FROM THE ECONOMIST INTELLIGENCE UNIT

Thanks to Germany, euro area growth rebounded in the second quarter. But large debt burdens, fragile banking systems and deep macroeconomic imbalances point to testing times ahead.

Despite a German-driven boost to second-quarter growth, the euro area remains embroiled in the worst crisis since its inception in 1999. Large debt burdens, fragile banking systems and deep-seated macroeconomic imbalances within the region have severely undermined market confidence in the solvency of peripheral euro area sovereigns and the very viability of the single currency. Although financial support packages have, in theory, bought policymakers time to try to stabilise the weaker peripheral countries, concerns about fiscal sustainability will remain a source of market turbulence, particularly if recent signs of a marked softening in global economic activity persist. We expect that, given its huge debt burden, Greece will ultimately have to restructure its debt, which could raise fresh fears about contagion in the region.

European policymakers belatedly responded to a marked shift in investor sentiment in May 2010 by agreeing a €110bn (US$138bn) bailout of Greece and a European Financial Stability Facility (EFSF), which could provide €750bn of financial assistance to euro zone members. At the same time as the EFSF was announced, the European Central Bank (ECB, the euro area's central bank) launched a programme of government debt purchases aimed at improving liquidity in the bond markets of peripheral euro area member states, while in July the EU sought to calm market nerves by announcing the "positive" results of stress tests conducted on the region's largest banks.

These policy initiatives helped to stabilise the bond markets of weakened periphery member states for a time, enabling governments to issue new bonds at reasonable rates. The euro also recouped some of its earlier losses against the US dollar, in part owing to growing (and valid) concerns about the US's own growth prospects, while a number of European banks have been able to tap the capital markets on the back of the stress test results. More recently, however, there have been signs that these positive developments may be a short-term phenomenon. With global risk aversion on the rise, the euro has fallen back against

major currencies, at the same time as spreads on European peripheral sovereign debt have moved wider and banks' reliance on ECB liquidity has increased.

Even if the EFSF, which appears a cumbersome structure, works well, it largely buys time and does nothing to resolve the deep-seated structural problems of restoring solvency and addressing imbalances within the euro area. At present, with many countries struggling to recover from balance-sheet recessions triggered by the end of a multi-year credit boom, there are few signs that politicians or electorates are prepared to undertake the reforms necessary to strengthen the underlying framework of the euro area.

Cut...and cut again

Following the deterioration in public finances since the onset of the recession, several euro area countries are now in a situation where even drastic fiscal consolidation measures may not restore fiscal solvency. Although austerity measures may achieve the objective of reducing government expenditure and raising tax revenue, they may have such an adverse impact on the economy that debt/GDP ratios continue to rise rapidly. For example, Greece's drastic consolidation measures appear to be having some success in narrowing the country's large fiscal deficit, but unsurprisingly the painful austerity is also contributing to a further sharp contraction in economic output. The medium-term risk persists that as the impact of ongoing fiscal retrenchment continues to bite on broad sections of the population in Greece, and in other struggling economies, the public's accommodating stance to date could quickly unravel.

In the light of the challenging debt dynamics, we expect that Greece will eventually restructure its debt, probably in 2012. A restructuring might entail a reduction of around 30% in the face value of the debt initially, although even this may not be sufficient. At present, we assume that other governments in the euro area facing a loss of investor confidence, such as Ireland, Portugal and Spain, will be able to continue to service their debts, although some may need to tap the EFSF.

We do not foresee any member of the single currency deciding to leave the euro over the forecast period. Whatever the pain of adjustment (most likely a protracted period of falling wages and living standards), this would be outweighed by the high costs of leaving the euro area (widespread bankruptcy and insolvency, and the loss of savings). Thus we believe that no government would rationally decide to leave the euro area, although we concede that such an outcome could be forced on a country because of financing constraints. Rather than weak peripheral countries leaving the euro area, another potential outcome would be for Germany and other stronger countries to leave. This might prove less catastrophic financially than forced exits by weak members, but it would still create massive instability in financial markets.

What's all the fuss about?

Despite the debt crisis, the euro zone has posted a half-decent recovery from the recession, although it should be noted that the recent rebound in activity has been far from uniform across the region. Having expanded by 0.2% quarter on quarter in the first three months of 2010, euro area GDP is estimated to have grown by a full 1% in the second quarter. This strong performance was driven primarily by Germany, which grew by 2.2% over the quarter, as German manufacturers benefited from buoyant demand--particularly for capital goods--in emerging markets. France and Italy, the second- and third-largest economies, grew by 0.6% and 0.4% respectively, better than expected but lagging far behind the German machine.

