Europe: Out Of The Laboratory, Back To The Labyrinth

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BoAML | The ECB has closed many doors in December. The 2015-16 strategy of monetary policy covering for fiscal loosening to facilitate structural reform has changed.We are back to national governments having to navigate through strained fiscal trajectories, leaving very little room for mistakes. Potential growth prospects are not great, not only in the periphery. Weak domestic fundamentals mean we may depend on global demand, again.

The experiment of monetary policy to cover for fiscal loosening may be ending

In 2015-2016 the Euro area went into a controlled laboratory experiment. Breaking with the purely reactive, emergency crisis management of the previous five years, some implicit but consistent strategy was implemented. Extraordinarily supportive monetary policy, with the ECB passing the Rubicon of QE, would provide cover for some fiscal loosening, which itself would make unpopular structural reforms more palatable and keep populist tendencies at bay. Italy was the country where the experiment was conducted in the purest form. As we get into 2017, it seems that the experiment is being aborted before results are actually fully available. National governments are left with trying to find their own way out of the labyrinth. We struggle to find a unifying narrative for the Euro area.

True, the ECB is not engaging in tapering in the true sense of the meaning, but beyond the reduction in the pace of buying, so many doors have been closed (on the capital key, on the 33% limit) that the programme’s open-ended nature has been lost. This may not have immediate consequences for the market, but a sense that we are past the “Draghi peak” colours our view of 2017-2018. We believe we are back to a disciplinarian version of the Euro area which leaves very little room for mistakes.

In his interview to French radio the morning after the ECB decision, board member Benoit Coeure could not have been clearer. “Long term interest rates will rise…governments need to prepare themselves”. The fiscal strategy of 2015/2016 was always flawed to begin with. Since the countries with fiscal space refused to use it, most of the fiscal push came from governments with already strained fiscal trajectories. With the central bank implicitly endorsing the new, higher level of real interest rates, the fiscal experiment is nearing its end.

With the possible exception of France, we think the structural reforms’ leg of the “plan” will also have to go away. Since even Germany will struggle with weaker potential growth in the coming years, the capacity of the Euro area as a whole to contribute to world growth will be limited, in our view. The region will be a “price taker”, dependent on the volume of external demand to offset poor domestic dynamic. From that point of view, looming fiscal stimulus in the US is a source of hope, especially if combined with a steep depreciation in the euro…as long as the cost in higher interest rates at the global level does not add too much to Europe’s headwinds.

The return of strained fiscal trajectories

Last year we argued that the ECB was de facto targeting a “frontier interest rate”, i.e. the interest rate below which the public debt trajectories would be fully sustainable. Quite simply, if the interest rate paid on public debt exceeds nominal GDP growth, in the absence of a primary surplus debt grows. What matters though is not the static, current nominal growth, but what the market expects over the duration of its lending to the government. To proxy this we take from Consensus Forecasts the average of projections for inflation and GDP growth over the next 10 years. In Italy this “sustainable interest rate” is very low, at 2.5%, reflecting the market pessimism on Italy’s prospects. But the ECB had managed to push actual market rates markedly below this level, offering Renzi some scope to “lubricate” his reform agenda with some fiscal kudos. Market rates are now getting nearer this limit.

Of course it is not a hard threshold. The European Commission expects Italy’s primary surplus to stand at about 1-1.5% of GDP between now and 2018, which would push the sustainable rate to c.3.5%. In any case all peripheral governments have used QE to lengthen the duration of their debt which will offer them significant cash-flow buffers for a long while. Still, the writing is on the wall: States may not need to engage in hard austerity, but the short parenthesis of fiscal loosening is closing.

Italy is not the only case. For all its impressive rebound in GDP growth over the last few years, Spain has some hard work ahead, since large structural and fiscal challenges remain. Fiscal is the most immediate one. As an example, if we take consensus forecasts of 3.6% long-term nominal growth and we use the European Commission estimate of around a 1% structural primary deficit, 10y rates need to stay below 2.5% for debt levels to stabilize in the long run. If, in turn, we take 3% as an estimate of long-term nominal growth (consistent with our long-term forecast of real growth of 1% and 2% inflation), then we would need rates below 2% for the Spanish public debt to GDP ratio to stabilize.

Low potential growth happens to the best

Extraordinarily low interest rates would indirectly help boost potential GDP not only by making structural reforms a bit easier, but also by offering governments and businesses the opportunity to replenish their capital stock – an urgent necessity given Europe’s depleting labour supply. It is quite clear that it did not work, including in countries such as Germany which did not have to work through huge legacy debt.

