Daily Themes 12 December 2011

EU leaders move crisis down new road

We believe that the European Union leaders’ agreement last week has delivered very little immediate relief for the on-going euro crisis and most materially there is no immediate commitment for unlimited European Central Bank bond buying. There remains the immediate risk of further ratings downgrades for both sovereigns and banks and going into 2012 there is the need for parliamentary approval/referendums on the agreement. Europe is now on a clear agenda of prolonged austerity, in order to 'save' the euro, placing a global reliance on the US and Asia to provide offsetting growth.

Since September, we have used the Coutts Global Policy Roadmap (Table 1) to outline measures which we believe necessary to establish a durable end to crisis in Europe. We believe this combination of measures to de-lever economies, strengthen banking systems and sustain global growth would establish a sustainable backdrop against which meaningful structural reforms could be pursued.

This weekend's announcement by EU leaders seems to move the bloc towards more meaningful structural reform. While encouraging in the long-run, the announcement still leaves the plan short of the measures that might establish a sustainable environment in which to do this.

The EU (ex-UK) plan is to seek an "intergovernmental agreement" rather than an amendment to the EU’s main Lisbon Treaty in order to speed up implementation. This is similar to the approach taken to secure the Schengen Agreement in 1985 (for more details, please see EU Set to Take Big Steps, but More is Needed, December 5, 2011). An aggressive target of March 2012 has been set for each of the nations to consult their domestic parliaments and formally approve the agreement.

EU Agreement: Long on Intent, Short on Detail

On paper, the agreement being pursued appears to be a significant step forward towards structural reform, focusing on a rules-based approach to fiscal discipline. A stronger firewall would also be established through an accelerated introduction of the new European Stabilization Mechanism (ESM) and temporary liquidity support via the IMF, bolstered by €200bn in reported commitments from EU central banks. But critics will point out the similarities to the original “Stability and Growth Pact”, which was put forward by France and Germany and adopted by the full EU in 1997 and has now clearly failed.

Moreover, though this represents progress towards securing a more viable firewall than the ill-fated European Financial Stability Fund (EFSF), the ESM would require capital commitments from national treasuries, which may pose a challenge in current circumstances. The ESM’s lending capacity of €500bn, even with the proposed €200bn in additional commitments, still falls short of estimates of the potential need for capital in the European financial system.

Global growth burden shifts to the US and China Although only an agreement to pursue an agreement has been struck, it does signal that the previous approach of liquidity injections and refinancing the enormous stock of debt of troubled euro-zone countries is now at an end.

However, in its place, the latest plan pursues internal deleveraging and economic restructuring with little debt relief for overly indebted nations. All else being equal, the outcome of such a policy will be negative for growth and inflation within the euro-zone and potentially increase strain on an already stressed financial system.

Thus, with the EU (ex-UK) having fallen in line with the German strategy of austerity, Europe will need to look externally for growth as deleveraging and restructuring weigh on local economies. In addition, its banking system sector will need to rely increasingly on the European Central Bank (ECB) to maintain liquidity, especially if slowing growth cast doubt on the quality of assets on banks’ balance sheets.

In the US, the roughly 2% trend rate of growth we expect as it de-leverages its own economy may be insufficient to sustain global growth. With little fiscal or monetary stimulus available to US policy makers, the US and global economies will be vulnerable to any shocks to growth.

Moreover, for China, with Europe as a key trading partner, it may force an acceleration of domestic-demand-driven growth in the years ahead. However, in the near-term this may pose a challenge as China continues to battle with elevated asset prices and high leverage in parts of its economy.

Volatility should remain elevated

Given a timely and well-executed EU plan, coupled with sufficient US and Chinese growth to allow for both the gradual deleveraging of the major Western economies, the handoff to Asian and emerging-market domestic demand as global growth drivers could continue seamlessly.

More likely, though, the progress towards agreement in Europe will be uneven. Similarly, while policy-makers in the US have been active in facilitating a gradual deleveraging of their banking system, more needs to be done (see the chart opposite). Meanwhile, European policy-makers appear more constrained in their efforts.

The transition in Asian and emerging-markets to domesticdemand- driven economies presents it own hurdles. As observed in 2011, inflationary pressures, income inequality, and their own need for deepening and strengthening of financial systems suggest a challenging road ahead as well before China and other developing economies are capable of fully taking the lead in global growth.

Thus, even if optimistic that the agreement among most of Europe's leaders this weekend represents a step towards much-needed structural reform, it is unlikely that volatility will decline as these reforms are pursued not only in Europe but also in the US and the emerging world.

If on the other hand, the next round of austerity results in disappointing growth in Europe and its key trading partners, the risks to the global economy will have risen.

Though the ECB may signal its support for the agreement among EU leaders with a new round of bond buying, it remains unclear whether the much-hoped-for, unconstrained bond buying from the ECB lies ahead. As this announcement is simply an agreement to pursue an agreement, the ECB may wait for a more concrete accord before committing its balance sheet. Comments so far suggest the ECB is not yet prepared to put its balance sheet unconditionally on the line.

Key markets price recession but not crisis

Though our analysis suggests European equities are pricing an 80% probability of recession, we expect rallies as a result of this weekend's announcement should be short-lived. Further austerity increases the probability of recession in Europe, but also raises the risk of a deeper recession than the mild -0.4% contraction forecast by the ECB last week. Investors should be prepared for further volatility ahead.

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