In June it was agreed that the EFSF can also intervene in the secondary markets on the basis of an ECB analysis in order to avoid contagion. It was also agreed that the funds can be used to finance recapitalisation of financial institutions through loans to governments including in non-programme countries.
The six pack that should strengthen the Stability and Growth Pact has not yet been adopted because the European Parliament is asking for a reverse qualified majority voting but when agreement is reached on the final details the six-pact will also be a notable step towards closer co-ordination and more surveillance.
The move towards a quasi-fiscal union is a long and slow process – often delayed by national interests or the need to get consent from the European Parliament – but the direction is clear. Each time a crisis hits, the solution has been to come a little bit closer together. We expect this process to continue in the future.
New crisis scenarios
On the basis of recent political and financial market developments, we have updated and adjusted our debt crisis scenarios.
- Debt crisis slowly calms down as austerity measures begin to work and a situation where Italy needs a rescue package is successfully avoided.
- Turmoil continues and pushes a move towards a quasi-fiscal union and possibly at a later stage euro bonds.
- Default or euro break-up.
It seems unlikely that the debt crisis will calm down any time soon. Removing the uncertainties surrounding the next rescue package for Greece should help but uncertainty remains about the possible need for a third Greek rescue package or help for Italy remains. Turmoil is thus likely to continue for quite a while and this would push the euro area even further in the direction of scenario 2, which has become our main scenario. Eventually we expect austerity measures to calm markets down but we do not expect this to happen until the more distant future. The risk that we end up in scenario 3 with some kind of euro break up has also increased due to a deterioration in the general support for further belt-tightening in periphery countries and in particular an increase in the resistance to further financial support in core countries. We still assess the risk to be low. The commitment among the euro leaders remains intact and the main risk is a continued rise in public opposition.
Case by case approach
Our main scenario is thus scenario two – that the debt crisis will continue while we move towards a quasi-fiscal union. We expect financial markets to continue scanning the systems for weaknesses and through pricing, force politicians to respond or as ECB President Jean-Claude Trichet recently stated, “When serious crises arise, such as the one that we have been in since 2007-08, they expose weaknesses as sure as x-rays show up the skeleton inside the body. A good way of not letting speculation take hold is to identify one’s own weaknesses upfront and to correct them. In the years that preceded the crisis, countries in particular had a false sense of security…Once again, the lesson that we Europeans must draw from this is to strengthen the governance and monitoring of economic and fiscal policies. That does not mean to say that the functioning of the financial markets does not need to be substantially improved. At the moment, the key word for all industrialised countries is confidence.”
Recently we saw an example of this in Italy, see Flash Comment: ECB expected to start buying Italy today, 8 August 2011. The Italian 10-year yield rose by more than 150bp in less than two months. Italy was forced to present a very ambitious plan. The first plan presented aimed at balancing the budget by 2014. This was not enough to calm the markets. The austerity measures were frontloaded aiming at a balanced budget in 2013. This was welcomed by the ECB, which responded by including Italian and Spanish government bonds in the SMP purchases pushing 10-year yields below 5%.
Also, France has been in the spotlight, which has forced the French government to present austerity measures that are expected to more than fulfil the targets set out in the French Stability Programme. This implies reducing the budget deficit from 7.0% of GDP in 2010 to 4.5% of GDP by 2012
In a crisis environment, the euro area leaders will continue to use a case-by-case approach in an attempt to prevent an escalation of the crisis. It is difficult if not impossible to predict where the next ‘blowout’ will be but we can highlight potential triggers and monitor developments very closely. There are simply too many risk factors and the member states’ economies are still not sufficiently strong to expect smooth sailing from here. The euro area leaders need to continue the process towards more economic integration and we expect Germany in particular to take advantage of the leverage from the financial markets to push through much needed reforms in the peripherals.
Putting more money in the EFSF would be a plausible next step towards further integration. A strict implementation of the six pact and the Euro-plus-Pact would also push the euro area in this direction.
