euro area update - the euro area in the debt crisis maelstrom

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Page 1: Euro area update - The euro area in the debt crisis maelstrom

Euro area Update The Euro area in the debt crisis maelstrom Nordea Research, 29 November 2011

The failure of Euro area politicians to agree on a framework, which can quell the debt crisis, has pushed the Euro area towards a recession over the coming months. Thus, we have adjusted our forecast for 2012 growth significantly down to a decline of 0.2% compared to 0.6% growth in August. Similarly, we have scaled down our growth forecast for 2013 from 1.8% in August to just 1.0% now.

Our new macroeconomic forecast is based on an assumption, that a workable solution to quell the debt crisis is found before the end of the year. If Euro area leaders fail to agree on such measures, the risk of a far more serious recession grows dramatically.

The main channel for propagating the risk of a recession continues to be the banking sector, but a tightening of fiscal policy will also subtract nearly 1%-point from GDP growth in 2012 and 2013.

Finally, the sharply deteriorating outlook for the Euro area points to a further easing of monetary policy by the ECB. We now expect the next 25bp rate cut in December, bringing the refi-rate to the same level seen during the great recession 2 years ago. In addition, we expect the ECB to offer a host of new liquidity measures aimed at loosening funding conditions for Euro area banks. This might well push EONIA rates to 30-35 bps, as was the case between July 2009 and July 2010.  

The Euro area is headed for a recession In our latest Economic Outlook from the end of August we pointed to a significant risk of a mild recession in the Euro area. In particular we saw a continuation of the sovereign debt crisis as a key trigger for such a recession. This risk scenario is now rapidly becoming reality. Consequently we have adjusted our forecast for 2012 growth significantly down to a decline of 0.2% compared to 0.6% growth in August. Similarly, we have

scaled down our growth forecast for 2013 from 1.8% in August to just 1.0% now.

In addition, it should be highlighted that the risk of an even more negative outlook for 2012 has risen significantly. Despite great expectations, the EU summit conclusions from October 26 have utterly failed to quell the turmoil in financial markets. The summit conclusions aimed to increase the firepower of the European Financial Stability Facility (EFSF) by leveraging the remaining funds 4-5 times to somewhere between EUR 1000 and 1400 bn. At the moment, there are no signs that either of the two leveraging instruments; offering first loss bond insurance on new issues of government bonds or creating SPV’s focusing on purchasing government bonds in secondary markets, can actually work.

We expect a mild winter recession

In this situation, many observers and market participants point to large scale bond purchases by the ECB as the only realistic option to quell the crisis. This is clearly anathema to the ECBs governing council, as the new president Mario Draghi and several other members have argued that it is not the ECB’s remit to act as lender of last resort to Euro area governments.

Euro leaders can avoid a deep recession Our new macroeconomic forecast is based on an assumption, that a workable solution to quell the debt crisis is found before the end of the year. We have previously pointed to the option of turning the EFSF into a bank, which could refinance its bond purchases at the ECB as a solution which might work. This solution has so far been flatly rejected by the German government and the ECB, but we

02 03 04 05 06 07 08 09 10 11 12 13-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0 % %

GDP, annualized, q/q

Euro Area GDP, y/y

Page 2: Euro area update - The euro area in the debt crisis maelstrom

still think this solution may come back in vogue when (if?) the current leveraging strategy for the EFSF fails.

Levels of financial stress at record highs

If Euro area leaders fail to agree on robust measures, which can quell the debt crisis, the risk of a far more serious recession grows dramatically. The main channel for propagating the risk of a recession continues to be the banking sector, where we already see signs of financial stress which in some respects are comparable to the period immediately after the collapse of Lehman Brothers. This could easily trigger a far more dramatic decline in inventories and business fixed investment than we expect in our baseline scenario.

Credit crisis likely to weigh on investments A key factor behind our significant downgrade of the economic outlook is a substantial downwards adjustment of fixed investments. This is largely based on the fact that the funding crisis for several Euro area banks is likely to lead to a further tightening of credit conditions for non-financial companies. This credit tightening could be further aggravated by the new requirement for the largest EU banks to bring their Core Tier1 capital ratios to 9% by the end of June 2012, well ahead of the 2018 deadline otherwise envisaged in Basel III.

