EUROZONE: Eye on the prize

A negative feedback loop between economic output and confidence in the eurozone will be hard to break – not least since progress towards political union won’t happen any time soon

  • By Phil Thornton
  • 11 Oct 2012
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Mario Draghi could be forgiven for feeling like a beleaguered driving instructor. Every time the eurozone looks set for a major collision, he has to slam on the emergency brake and grab control of the steering wheel from an errant politician.

The latest manoeuvre was in September when the president of the European Central Bank unveiled the ‘outright monetary transactions’ (OMT) – purchases of sovereign bonds with maturities of up to three years. The purchases would have no limit and would be launched when the yields on the sovereign bonds showed that the normal monetary transmission mechanism had broken down, provided that the issuer requests help from the eurozone’s rescue fund and agrees to tough austerity measures to bring its finances back under control.

This followed up on his verbal intervention in July when he said the ECB would do “whatever it takes to preserve the euro”, which gave the eurozone politicians a relatively peaceful summer, and his promise after the ECB’s monetary policy meeting in August that the central bank would buy more bonds.

After September’s OMT announcement, share prices surged, and yields on those countries targeted by speculators – Spain and Italy – fell sharply. Spanish 10-year bond yields fell by a full percentage point while investor euphoria sparked a rally in emerging market assets. Some officials in emerging markets say the worst is now behind and the eurozone is on track for fixing its debt problems. Polish finance minister Jacek Rostowski tells Emerging Markets that the central bank’s move, coupled with a decision by the German Constitutional Court to give a green light to German participation in the euro area’s second rescue fund, the European Stability Mechanism, have stabilized the situation.

“Obviously there are still important elements to be ironed out, various elements of closer fiscal and banking union within the eurozone,” Rostowski says in an interview, but adds: “Our view, and we’re not the only ones, is that the corner has been turned, and we shall now be facing stable political and economic conditions in Europe for the medium term. Certainly the spill-over from the eurozone – which we were very worried about over the last two years – we feel that that is receding quite fast.”

Only seven months before, the ECB announced the long-term refinancing operation (LTRO), a cheap loan scheme for European banks who took out almost €500 billion of loans. “With its clear signal that the ECB will keep all solvent reform countries in the euro, it is now reversing the confidence shock that had hit the eurozone,” says Holger Schmieding, chief economist at the German bank Berenberg.

The ESM, the eurozone’s permanent bailout fund, will have capital of €700 billion, to give it a lending capacity of €500 billion. It is due to take over from the temporary European Financial Support Facility (EFSF), which had a lending capacity of €440 billion.


But the worry still hanging over Europe is that the ECB’s skids and handbrake turns have only bought time for reform that politicians will – yet again – simply waste. In the last week of September, Greeks took to the streets again protesting against the bailout’s tough austerity measures, while Spanish sovereign bond yields again hit the 6% level seen by many in the markets as unsustainable as political tensions over bank bailouts and fiscal measures intensified amid street protests.

But many analysts say that – given that the eurozone has probably slipped back into recession – real structural reform by governments in debt-ridden states is exactly what is needed. The problem is that the reform recommended by both Germany and the IMF involves massive spending cuts, liberalization programmes that could lead to job losses and pay freezes or cuts for public-sector workers.

Jonathan Loynes, chief European economist at Capital Economics, the research house that two years ago was seen as an outlier for giving a 50% chance on a break-up of the euro, says the ECB’s move had prompted clients to ask whether they would abandon their bet. He is unrepentant, describing the ECB action as “no more than a time-buying exercise”. “It won’t address the deep-seated economic and fiscal problems facing those countries, and hence won’t relieve the need for painful adjustments and bigger steps towards fiscal and economic union,”

he says. “The ECB deserves credit for, yet again, eliciting a positive initial response to its latest ‘bazooka’. But has the game really changed? I doubt it.”

Unlike his US counterpart Ben Bernanke at the Federal Reserve, which launched the third round of quantitative easing in the same week as the ECB move, Draghi has had to mollify German concerns by imposing conditions on the use of the OMT. Germany was the only country to oppose the move, with Jens Weidmann, the head of the German central bank, the only ECB board member to vote against it.

Rather than offer a blank cheque, the ECB is imposing strict conditionality on its bond-buying programme. “Critically, the ECB will only consider bond purchase if a country fully respects its programme,” says Howard Archer, chief European economist at analysts IHS Global Insight.


Laurence Boone, chief European economist at Bank of America Merrill Lynch, picks up on the driving metaphor. “The ECB has offered a seatbelt to a driver with a bad driving record, which will only work if the driver agrees to a strict monitoring of his driving,” he says. “Will the driver accept the offer in the first place? Will he change his behaviour afterwards? And if not in the latter case, is the threat of removing the seatbelt credible?”

This uncertainty hanging over the eurozone is affecting confidence in the rest of the world. Economists at Stanford University in the US have built an index based on measures of policy uncertainty, drawn from sources such as newspaper articles and the scale of disagreement between economists’ forecasts. It shows that the crisis triggered last year over the restructuring of Greek debt sent the index to levels above those seen in the wake of the collapse of Lehmans or the events of September 11, 2001.

