There have been 4 major recent events in the European recession scenario:
- Spain has declared that they are now targeting a budget deficit of 5.8% of GDP for 2012. The target agreed previously was 4.4%. However growth for 2012 has now been revised down to -1.7% which equates for the difference in the deficit. It also means that it is likely that Spain will miss it's 2013 target of below 3%.
- The Netherlands Bureau for Economic Policy Analysis has said that the Netherlands will not now hit the 3% budget deficit target for 2013, as agreed with the European commission. The projected deficit for both 2012 and 2013 is 4.5% of GDP. It is estimated that the Dutch will have to cut spending by €9 billion to hit their target of 3%. The required further austerity is putting pressure on the Dutch coalition government as the economy is presently in recession. The prime minister has said that he is looking for ways to bridge the budget gap. It is estimated that the Netherlands' economy will contract 0.75% in 2012 before any further measures.
- Francois Hollande has said that if he is wins the upcoming French presidential elections in May, he will renegotiate the fiscal pact.
- Ireland has said that it will have to have a referendum on the fiscal pact.
So what does all of this mean?
Spain is clearly suggesting that the target of a 3% budget deficit in 2013 is unattainable. They are not prepared to change policy any further to achieve the 3% goal. This will undoubtedly annoy the Germans and all of the more prudent nations. There has been no official or unofficial comments from Germany concerning their response to this Spanish announcement. It is likely that behind the scenes there is contact to resolve the issue. The result of these negotiations must either be:
- That Spain can proceed more slowly than they have previously agreed. If this is the case the Eurozone recession will not be anywhere near as deep as I have been suggesting (this would be bullish for European stock markets). This would also mean that all of the other countries can proceed more slowly as well. This would be the first death knell for the fiscal stability pact. If even before the pact is ratified by all of the governments, one of the countries is no longer complying with the rules, the whole pact becomes an irrelevant sideshow.
- That Spain will be told to find further measures to meet its commitments or be cut off from help from the EFSF/ESM and potentially the ECB. This would mean that the Eurozone recession will be deeper than presently envisioned (this would be bearish for European stock markets).
Once the response comes from Germany we will know which is the likely scenario. It would seem that Germany holds the cards here, and I would suggest that it is unlikely that they will be able to sell a slower rate of progress from Spain to their electorate (as it means that their financial support becomes greater). I also think that they will consider the message that this sends to the rest of the Eurozone if Spain remains on a slower timescale to achieve fiscal balance. It is clear that a showdown is approaching, but it is one that is likely to be played out behind closed doors. There has also been no comment on this from the ECB. What will they do about the purchase of sovereign bonds if the country concerned is not complying with the fiscal pact?
I will be very interested to hear how the ECB is viewing this development. One thing is clear, if countries wish to progress their fiscal balancing more slowly the money to finance the prolonged deficits will have to come from either fiscal transfers (read: EFSF/ESM) or money printing by the ECB. I find it extremely unlikely that private finance will fill this gap. In the past it has been surmised that the ECB has rewarded countries that it feels have achieved the required changes by buying their bonds and thereby reducing the interest rate that they have to pay on their debt. Will this be the tool that they use to bring countries back in line?
Mr Rutte, the prime minister, has suggested that he will review the options to cut the budget by the €9 billion required. However his coalition partner Geert Wilder (the populist Freedom Party) is not in favor of further cuts. The prime minister has suggested he will make the cuts in a way that promotes growth to gain support from his coalition partner. I will be interested to see how he finds cuts that promote growth!
If the Netherlands does not find agreement on further cuts, the fiscal pact will die completely and with it any semblance of fiscal integration in the Eurozone. However the likelihood is that the cuts will be found and that the Netherlands complies with the fiscal pact.
This is very problematic. France is the second largest economy in the the Euro area. If they abandon the pact it is truly dead. If Hollande is elected, will he go through with his stated policy of renegotiating the fiscal pact? I have long thought that the most likely result in the breakup of the Euro is that the Germans will be the country that leaves. If the Germans do not garner support from the French I am sure that they will be pushed 1 step closer to leaving the Euro. I have stated in previous articles that all of the nations only stay in the Eurozone whilst there is a financial incentive for them to stay. As countries delay fiscal balance the bill to Germany goes up. At some stage they will decide that the bill for staying is larger than the bill for leaving.
Often held up as the poster child for how to make austerity work the Irish referendum is in the balance. The present position is:
The two governing parties and the main opposition party in the Dáil, Fianna Fáil will all urge a Yes vote. However, Sinn Fein, the United Left Alliance and a range of Independents will call for the treaty to be rejected.
It seems that the majority of the political parties will be urging a yes vote. However in the first vote on the Lisbon treaty the electorate rejected the yes vote, despite government support. It is possible that this will happen again. If the vote is no the Irish will be cut off from help from the ESM in the future. It is unclear if they can remain in the Euro. It is clear from this development that the ratifying of the fiscal treaty by all of the governments will be more difficult than previously thought.
Without some discipline from Euro area governments, the fiscal pact will fall apart and further fiscal integration with it. This must be negative for the Euro currency and the long term success of the Eurozone. However in the short term it may be bullish for the European stock markets, if the pace of the fiscal balancing progress is slowed. It is not clear which option will prevail. Clearly European leaders are becoming more guarded with their comments (or we would have heard some comments from German finance minister Scheuble by now) and it seems likely that we will only know the answer once the resolution has been agreed.
None of the above situations are positive for the long term health of the Euro area. It is unclear now how the situations will resolve themselves and so it is difficult to decide on the effect on markets - the outcomes may be bullish or bearish!
I have in the past taken positions in European markets. I am presently waiting for clarifications on how the above situations resolve themselves to make any further commitments in Europe.
Disclaimer: This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.
Disclosure: I am long RWM and short S&P 500 futures.