Becoming More Optimistic About Europe

Includes: FXE
by: Shareholders Unite

Yes, economically, it is in a perma-funk and things are even turning sour in Germany. But there is also reason for optimism:

  • Adjustment process is underway
  • Spain's competitiveness never that bad
  • The euro is falling, which should help the whole of the euro zone
  • A grand bargain is in the making
  • The alternative is too scary

Adjustment process
At the heart, the euro crisis is a balance of payments crisis. Capital first moved into the periphery, causing higher inflation compared to the center. Over time, this caused the periphery to lose competitiveness. This wasn't noticed at first, because the capital inflows and the cheaper borrowing thanks to being a member of the euro zone also caused a bit of a boom.

Then the financial crisis came and the capital flows changed direction. This was accelerated by the decision to impose increased capital requirements on banks:

Eurozone banks have cut their balance sheets by €4 trillion since late 2008. They have done this by pulling their money out of foreign ventures, especially southern Europe. Spain is the victim of a "sudden stop" in capital flows, just like Germany in 1928 when Wall Street cut off loans. [The Telegraph]

It will take time, but together with the fiscal adjustments and wage moderation and structural reforms taking place in the periphery, restoring some of the lost relative competitiveness versus the center isn't an illusion. We're not there yet, it would help if the center reflated (badly needed anyway) as the "internal devaluations" in the periphery would have to be smaller. But slowly we're getting there.

The country is in a terrible funk, things in the manufacturing sector were never as bad to start off with:

While Spanish wages rose much faster than the euro zone average during the pre-crisis years, large exporters kept costs under control, allowing them to stay relatively competitive. Meanwhile Spanish employers with more than 250 workers stayed just as productive as their German, Italian, and French counterparts, according to BBVA, Spain's No. 2 bank. Consequently, despite Asia's rise, Spain has managed to hang on to its global market share of exports. [thedailybeast]

It's internal demand that's bothering Spain. There is an enormous excess of houses, built during the boom the previous decade, and prices have further to fall. This will further deteriorate the balance sheets of households and banks, the latter already so battered they had to apply for a euro zone rescue package.

Households react by the wealth destruction of their housing by deleveraging, spending less, saving more, which shrinks the economy. As a result, tax receipts have cratered and the Spanish public finances, only a few years ago much sounder than those of Germany, are rapidly deteriorating.

The state and regions react to the deterioration in their finances (and pressure from Frankfurt, Brussels and Berlin) by cutting spending and hiking taxes, further slumping the economy. with respect to the fiscal tightening, it is instructive to listen to Evans-Pritchard from The Telegraph. You might want to keep in mind this is a conservative newspaper:

Fiscal policy has since become maniacal. The latest EU-imposed cuts, passed by the Cortes on Thursday as a condition for Spain's €100bn bank rescue, entail further tightening of 6.7 pc of GDP over three years. It is a ruinous for an economy already contracting, with unemployment of 24.3pc, in the grip of ferocious deleveraging by firms and households. [Evans-Pritchard]

They can't stimulate their economy. They can't devalue. They can't lower interest rates or embark on other forms of monetary stimulus. Growth will contract by a least 3pc next year, according to Citigroup. Banks bleed 50B euros in deposit per month.

Euro falling
All the mess in the eurozone has had one favorable side effect, the euro has been sliding pretty significantly against most major currencies.

Now, this matters less than people normally assume, as the euro area trades mostly with itself, but any development that is not negative for the euro area is very welcome.

There is no alternative to the ECB
Just take the following in for a moment:

Between now and mid-2015, Spain's funding needs stand at €542bn, with its banks needing a cash injection of €100bn on top of this. This compares to the combined lending power of the EFSF and the ESM, which will only reach €500bn in mid-2014.... Fully removing Spain from the financial markets for three years - could total between €450bn and €650bn. This is economically impossible as the combined lending capacity of the EFSF and ESM, the eurozone's two bailout funds, will only total €345bn in 2012. [OpenEurope]

Simply stated, even if the German Constitutional Court gives the green light for the ESM on September 12, it isn't large enough to take on Spain (let alone Italy). The logical consequence of this is that there is no alternative to some form of ECB role in keeping Spain from wrecking the whole eurozone.

Grand bargain
ECB intervention in the bond markets is anathema to the Germans, but the reality is that the Germans do not have a majority on the ECB. We therefore agree with Olaf Storbeck of the German Handelsblatt who argued Draghi (the ECB president) was not well understood on Thursday:

Between the lines the message was perfectly clear. The Bundesbank might not like it, but the ECB will intervene in the bond markets in the foreseeable future. And big time. From my perspective, the most important piece of the speech was Draghi's implicit acknowledgement that the ECB has a target rate for bond yields. Draghi described the current yields as unacceptable and he stressed that the ECB "may undertake outright open market operations of a size adequate to reach its objective."

The Germans might not like that but they had three years to basically do it their way, three years which has seen the crisis escalating, so with the economic (and increasingly political) crisis hitting the point of no return in the periphery, it's time something different is tried.

What exactly that will be is a matter of speculation, but in essence it will involve some kind of safeguard for the Germans that the Spanish (and Italians) will not abuse ECB involvement in the bond markets and renege on their reform and austerity program. Such a safeguard could most easily be established by these countries signing up for some form of EFSF/ESM bailout, which are hard parts to swallow.

Perhaps there could be face saving mechanisms found, but don't misread what came out of the ECB yesterday, Draghi means business and, equally important, the Germans can whine, they don't have an alternative and they have too much to loose.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.