It has fallen back in the wake of the ECB actions but is still high. “The policy uncertainty in Europe is really over the whole future of Europe,” says Nick Bloom, economics professor at Stanford. “Will the southern European countries successfully manage to deregulate to boost growth so they can stay in the euro, or will the whole euro collapse? I’m not optimistic frankly that the southern Europeans will reform, and there is clearly a lot of uncertainty.”

There is growing evidence that Europe is being hit by the negative feedback loop between confidence and actual economic output that worries Bloom. Investment banks are starting to put a lot of weight on this link. “Heightened policy uncertainty is weighing down on corporates’ and private households’ spending decisions,” says Joachim Fels, chief global economist at Morgan Stanley. “Talks about fiscal and political union in Europe, which is a necessary pre-condition for the survival of the euro, are only starting.”

The composite output index for services and manufacturing activity in the eurozone sank to a 39-month low in September. The index slid to 45.9 from 46.3 in August. This is substantially below the 50.0 level that is meant to indicate stable activity and separates contraction from expansion. Incoming new orders contracted at the fastest rate since May 2009, while backlogs of work fell at the sharpest rate for 37 months.


The data, which were much worse than expected, have fuelled fears that the eurozone economy will contract for a second consecutive quarter, pushing the zone into its second recession in three years. According to Yaneer Bar-Yam, a professor at the New England Complex Systems Institute (NECSI), the eurozone looks fated to have to endure this cycle, unless bodies such as the G20 intervene with tougher regulation. He blames speculators for panicking policymakers into over-reacting.

NESCI, which hit the headlines after using financial analysis to predict the current surge in food prices, has applied the same techniques to show that policymakers have made the crisis worse at each turn. Surges in bond yields have been driven by what Bar-Yam calls “speculator-led bandwagon effects”, and perhaps even by “outright market manipulation”.

“The vulnerability of sovereign debt markets to bandwagon effects has led to painful austerity measures that may not have been necessary,” he says. The OMT initiative will help stabilize the markets but, by imposing conditions, the ECB has simply left countries vulnerable to renewed speculative attack, Bar-Yam adds. “The lack of stability is triggering policy responses that swing wildly every time the market hiccups because of the risk of crashes. If the markets were to be stabilized by simple trading policies, this wouldn’t be necessary.”

Given that coordinated action by G20 finance ministers to curb speculation is unlikely, most economists believe that the eurozone is heading for further market instability as speculators watch for the next moves by Spain and Italy. The next big test is Spain, which is expected to have to seek help from the ECB through the OMT although probably not until after the regional elections on October 21.

Meanwhile the resolution to the Greek debt problem threatens to cause an upset as it did ahead of the G20 summit in Cannes when then-prime minister George Papandreou shocked markets by calling a referendum on the EU bailout. The new government is in painful and protracted negotiations over implementing an €11.5 billion package of budget cuts with the ‘troika’ of creditors – the IMF, EU and ECB.


The good news in this picture is that emerging market economies have so far proved resistant to contagion from the eurozone. The IMF forecast in July that the economies of emerging and

developing countries would grow by 5.6% this year and 5.9% in 2013. This compared with 1.4% and 1.9% respectively for the advanced economies. However those forecasts represented a 0.1 percentage point cut from its April outlook, and managing director Christine Lagarde warned of further reductions when the IMF publishes its World Economic Outlook report in Tokyo.

“It is true that Africa has managed the global financial crisis well, as did Asia, and that has been a positive surprise,” says Wolfgang Fengler, lead economist for the World Bank in Africa. However, speaking on the fringes of an Economist conference in London last month, he warned against complacency. “The growth projections are robust but Africa, like the rest of the world, is connected to Europe,” he says. “The big risk – probably the top short-term risk – is a reduction of trade flows through the euro crisis.”

The problem is exacerbated by the fact that many emerging and developing economies no longer have the financial resources to combat a fresh round of contagion. “Debt is lower in Africa than it is in the rich world, but it is higher than it was in 2007,” he says. “It is a double-edged sword. On the one hand, the euro crisis shows the changing parameters in the world, but on the other, their exports are affected by the euro crisis.”

Louis Kasekende, Uganda’s deputy central bank governor, agrees that Africa’s economies had proved resilient but says that a further downturn in the euro crisis was his number one concern. “For Africa it is the euro,” he says. “The worrying part for us is that because of the uncertainty it has brought on, there is nervousness at the short end, especially for those countries that are dependent on portfolio flows. It brings in a lot of volatility and complicates macroeconomic management.”

There is a similar message from Asia, where countries have less room to carry out the sort of fiscal stimulus that China did in 2008 when it injected $586 billion into the economy.

“We know, we are aware that a protracted situation in Europe can impact our trade, remittances, capital flows and tourism sectors, so we continue to monitor this, together with other risk factors, like the still weak US recovery, the slowdown in China, the volatile oil prices, as well as weather and other calamities,” Amando Tetangco, governor of the Philippines central bank, tells Emerging Markets.

