EU bank regulator to stress-test 91 banks

Europe's banking supervisor said that 91 banks will take part in the financial sector stress tests that will check their resilience to further market and credit risks. The Committee of European Banking Supervisors also laid out the key features included in the tests. "The exercise is being conducted on a bank-by-bank basis using commonly agreed macro-economic scenarios," the CEBS said. The scenarios would show a different impact on the various European Union member states, said CEBS. It also envisages adverse conditions in financial markets and a shock on interest rates to capture an increase in risk premium in bond markets, said London-based CEBS. The adverse scenario assumes a 3% decline in GDP from European Commission forecasts for 2010 and 2011, and tests for resilience to sovereign risk at a level beyond the market conditions experienced in early May 2010. The EU expects its economy to expand 1% this year and 1.75% in 2011. The scope of the tests was also extended to include shocks from sovereign debt defaults.

Eurozone economic forecast slashed

The eurozone economy will shrink at twice the pace predicted three months ago, and the end of Europe's severe recession will not materialise till the second half of next year, the European Commission said in its latest forecast. The region's Brussels-based executive arm said that job cuts in the next two years will almost wipe out employment gains since 2006 and the region's deficit will swell to more than double the EU limit. The economy of the 16 countries sharing the euro will shrink 4% in 2009 and 0.1% in 2010, the commission said today, revising a January estimate for a contraction of 1.9% this year and 0.4% growth in 2010. The commission's new forecasts are in line with numbers from the IMF and the OECD. The IMF said on April 22 that the euro-area economy may shrink 4.2% this year and 0.4% in 2010, while the OECD forecast a contraction of 4.1% this year and 0.3% in 2010.

"The European economy is in the midst of its deepest and most widespread recession in the post-war era," Economic and Monetary Affairs Commissioner Joaquin Almunia said. "The outlook is still gloomy, but for the first time since mid-2007 some positive signals have appeared in the last week," he told a news conference. The ambitious measures taken by governments and central banks in these exceptional circumstances are expected to put a floor under the fall in economic activity this year and enable a recovery next year, Almunia said. "We have the feeling the bottom is closer and closer, and thanks to fiscal stimulus and monetary stimulus we will avoid any new falls," he said.

Europe: The ECB's Balancing Act

Elga Bartsch | London

So far, tightening monetary policy in the euro area was easy. Coming from a record low of 2% for its main refinancing rate, the ECB Council was unanimously in favour of a gradual withdrawal of monetary stimulus over the last 12 months. Throughout the first year of the new ECB interest rate cycle, inflation and GDP growth forecasts were steadily upgraded providing arguments for nudging interest rates higher. Money markets and ECB watchers, by and large, anticipated the future course of ECB action correctly thanks to a set of code words signaling the timing of the next move. Financial markets took the ECB’s tightening campaign in stride. The common currency grinded higher only gradually, with the brief exception of a more rapid rise in late November. Yields of longer-dated government bonds hovered in a trading range between 3.5 and 4.0% for most of the year. The next 12 months are likely to demand a much more delicate balancing act from the ECB, in our view.

We expect the ECB to hike interest rates further in 2007 — in the light of GDP growth at or above trend, ongoing robust job creation, and rapid money and credit growth. We forecast a total of 50 bps of ECB interest rate hikes by December 2007. This compares with market expectations of slightly more than 25 bps. A total tightening of 50 bps would constitute a noticeable slowdown in the pace of tightening compared with the ‘every-other-meeting’ pace pursued in the second half of 2006. The much more gradual tempo of tightening reflects the fact that the ECB would be pushing the refi rate towards the upper end of the neutral range, which we estimated to be between 3.5% and 4.0%. Even though the inflation outlook isn’t showing significant pressures at present, the risks remain tilted to upside, in the view of the ECB. This perception was emphasised again in the December press conference. Even though that press briefing gave conflicting signals with regard to the timing of the next move, we still believe that the most likely timeframe is March. But by stating that it “monitors risks to price stability very closely” — a phrase that in the past indicated that the next rate hike was only two meetings away — February is a possibility too.