In the conclusions from the EU summit on October 26, it was specified that banks should seek to raise the capital themselves and only in the case where this could not be achieved should member states step in with capital. This process creates a significant risk that banks will seek to meet the capital requirements by shedding assets, as the low equity valuations makes it quite unattractive for banks to raise the necessary funds in capital markets. Consequently, the EU summit conclusions called for national supervisory agencies to oversee that the capital requirement was not achieved through deleveraging.

Outlook for business investments is bleak

In spite of the supervisory requirements, we actually think that the completion of the recapitalisation process in Q2 next year could be a turning point for the Euro area. Growth in business investments and private consumption are usually dependent on the credit impulse, which we have defined as the second derivative of the outstanding stock of credit to non-financial enterprises and households. As such, the fact that loans to households and non-financial companies would stop falling once the EU banks have met the new capital requirements could spur new growth private consumption and investments.

The credit impulse is key to turns in the cycle

Note: The credit impulse is defined as the annual change in the quarterly nominal change in the outstanding stock of loans to households and non-financial companies.

Fiscal tightening across the board in 2012 Turning to fiscal policy, nearly all the budgets for 2012, currently being finalized in Euro area member states, point to a further tightening of fiscal policy. The pressure in financial markets is rapidly forcing Euro area governments including France and Italy to accelerate plans for fiscal consolidation. In particular Italy is slated to undertake a substantial tightening of fiscal policy next year, as it has pledged to bring public budgets back to balance already in 2013 even though the Italian economy is already headed for a deep recession.

Source: Nordea Markets and Reuters Ecowin

Aug08Nov

09Feb May Nov

10Feb May Aug Nov

11Feb May Aug

50

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325

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125

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325 Bp

Itraxx senior financials, 5y bid

Bp

Source: Nordea Markets and Reuters EcoWin

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11-20

-15

-10

-5

0

5

10

15

-40

-30

-20

-10

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10

20

30 y/yMachineryinvestments, r.a.

New ordersmanufacturing, advanced 3 months, l.a.

y/y

Source: Nordea Markets and Reuters Ecowin

99 00 01 02 03 04 05 06 07 08 09 10 11-300

-250

-200

-150

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-50

0

50

100

150

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-6

-5

-4

-3

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-1

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1

2

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4

5 BN EUR

Credit impulse, r.a.

Euro area

Real GDP, l.a.

% y/y

Page 3: Euro area update - The euro area in the debt crisis maelstrom

Fiscal tightening to weigh on growth in 2012

Source: National Stability and Growth Programs, German Ministry of Finance, The EU Commission and Nordea’s own calculations.

Overall we estimate that this will subtract just above 1%-point from growth. The degree of fiscal tightening in 2013 is less certain, but with a continuation of the debt crisis the drag from fiscal policy is likely to be of similar magnitude.

Debt crisis is depressing consumers

Only limited help from exchange rates The Euro area debt crisis has intensified in step with a sharp slowdown in global growth. We still expect fairly robust growth in the BRIC countries during 2012 and 2013, and this should provide some underlying momentum for export growth. Growth in the most important export markets, the UK and the US is likely to remain very subdued in 2012, however, see our US Update: No recession but slower growth.

Even though demand growth will be fairly modest in the Euro area’s key export markets, Euro area exports will also be lent a helping hand from a depreciation of the EUR vis-à-vis the USD and the CNY. In our baseline scenario we only expect the effective exchange rate of the EUR to depreciate by just under 4%-points in 2012 compared to 2011. Based on standard multipliers this modest depreciation should only lift the Euro area GDP level by 0.3%-points in 2012 rising to 0.5% in 2013.

Modest depreciation of effective exchange rate

Based on the ECB’s Effective Exchange Rate (EER) weights and Nordea’s own calculations.

In a risk scenario, where the Euro area debt crisis causes a significant fall in the EURUSD to 1.00 with a corresponding depreciation of the EUR vis-à-vis the CNY and the JPY, the support for Euro area exports would be far larger, see table. Overall, this could lift the Euro area GDP level by nearly 1%-point in 2012 rising to nearly 1.7% in 2013.

The ECB might try privatized QE The rapid deterioration in the economic outlook prompted the ECB to cut interest rates by 25bp to 1.25% at the beginning of November. So far we have expected the ECB to follow this move by another cut in the first quarter of 2012, possibly already in January. With this update of our economic forecast for the Euro area we now expect the next rate cut already at the ECB meeting on December 8.