In Italy, the labour reform of last year was the promise of proper progress on potential GDP growth. The current political turmoil and the energy and time devoted to sorting out the banks would in any case slow down any further progress on that front. Worse, there is now a risk that the labour reform could be repealed. Indeed, CGIL union managed to get enough signatures to trigger a referendum on this matter. It would normally take place before this summer. The government can try to hasten the re-negotiation of the electoral system to organise snap elections this spring, which would postpone the referendum by a year, but this would merely kick the can down the road. In the meantime, we very doubt that any government will take the risk of antagonising the unions further with more reforms. The cycle there has closed.

Pending structural challenges, locking Italian growth, are multiple: complex regulations and procedures, government inefficiency, burdensome taxation, market rigidities, high degree of resource misallocation and the small size of the industrial base. While past reforms helped to improve labour market flexibility and to reduce fiscal pressure, little was done on other fronts. Productivity growth continues to perform poorly. Our recent estimates of long-term growth in Italy at 0.9% were supported by better-than-peers future demographic developments . We were assuming a continued reform momentum and investment growth back to pre-2007. However, the latest political developments (impairing the government’s reform focus in the next months) and the so-far subdued investment recovery pose downside risks to our projections. Medium-long term prospects seem more discomforting at this stage.

And do not forget Spain. As argued above, structural challenges are important. There are still large rigidities in some markets, poor education performance, duality of the labour market, reallocation of the large pool of unemployed across sectors is needed, and there is heavy dependence on foreign investors given the large external debt. Political capital/appetite will not be conducive of fully addressing these issues. Demographics ahead are poor, productivity developments will not fully compensate for that. We estimate long-term growth in Spain not far from 1%.

That the periphery is struggling with its long term prospects is not new and won’t surprise anyone. Still, we believe similar issues facing Germany are routinely ignored. Germany’s population is ageing quickly. Absent the increase in immigration flows post-global crisis, Germany’s labour force and its potential growth would probably already be slowing. We estimate potential growth at 1.5% now, but it will slow over time to below 0.5% by 2025. It will get increasingly difficult for immigration or labour market reform to offset enshrined demographic fundamentals. Without capital deepening (which probably requires a rethink of government capex policy) or productivity unleashing services sector reform, the only way out would be difficult reforms to incentivise older age groups to stay at work for longer. But just like services sector liberalisation, pension reforms are unpopular. Political choices may become increasingly difficult, including on immigration. Germany, like the rest of the Euro area, may have missed the opportunity of the past years to get its economy on track.

There is an upside risk in France

What is also routinely ignored is that, given the demographic and productivity dynamics, France and Germany share the same baseline for potential GDP growth in the decade ahead (0.8% in our estimates). The difference is that France would reach this pace with little or no reform, while Germany has implemented far-reaching reforms over the last 10 to 15 years. In other words, Germany has plucked the low hanging fruits, while the upside for France is significant. We estimate that if France manages to liberate the same pent-up labour supply as Germany in the early 2000s potential growth could reach 2%. This is what makes the looming presidential elections so crucial, and so binary, given the stark contrast between Le Pen’s statist agenda and centre-right Francois Fillon’s thatcherite approach. However, more generally, what we find interesting is that all three polls released since President Hollande announced he would not run again point to an absolute majority of voting intentions for candidates who, to varying degrees, defend a business-friendly approach. Quite unusually, there is no identifiable “pro status quo” candidate between the prominent contenders. This makes France a bit of an exception in Europe: the populists are not the only ones offering an alternative to “more of the same”.

But cyclical headwinds event there

Still, in our discussion with clients the risk, however remote, of Le Pen winning the presidential elections could push the French risk premium up in the next few months, coming on top of the global rise in yields. While the absolute levels of rates would remain historically low, and hesitant borrowers could hasten their investment decisions to beat the looming increase in funding costs, this more generally reflects a certain lack of confidence ahead of the elections, which could have a dampening effect on “animal spirits” in the first half of the year. Moreover, if Francois Fillon wins – the current most likely scenario in all available polls – his fiscally hawkish stance (epitomised by his pledge to hike the VAT rates by 2 points in Q4 2017) could transitorily weigh on domestic demand. France would thus participate to the reversal of the fiscal stance across the Euro area which we described above. Recall in addition that domestic demand over the last 2 years was boosted by remarkably low inflation which kept real wages growing in spite of a poor nominal dynamics. The energy-led rebound in headline inflation will be another headwind next year.

Dependent on world demand, again

All in all, we think that over the next two years the Euro area will, again, be ultimately dependent on world demand. From this point of view, the looming fiscal stimulus in the US could help, together with a weaker euro relative to the dollar. But this will hold as long as i) European market rates do not align too much on the US market and ii) higher rates in the US and protectionist noises do not trigger too much adverse effects on emerging demand. The Euro area is walking on a narrow path. We think the ECB’s expression of optimism last week was a risky decision. One may argue that less support from the central bank will prod governments into coming up with a consistent macro strategy at the region’s level. However, we think that the probability of such “disruptive creation” has to be balanced against the “renationalisation” of politics and economic policies.