Giving the European Court of Justice more powers to give verdicts in the case of violations of the Stability and Growth Pact as suggested by Angela Merkel in her speech on 7 September would be another possible move towards further integration. This would demand treaty changes, which Angela Merkel has also said should not be taboo.
Euro bonds – maybe in the distant future
Euro bonds is a possible end solution but we do not expect euro bonds to become reality until integration has been extended much further – if ever. Angela Merkel is against “collectivising risks”. In addition, the German constitutional court’s ruling on bailout packages, which also says that the German parliament is “forbidden from setting up permanent legal mechanisms resulting in the assumption of liabilities based on the voluntary decisions of other states” seems to be a no-go for euro bonds.
Euro bonds are attractive to indebted countries because they can secure cheap funding for all euro area countries. But it also means that market pressure on individual countries to deliver sound fiscal policies would disappear. When the debt crisis eventually calms down, this is an important mechanism to avoid future crisis. President Van Rompuy put it this way “It is the overall combination of institutional pressure, peer pressure and market pressure that will help to avoid getting into such difficulties again. All three have been enhanced…In the first decade of the euro, the markets were asleep. Now they are awake – and even if they are sometimes overreacting, they will not go back to sleep again. Market signals were not being transmitted in an early and more gradual way to states whose debt levels rose dangerously high or whose current account deficits were unsustainable.” So institutional pressure and peer pressure may have to take over successfully the role played by market pressure today before euro bonds would be a success. We believe getting there will require more turmoil, with high market volatility and a continued focus on the ongoing debt crisis.
Risk factors
The financial system is very vulnerable to negative surprises. Should one of these take place, it could set off a chain reaction with increased financial turmoil with rising tensions in money markets, a further increase in credit spreads and an additional fall in equity markets. Although it is difficult to pinpoint exactly what could trigger this, there are a number of candidates.
- Renewed pressure on the Italian bond market, for example on negative budget news or political instability.
- Greek vote on tough new austerity measures expected in early October
- Uncertainty over the size of EFSF if it is necessary to buy continualsly in the secondary market to keep yields down in Spain and Italy.
- Problems in finding agreement among EU leaders on further measures in the event of renewed tensions.
- A negative event at a larger European bank.
- Negative surprise on losses in the Spanish banking sector and problems with recapitalisation of this sector.
- Increased focus on the burden sharing in Europe through EFSF could trigger downgrades of AAA countries, for example France (see Research France: No downgrade in 2011 – but small margin for error (24 August 2011).
- France is coming under pressure, due to a sharp drop in houses prices, which would weigh on the French banking sector.
Inertia
The news coverage and market dynamics appear to play an important role in adding inertia to the debt crisis. The tendency for both media and market participants to focus mainly on the negative aspects is noteworthy. We have seen this recently in Italy and Greece where, for example, ambitious new austerity measures have attracted little attention.
Ireland stands out as a good example of how markets can begin to regain confidence. Since it received the bailout package, it has improved its public finances considerably and is now broadly following the bailout plan. This was also supported in the third IMF review. S&P has confirmed that Ireland’s rating is stable and has said that it does not expect Ireland to need a second rescue package. As a result, Irish yields have clearly drifted downward and the Irish 10-year yield is currently 8.5%, down from close to 14% in July.
We expect to see similar dynamics for other countries. We expect hard data to begin improving eventually and news flow to turn positive slowly – but it will take some time.
Growth outlook
Despite all these risk factors, we do not expect a recession as our main scenario. However, the risk of recession has been rising and we assess the probability to be around 20% currently. The euro area has previously delivered decent growth despite the debt crisis. Looking ahead, we expect very modest growth as the unwinding of imbalances in the public, private and financial sector takes place. In 2011 and 2012 we expect growth of 1.6% and 1.1%, respectively. This is a significant downward revision from the 2.2% in 2011 and 1.9% in 2012 published in our June global scenarios.