EONIA rates could return to 30-35bp range

In addition to a December rate cut, we also expect the ECB to offer a new range of liquidity measures. We find it most obvious that the ECB will announce additional LTRO’s at the December meeting. In particular we have taken note of rumours, that the ECB should be contemplating LTRO’s with maturities of 2-3 years an alternative to government guarantees on bank funding, which

Change in cyclically adjusted primary balance Share of Euro area GDP 2011E 2012E 2013E

Germany 27.0% -0.7 -0.8 -0.5France 21.0% -1.3 -1.5 -1.5Italy 17.0% -0.9 -2.6 -1.3Spain 12.0% -3.4 -1.5 -1.3Belgium 3.8% -0.4 -0.5 -0.9Netherlands 6.4% -1.6 -1.2 -0.8Austria 3.1% -0.6 -0.6 -0.3Ireland 1.5% -2.6 -1.9 -2.3Greece 2.6% -3.4 -2.4 -2.0Portugal 1.9% -3.3 -1.6 -0.1Euro area (weighted average) -1.3 -1.4 -1.0

Source: Nordea Markets and Reuters EcoWin

05 06 07 08 09 10 11-80

-70

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0

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10

20 Balance

Portugal

Greece

Consumer sentiment

Spain

BalanceGermanyFrance

Italy

Baseline Risk scenario

Sweden 0.1 0.1Switzerland -0.1 -0.1China -0.9 -2.2Japan -1.0 -2.9United Kingdom 0.2 -1.9United States -2.1 -6.5Sum -3.7 -13.4

EER-impact for 2012

%-points

Source: Nordea Markets and Reuters Ecowin

Jan09

Apr Jul Oct Jan10

Apr Jul Oct Jan11

Apr Jul Oct0.0

0.5

1.0

1.5

2.0

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3.0

0.0

0.5

1.0

1.5

2.0

2.5

3.0 %%

The corridor between the refi-rate and the deposit rate was widened to 75bpsin May 2009.

Main refi-rate

ECBs deposit rate

Page 4: Euro area update - The euro area in the debt crisis maelstrom

Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets.

are currently not very useful in the member states languishing under the sovereign debt crisis. Such a policy would thus aim to prevent a further tightening of credit conditions, and it might also be attractive for Euro area banks seeking to fund their holdings of short term bonds.

Whether such operations will be successful will probably depend on the terms offered under such operations. As an example, the new 12 month Long Term Refinancing Operation (LTRO), launched on October 27 only attracted bids of EUR 56.9 bn, far below the levels seen at the 12-month LTRO’s offered in 2009 even though money markets are currently under severe pressure. This might be

explained by the fact that the 12-month LTRO was offered with interest rates indexed to the average of the refi-rate over the maturity of the operation. If instead the ECB returned to letting the interest rate be fixed at 1.00% on the forthcoming 13-month LTRO, we might see much higher liquidity withdrawals. In turn this would probably push EONIA rates down to 30-35 bps, as it was the case between July 2009 and July 2010.

Anders Matzen, Chief Analyst [email protected] + 45 33 33 33 18

Euro area: Macroeconomic indicators (% annual real changes unless otherwise noted)

*Growth contribution as % of GDP.

2008 (EURbn) 2009 2010 2011E 2012E 2013EPrivate consumption 5,169 -1.2 0.9 0.4 0.2 0.9Government consumption 1,901 2.6 0.4 0.4 0.0 0.0Fixed investments 1,981 -11.9 -0.9 2.4 -1.0 1.6Stockbuilding* 62 -0.9 0.9 0.5 -0.2 -0.2Exports 3,877 -12.8 10.1 5.1 0.5 3.5Imports 3,788 -11.6 9.2 4.5 0.2 3.1Net exports* 89 -0.7 0.5 0.3 0.1 0.2GDP -4.2 1.8 1.6 -0.2 1.0Nominal GDP, EUR bn 9,243 8,938 9,168 9,445 9,580 9,834

Unemployment rate, % 9.7 10.1 10.0 10.5 10.5Industrial production, % y/y -3.5 4.7 2.0 -1.0 1.5Consumer prices, % y/y 0.3 1.6 2.7 1.8 1.6 - core inf lation** 1.3 0.9 1.6 1.6 1.2Hourly earnings, % y/y 1.4 1.5 1.6 2.1 1.6Current account, bn EUR -27.9 -45.7 -55.0 -50.0 -50.0Current account, % of GDP -0.3 -0.5 -0.6 -0.5 -0.5General government budget balance, % of GDP -6.3 -6.2 -4.1 -3.5 -2.7General government gross debt, % of GDP 79.1 84.7 86.3 88.6 89.0