Against this backdrop of further ECB tightening, we expect ten-year Bund yields to rise from the current 3.76% level and eventually break markedly above 4% in 2007. Demand for long-dated bonds, a moderation in nominal GDP growth and pre-emptive monetary policy action will likely limit the rise in bond yields at the far end of the yield curve though. As a result, would not even rule out a renewed inversion of the yield curve in the next 6–9 months. When the spread between the ten-year Bund and two-year Schatz briefly dipped into the red in November, investors debated whether this would signal a recession. This debate could resurface if the spread would move into negative territory again. Historically, the yield curve has been the most reliable leading indicator for recessions. But a number of factors distorting the long-end of the bond market suggest that the message is less clear today (see Debating the Yield Curve, November 25, 2005 by our Global Economics and Strategy Team). These factors range from pension fund demand, central bank buying, compressed term-premia to excess liquidity and/or a savings glut.

The discussion about the ECB’s appropriate policy stance — both within the Governing Council and outside — is expected to become much more controversial in the coming year than it was in the year just ending; for the following reasons: First, at a refi rate of 3.5% euro area short rates are getting closer to the neutral level, which we would deem to be between 3.5% and 4.0%. While there was broad agreement that the bank should gradually take its foot off the monetary accelerator, whether it might need to push interest rates towards the restrictive end of the neutral range (or even higher) will likely be debated much more heatedly. The ECB itself uses a broader concept than just the short rate to assess the stance of its monetary policy. The rapid rate of expansion in monetary aggregates is one of the reasons why it is still regarding its monetary policy as accommodative. Second, the euro economy is likely to enter into a phase where risks to growth are tilted to downside and risks to inflation to the upside. The combination of moderating real GDP growth and intensifying inflation pressures always makes an awkward mix for a central bank. This also holds for a central bank that — like the ECB — gives precedence to inflation concerns.

Third, the ECB might find its policy decisions getting more than the usual amount of unsolicited advice from politicians as France heads for a presidential election, as domestic demand growth cools, and as the currency strengthens. While an independent central bank is unlikely to pay much attention to such broadcasts, this does not make its task any easier, especially in communication with the public at large. Fourth, the two pillars of the ECB monetary policy strategy — the broad-based inflation outlook and the monetary analysis — might soon send diverging signals. The persistent, strong expansion of monetary aggregates will likely continue to signal upside risks to price stability even after the broad-based inflation outlook stopped signaling such risks. Strong money supply growth caused the present tightening campaign to start earlier. It could also cause it to last longer (see EuroTower Insights: The Meaning of Money, November, 13, 2006). Finally, the uncertainty about the near-term economic outlook seems to be on rise at present. The unknowns include whether the US economy will be able to avoid a hard landing this winter, whether the German economy will be able withstand a three-point VAT hike, and whether financial market volatility could show a renewed rise.

A year of challenges. To sum up, the year in which the euro area will welcome its thirteenth member — Slovenia — is likely to hold several challenges for ECB policymakers as the bank’s refi rate approaches the neutral level. Hence, discussions about the appropriate policy stance both within the Council and outside will likely liven up. After a year of successfully micro-managing money market expectations by using a standard set of code words (see EuroTower Insights: Too Much Communication?, May 19, 2006), ECB Council members might start to send much more mixed messages in 2007 as the bank attempts to delicately balance a number of different factors.

Europe: About Decoupling, Reforms and Tensions

Eric Chaney | London

The short-term outlook for the euro area is clouded by major macro uncertainties, from the nature of the slowdown in the US to the consequences of a three-point VAT rate hike in Germany, effective on January 1. Yet we believe that the domestic recovery, fuelled by a powerful monetary stimulus and structural improvements such as faster productivity and more flexible labor markets, should provide a robust base for growth next year. While GDP growth should decelerate significantly, from 2.7% in 2006 to 1.9% in 2007, on our forecasts, the consequences of the VAT hike in Germany should be limited, being fully anticipated by German consumers and companies operating on the German market. Nevertheless, uncertainties are so high that financial markets may turn much more volatile than they were in 2006. These uncertainties will likely also cause the ECB to approach further tightening more cautiously (see Elga Bartsch’s “The ECB’s Balancing Act” in this issue).