In contrast (and possibly as a portent of things to come in the region), the Greek economy contracted by 1.5%, weighed down by fiscal retrenchment, widespread strikes and high borrowing costs. Spain and Portugal, two of the other distressed southern periphery economies, both grew, albeit by a negligible 0.2%. Five other euro area countries, including the austerity test-case currently known as Ireland, are still to publish second-quarter GDP data.

The unexpectedly strong showing by Germany has led us to revise upwards our 2010 forecast for euro area growth to 1.3%, from 0.7% previously. However, this should not distract from the temporary nature of some of the second-quarter growth drivers and the underlying weakness across much of Europe. More recent data releases, such as a decline in industrial production in June and weakening new orders data, lend support to our expectation of a significant slowdown in activity in the months ahead. Strains have also re-emerged during August in the sovereign debt markets of the southern periphery countries--not least in Ireland, where estimates of losses from its dysfunctional banking sector continue to mount. This may presage a return of wider turbulence in financial markets.

As the second-quarter GDP data indicated, performance across the euro area is mixed. Export-oriented countries, such as Germany and the Netherlands (and Sweden in the EU27), are clearly benefiting from robust emerging-market demand. The former have also received a boost to margins from the depreciation of the euro since late 2009. In contrast, the peripheral countries most under pressure (Greece, Ireland, Portugal and Spain) lack the export base to benefit to anything like the same extent from a weaker euro. Despite official claims to the contrary, rigid labour markets and private-sector wages will remain significant obstacles to these countries restoring their competitiveness over the medium term.

Stresses and strains

Fragilities in the banking sector stemming from the bursting of residential and commercial real estate bubbles in a number of countries are being compounded by asset impairments related to the continued stresses in government bond markets of the southern periphery countries. However, EU policymakers are refusing to recognise even the possibility of defaults on euro area sovereign debt in the short to medium term (up to 2014)--a denial that significantly undermined the credibility of the recent stress tests conducted on 91 European banks in July.

In its latest Financial Stability Review published in June, the ECB lowered its estimate for cumulative write-downs on loans and security holdings for euro area banks for 2007-10 to €515bn, from €553bn in its December 2009 report, but at the same time raised its estimate for loan losses, while acknowledging that loans in this category may be understated. According to the ECB, banks have already made large write-downs and loan-loss provisions, so that it expects only an additional €90bn of write-downs will be necessary (net of write-backs resulting from a rise in the value of some securities).

However, the outturn may well be far worse, given the duration of the economic downturn, the risk of impairments on peripheral euro area sovereign exposure, and the increasing threat of a slump back into recession against a backdrop of fiscal austerity and private-sector deleveraging. Concerns about asset quality and the imposition of tighter financial market regulations (albeit most likely watered down to a degree) will continue to weigh on banks' lending behaviour. Since the start of 2010 the stock of bank loans to the private sector in the euro zone has stabilised, exhibiting virtually no growth on a year-on-year basis. On the one hand, this reflects the tighter lending conditions facing all borrowers since the bursting of the credit bubble, and on the other hand a lack of creditworthy customers that banks are willing to lend to.

Easy does it

In addition to its ongoing programme of "enhanced credit easing", offering unlimited cheap liquidity to the banking sector, since May the ECB has also taken the unprecedented step to purchase government bonds in an attempt to contain disorderly conditions in some euro area debt markets and to support the €750bn EFSF rescue package. Previously, the ECB had refused to consider such a move (with the exception of ultra-safe covered bonds), in contrast to its US and UK counterparts, both of which have engaged in very large bond purchase programmes (quantitative easing).

The ECB's change of mind has raised concerns about political interference and undermined its reputation for orthodoxy, but we do not think that it will try to restore this by a premature tightening of monetary policy. Indeed, our forecast is that the ECB will start to raise interest rates even later than we had previously thought, in the third quarter of 2012 (rather than the fourth quarter of 2011), as it attempts to offset the impact of tightening fiscal policy with loose monetary policy. Despite the concerns of some observers, we do not believe that the ECB's interventions (which may have to be expanded in the months ahead) will lead to a surge in inflation. Despite some upward pressure from higher commodity prices on headline rates, it is deflationary pressures that are intensifying in the euro area.

SOURCE: ViewsWire