Wednesday, November 30, 2011

What's next in Europe?

Each time the debt situation has moved on in Europe the catalyst has been a sense of crisis. Here we are again. The only difference has been that each crisis has been more extreme than the one before.

At this point, while credit markets in Europe aren’t frozen, they are looking increasingly frosty. Sovereign bond yields have risen to unsustainable levels. There can be no room for doubt about the seriousness of the situation following the failure of a German bond tender last week. We are now at the tipping point.

Fortunately there is another European summit scheduled for December 9th. So there is still another opportunity to put in place the more enduring solution we thought we were getting in October. The good news is there is a solution in reach, it just needs taking.

We are not looking for anything we haven’t looked for before. We still want to see credible, implementable plans for fiscal consolidation in Europe; a firewall around Greece; a backstop for bond issuance in wider Europe and a plan for bank recapitalisation. We also want to have some understanding of the long-term plan for fiscal co-ordination in Europe and structural economic reform to boost medium-term growth prospects.

The most recent plethora of speculation has centred on the establishment of a framework for fiscal co-ordination in Europe, enshrined in Treaty. That’s good news, but it’s where the solution should have started two years ago. At that point such a move would have been sufficient to stem contagion. It seems unlikely that this alone will now be enough to save the Euro, especially given the time it will take to put in place, but it is an essential part of the long-term solution. In our view Euro bonds will be an inevitable part of that solution. It is unfortunate that the German Chancellor has backed herself into a corner on this issue.

The good news is that a firmer commitment to fiscal co-ordination could be enough to encourage the ECB to take another important step in the solution: larger scale bond purchases in Europe - most likely in conjunction with the EFSF and IMF. For all its reluctance to act as lender of last resort in Europe the ECB has purchased around €200b in sovereign debt since August. This has been as crisis points have been reached. Perhaps movement on fiscal co-ordination will get the ECB (most likely in conjunction with the EFSF and probably the IMF) over the line in terms of larger scale bond purchases.

It seems to us the ECB will inevitably buy more bonds. In the worst case scenario the ECB steps up its intervention, not as lender of last resort, but as defender of price stability and avoidance of a deeper European recession and deflation.

On the fiscal consolidation point, the move to technocrat governments in Italy and Greece is a positive development. The conventional wisdom is that Monti in Italy and Papademos in Greece will find it difficult to implement what is required in Italy and Greece. Of course it will be difficult but we think they have a better chance of implementing the necessary reforms than would have been the case for Berlusconi and Papandreou. We think it will be easier for technocrat leaders to implement what is required than it would be for the politicians the electorate blames for the crisis.

There is little doubt the situation in Europe is serious and has become more serious as time has moved on. The risk of a deep protracted recession in Europe, with flow-on implications for the global economy, is real. Most of the measures required will take time to implement and for the benefits to flow. The important factor now is that markets have confidence in the politicians commitment and ability to implement whatever it is they come up with on December 9th.