In late October there seemed to be room for optimism that Europe was going to head off a worst case blow up and that a “comprehensive” plan would be in place by the early November G20 leaders’ forum.
However, political blow-ups in Greece and Italy put paid to any respite.
The G20 leaders’ forum came up with nothing, and Europe has yet to implement much of what it announced in late October.
As a result, the European crisis has continued to worsen, with investors now bailing out of core countries.
Dr Shane Oliver, the chief economist of AMP Capital Investors asks, what does it all mean for the global economy and risk assets?
Contagion on steroids
The past few weeks have seen the European crisis enter a more dangerous phase.
It has moved beyond peripheral countries & is now seriously affecting Italy and Spain, where bond yields are at levels that prompted bailouts in Ireland and Portugal.
Furthermore it is now threatening even France, Belgium, the Netherlands, Austria and Finland, which have all seen their bond yields rise relative to German yields.
The basic concern of course relates to high debt levels.
But the weighted average 10 year bond yield in Europe is now 5.4%, versus a US ten year bond yield of just 1.9%, despite the fact US public finances are comparably worse.
The US 2011 budget deficit and gross public debt are equal to 10% and 101% of GDP respectively, compared to 4% and 90% of GDP respectively in the Euro zone (EZ). Clearly something else is at play.
Speculative contagion working against non- German euro-zone bonds is a part of this.
The unintended consequences of policy action are also playing a role:
- Fiscal austerity, in the absence of monetary easing, is adding to the economic downturn, which in turn is making investors sceptical that debt will be reduced;
- EZ banks appear to be selling bonds in order to meet heightened capital ratio requirements;
- The haircut on Greek debt has led to a reassessment of the risks of holding all EZ government bonds;
- Talk of providing first loss insurance on new bonds has reduced the value of existing bonds; and
- Investors have realised credit default swap insurance on bonds may be of little value if it doesn’t pay out in response to ‘voluntary’ debt restructuring.
So the crisis has spread from relatively trivial countries with Greece, Portugal and Ireland accounting for only 6% of EZ GDP and 8% of its debt, through to Italy and Spain (which together account for 28% of its GDP and 32% of its debt), and now to France, which alone accounts for 20% of EZ GDP and its debt. See the next table.
Much of the current turmoil could have been avoided if the ECB had acted earlier as bond buyer of last resort and erected a firewall around otherwise solvent countries such as Spain and Italy.
This would have involved the ECB threatening to buy unlimited quantities of bonds in threatened countries in order to ward of speculative attacks on bond markets, and running much easier monetary policy (cutting interest rates to near zero and quantitative easing) to provide an offset to fiscal austerity.
Despite suggestions to the contrary, there is no legal barrier to the ECB buying bonds or undertaking quantitative easing.
The ECB Statute prevents it from buying bonds directly from governments, but there is nothing preventing it from buying them in the secondary market and of course it has already undertaken quantitative easing during the GFC.
Rather, a desire to force economic reforms on troubled countries, avoid moral hazard, misplaced fears about inflation and political squabbling have brought Europe and hence the world to a dangerous place.
Sure the ECB has been buying bonds, but only on a very limited basis.
Since last May it has bought €195bn worth of bonds or $US263bn. But this has been sterilised by the sale of short term debt and compares with a massive $US600bn worth of debt purchases by the US Fed under QE2.
Three scenarios for Europe
Leading indicators are pointing to recession in Europe.
The question is now how deep and financially disruptive it will be?
Put simply, there are three possible scenarios for Europe.
Muddle through: the cycle of ‘revolt, response, and respite’ continues to repeat, with periodic interventions that never go far enough but are enough to avoid a major blow up.
This is what Europe has been going through over the last 18 months, but it’s questionable it can continue this way with core countries now being affected.
Blow up: the crisis comes to a head with a deep recession – Euro zone GDP falling 5-10% in 2012 – and a financial crisis rivalling the GFC.
This would be bad for growth assets – shares, commodities, the $A and euro.
Aggressive ECB monetisation:
the ECB finally realises the crisis is threatening deep recession and price deflation and so moves to undertake aggressive quantitative easing to push down bond yields and head off economic calamity.
This would probably be too late to head off a mild recession, an
