Eurozone: A Conditional Rebound

2012 will be remembered as the most chaotic year of the eurozone. Although the GDP contraction proved to be much milder than in 2009, the factors that provoked it were unprecedented.

Austerity policies adopted in southern Europe (Italy, Spain, Greece, and Portugal) stifled domestic demand and slowed exports to their northern partners. They sparked massive unemployment (17.5% in average in southern Europe) and fuelled electoral support for extremist parties, weakening the EU’s citizen image, which was already lacking in terms of democracy. One new development: the eurozone became the object of speculation about a possible breakup and even its very existence, a movement that peaked with the second Greek elections on 6 May.

The perception of a latent currency risk (convertibility risk) triggered the segmentation of capital markets and as a corollary, the rise of internal imbalances within the Eurosystem (Target2 accounts). This fed a vicious circle between banking and sovereign risks: deprived of funding, the financial systems of the most fragile EMU countries were seen as a threat to local public finances, casting doubts on both the quality of bank assets and state deposit guarantees. By the end of the first half, Spain, Portugal, Ireland and Greece were hit by deposit flight estimated at about €325bn over a year.

The acute crisis fortunately led to two major decisions needed to restore confidence. At the Brussels summit on 29 June, EU heads of state and governments launched the idea of a banking union. As part of joint supervision and common regulations, ailing banks would be able to turn to the European Stability Mechanism (ESM) to be recapitalised directly without burdening local public finances. Banking union is the first step in the move towards a political, economic and fiscal integration of the eurozone.

In early August, ECB president Mario Draghi pledged to do whatever it takes to preserve the euro. A month later, he presented the Outright Monetary Transaction (OMT), a securities purchasing programme in the secondary market for potentially unlimited amounts and maturities, for governments that still have access to the primary market and benefit from European aid.

By providing investors with a put option (even though exercise prices were not fixed), Mr. Draghi got foreign capital flowing back into debt segments in the peripheral countries that had been deserted. 2- year Spanish rates dropped from 6.9% in July to 2.9% in mid December, while Portuguese rates dropped from 5% to 1.8% over the same period.

The worst of the eurozone crisis is probably over. The simple announcement of OMT made all the difference by reducing the volatility of long-term interest rates. The probability of an outbreak of severe financial stress declined sharply once it was established that the ECB could intervene in an unlimited manner in the secondary market. Activity should begin to recover gradually in 2013. In Germany, manufacturing already seems to be picking up.

Yet this perspective remains fragile and depends on progress towards European governance, notably by transforming the promises of H2 2012 into acts. Yet with the easing of financial tensions in the eurozone, political leaders also come under less pressure and are less likely to take the lead on European issues. Spain is a typical example. The announcement of OMT brought down Spanish yields – especially on the short end of the curve - which let Mr. Rajoy take a free rider stance.

The Spanish Treasury shortens the maturity of the debt in order to take advantage of the easing of funding conditions without bearing the political cost of a financial aid request. Clearly this is not a viable strategy since rates declined solely in anticipation of the Spanish government’s request for European aid. It illustrates the conflicts of interest that can exist between the political interests of some countries and the general interest of Europeans, whose voice is not heard due to the lack of a political union.

The approach of elections in Italy and Germany is also propitious for inaction. Angela Merkel, criticised by her own party for a lack of firmness towards the peripheral countries, probably will not make any major decisions before the September 2013 elections. Italy is once again battling its old demons with the real/unreal comeback of Mr. Berlusconi, which triggered the resignation of Mr. Monti and raised doubts in the markets about the country’s determination to pursue reforms. Until elections are held, apparently next February, uncertainty could drive up Italian rates.

Lastly, the 13 December agreement on the Single Supervisory Mechanism (SSM) marks a decisive step towards banking union. Yet it also tends to sidestep the Federal architecture promised in the beginning. The ECB will directly supervise only the biggest 200 banks out of the eurozone total of 6,200 banks, with the others remaining under national regulations. Yet from Greece’s case to the Spanish savings banks, experience shows that size and systemic risk can be inversely proportional.

The year 2013 seems to be more promising than 2012. Assuming, of course, the eurozone stays the course.

By Thibault MERCIER