Gareth Leather, Capital Economics’ Asia economist, says that “the deterioration in most countries’ budget positions since the last crisis means they have less room for another splurge than before.”

Officials in Latin America are cautiously more optimistic. “I think that this crisis has had different cycles of tranquility, followed by moments of intense uncertainty and volatility,” Peru’s finance minister Luis Miguel Castilla tells Emerging Markets. “This is kind of a binary issue: either it goes well or it goes really bad. Basically, what is going to determine which way it goes is politics and leadership, in Europe in particular. Hopefully good political decisions are going to be made.”


The task facing finance ministers gathering in Tokyo this week is to decide what concrete steps they can take to prevent the euro crisis becoming a catastrophe. The first step would be to ensure that disagreements between different member states do not unsettle markets.

Speaking on the eve of the summit, Lagarde gave a thinly veiled warning to ministers. “It’s obvious it will take a lot of cooperative action between all players – and not just cooperative talk, but cooperative action,” she said.

Uganda’s Louis Kasekende echoes this. “For us it is the problem of the unknown,” he says. “How long is this going to go on for? What else can happen? Definitely a European recession is bad for Africa. Our prayer is that this should be short lived, and that whatever efforts that can be made for sustainable growth are made.”

But with the single currency area still on its knees, as the PMI figures indicate, the debate about how to restart the engine of growth is likely to spill over into the eurozone meetings.


For the last two years the message has been one of the need for fiscal austerity, led by Germany’s chancellor Angela Merkel. But with the election of Francois Hollande to the French presidency in May, the zeitgeist changed. Merkel backed Hollande in talking about a “growth pact” to complement her “fiscal compact”.

Over the summer, EU leaders unveiled a €120 billion growth package based on an injection of capital into the infrastructure sector. On a visit to London during which he met with UK finance minister George Osborne, Pierre Moscovici, the French finance minister, advocated the need for stimulus again.

“Growth will not come exclusively, or even primarily, by reducing financial deficits or introducing supply-side reforms but also from boosting demand as well,” he said. “Budgetary discipline needs to be balanced by growth-supporting measures. It is high time for growth to reclaim its essential position on the European economic map. More of the same budgetary tightening, more of the same fiscal consolidation and more of the same social unrest is not going to work and does not qualify from a policy perspective.”

As well as avoiding damaging rifts, eurozone finance ministers must also show that they are able to come together to take forward the institutional reforms that many of them agree are needed. He highlighted the need for the eurozone to look at a closer banking and fiscal union. On his visit to London, Moscovici said that a banking union must be completed as soon as possible.


The European Commission has proposed that the European Central Bank be given ultimate authority to monitor some 6,000 banks across Europe and step in when an institution is struggling. “A full-fledged banking union with the capacity to recapitalize troubled banks combined with a Europe-wide bank instruments scheme will go a long way towards breaking the feedback loop between banks and sovereigns,” he said. “It must be completed as soon as possible – before the end of this year.”

But this is highly unlikely, as some of the countries that are outside of the eurozone but in the EU argue that the banking union would affect them as well, even though they would not be able to influence it. Polish finance minister Rostowski says that more time is needed to get the details right, such as ensuring that the supervisor is democratically accountable and putting it in agreement with the European Banking Authority, created two years ago to prevent a banking crisis in the EU.

“We are not against the banking union as such,” he tells Emerging Markets. “We can’t join the single supervisory mechanism, certainly not in the shape in which it’s been proposed, but ... that doesn’t mean that we think that the banking union shouldn’t happen, but we think it should be a better banking union.”

The eurozone enjoyed a relatively smooth drive over the summer after a long period of coping with a series of potholes on the road towards long-term economic growth and stability. Mario Draghi’s intervention, the consequent calming in financial markets, and the decision by the German constitutional court have given a welcome triple boost to the outlook for the euro.

But will it last? Even the most pro-euro economists are unsure. Berenberg’s Schmieding still puts a 30% chance of a Greek exit from the euro. “The euro crisis is not over yet. It comes in waves. Grave risks are still ahead,” he says.

  • By Phil Thornton
  • 11 Oct 2012

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 313,852.39 1175 8.95%
2 JPMorgan 286,674.13 1305 8.17%
3 Bank of America Merrill Lynch 281,869.72 974 8.04%
4 Goldman Sachs 214,547.99 704 6.12%
5 Barclays 205,147.76 790 5.85%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
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1 Deutsche Bank 31,971.88 102 6.87%
2 HSBC 31,940.18 140 6.87%
3 Bank of America Merrill Lynch 29,065.55 82 6.25%
4 BNP Paribas 24,679.63 135 5.30%
5 SG Corporate & Investment Banking 22,195.55 122 4.77%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 14,960.44 66 7.87%
2 Morgan Stanley 13,992.90 72 7.37%
3 Citi 13,566.56 83 7.14%
4 UBS 13,028.25 52 6.86%
5 Goldman Sachs 11,994.74 65 6.31%