While increasing risks for investors, volatility also generates investment opportunities. Here are three macro themes that could provide investors with such opportunities: US-Europe decoupling; labor market reforms and tensions between capital and politics.

1. A ‘soft decoupling’ between the US and Europe. A widespread view in the markets is that Europe follows the US cycle with a six-month lag. This theory may regain popularity, but for the wrong reasons, we believe: growth is likely to slow in Europe in the first months of 2007, for domestic reasons — a 150 basis point monetary tightening by the ECB and a 0.6% of EMU GDP fiscal tightening in the German and Italian budgets. Rather, we anticipate a ‘soft decoupling’ between the US and Europe: GDP growth falling significantly below trend in the US while decelerating towards trend in Europe. Because domestic demand is the main driver of growth in both regions, business cycles are not necessarily synchronized. For sure, financial linkages matter, as we learned during the previous downturn, when European companies slashed investment projects from 2001 to 2003. Massive capital outflows to the US — mostly driven by acquisitions — at the outset of EMU had made investment projects by European companies highly sensitive to the US capex cycle. However, this time, the US slowdown is coming from housing investment, to which neither companies nor investors in Europe seem to be exposed. As we see it, once fiscal policies relax their grip, growth should re-accelerate in Europe, where the personal savings rate should decline further, while the US economy is likely to continue to grow below trend speed, as the personal savings rate rises. Thus, ‘hard’ decoupling could become a popular theme in the course of the year.

2. Labor markets: end of ‘easy reforms’? So far the rapid decline in euro area unemployment hasn't fuelled wage inflation, a sign that structural unemployment is steadily declining. Policies aimed at reducing the cost of low-skilled jobs (by cutting social contributions most of the time) have worked, but their unwelcome side effect was the creation of two-tier labor markets. Also, the secular upward trend in the female participation rate is increasing the share of flexi-jobs, on trend, which helps reduce structural unemployment. However, with euro area unemployment likely to ebb towards 7% in the next 12–18 months, tensions in labor markets may appear, leading to higher wage inflation. Since dual labor markets generate inefficiencies and social tensions, governments will have to consider more far-reaching reforms, such as relaxing wage-bargaining systems, removing obstacles to redundancies or simplifying labor contracts. Labor market policies are likely to be hotly debated ahead of the French presidential election but could also return to the forefront of political debate in Italy and Germany. More ambitious reforms would probably help the ECB keep rates lower, thus boosting growth and profits.

3. Watch tensions between capital and politicians. Together with ample liquidity, rising cross-border capital flows within the single currency area and divergent dynamics in domestic demand have fuelled rising current account imbalances. While Spain is heading towards a double-digit current account deficit to GDP ratio, Germany and the Netherlands are both running a current account surplus to GDP ratio of similar magnitude. A potential rise in intra-EMU imbalances may fuel political tensions, we think, against a general backdrop of anti-globalization sentiment. Interestingly, in the new EU member states, capital inflows also seem to fuel political tensions here and there. With slower growth ahead and large war chests accumulated in previous years making companies more aggressive, tensions may rise further next year. Taking a longer-term view, political leaders seem to have largely underestimated the practical implications of the European Monetary Union and of the EU enlargement: with capital easily crossing borders, restructuring has become a permanent and obsessive theme for European companies. The result is that companies operating on a pan-European basis and having global ambitions have a growing influence on economies, while governments have less. The tug-of-war between the power of capital moving freely across borders, while most workers won’t, and institutions changing slowly, creates investment opportunities. For that, investors need to pay attention to two elements: political resistance, which differs across countries and sectors, but also the long-term picture, which is in my view the emergence of large global companies operating from their historical European base.