Research Dept. News
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Monthly Report, num 358 - June 2012
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Executive summary
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Uncertainty returns
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The economic-financial scenario deteriorates in May.
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In April, the pillars that seemed to underpin the improvement in the economic-financial scenario started to wobble. In May, far from stabilizing, this situation has merely got worse. Two factors have had a combined effect: a more agitated political and economic climate in the euro area and poor economic activity figures in the emerging countries, in particular China.
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After the elections on 6 May, Greece's political crisis, reflecting the country's hesitant support for the adjustment plan, is jeopardizing the euro area as a whole. Speculation that Greece might leave the euro, together with wariness regarding the health of Spain's banking system, have sent risk premia soaring in peripheral Europe. Debate on the design, orientation and functioning of the Economic and Monetary Union has entered a decisive phase, just at a time of elections to provide the big decisions coming up with democratic legitimacy. France's change in government entails a notable alteration in the correlation of forces within Europe, initially adding to the uncertainty.
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The uncertainty generated by Greece's political situation is keeping the whole euro area on tenterhooks...
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The evident risk is that, should this uncertainty consolidate over several months, it might harm economic activity. The publication of the euro area's gross domestic product (GDP) figures for the first quarter is not particularly encouraging. With a quarter-on-quarter growth rate of 0.0%, activity remained completely at a standstill. Technically it avoided recession, as there have not been two consecutive quarters with negative growth (in the last quarter of 2011, GDP fell by 0.3%), but this was thanks to the good performance by the German economy, whose GDP advanced by 0.5%. In France growth was zero while in Spain and Italy there was a notable drop, namely 0.3% and 0.8% respectively. Moreover, leading indicators from the second quarter point to this weak tone increasing, particularly if far-reaching measures are not taken to put a stop to the current uncertain context.
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In this respect, the most relevant element of the last few weeks in terms of the euro area's monetary policy is probably related to the Bundesbank. The President of the German Central Bank, Jens Weidmann, stated that it would be appropriate to let the German inflation rate remain above the euro area average, as a measure to help correct the imbalances in competitiveness between Germany and countries in the south of Europe. The German Finance Minister, Wolfgang Schäuble, also supported this position, specifying that an inflation range of between 2% and 3% for Germany would be desirable and confirming that there was enough margin for wage rises in the country. Should it come about, Germany's more flexible stance on inflation is another ingredient in the formula leading to the region's economic and financial stabilization.
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...and is starting to hit economic activity.
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In the international macroeconomic context, the publication of poorer activity figures than expected in key countries such as China has also marred global growth prospects. Although the most probable scenario for the Asian giant is still that of a soft landing, these events call for more forceful monetary and fiscal policy to support growth. The rate of growth of another large emerging country, Brazil, is also somewhat disappointing. A continual decline in industrial production and perceptible drop in employment are clear signs of moderation in the pace of economic growth, a greater moderation than expected, especially taking into account the marked expansionary tone of economic policies since last autumn, which has led Brazil's Central Bank to revise downward its own growth forecast for 2012.
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China's activity figures are weaker than expected.
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Within this context, the financial markets, reflecting investors' hopes and fears, are going through a period marked by uncertainty and the search for safe options. The yield on Spain's 10-year bonds went through the barrier of 6% and their spread with Germany reached 490 basis points, the highest since 1995. Italy's debt also performed badly, although still far from the peaks reached a few months ago.
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In spite of the difficult situation, the ECB has still not intervened, nor has it declared any intention of doing so, in the secondary market by buying up Spain and Italy's debt to contain this upswing in yields. In any case, debt issuances in the primary market have offered a less dramatic view as the respective Treasuries have managed to place securities with different maturities, registering good demand at higher interest rates which they've had to accept.
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Spain's spread with Germany for 10-year bonds reaches its highest level since 1995.
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Germany's sovereign bonds were once again benefitted by more investors opting for safety, pushing the 10-year yield down to 1.41%, a record low. On the other side of the Atlantic, US sovereign bonds have performed similarly to their German peers. In addition to being supported by relatively better economic expectations than those of the euro area, US debt is also helped by a very lax monetary policy. This, together with the security provided by a country with a very high rating and the expectation that the Federal Reserve could implement, if necessary, another round of quantitative easing, has meant that investors have pushed down yields on ten-year US debt from 1.95% to levels of around 1.70%.
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The US economy's expansion is being supported by falling oil prices, the possible expansionary effects of the electoral year and strong consumption. GDP for the first quarter grew by an expected 0.5% quarter-on-quarter and by 2.1% year-on-year. Consequently, a large part of the upswing from the end of last year has remained and everything points to a slight advance of more than 2.0% for the whole of 2012, more than expected two months ago. However, the composition of GDP did cause some surprise, revealing the modest nature of this recovery. Growth was mostly based on private consumption, which increased by 0.7% and exceeded expectations that had already been optimistic. The second contribution in terms of importance for growth came from the accumulation of stocks, which was also higher than expected. The other side of the coin was provided by capital goods investment, which unexpectedly fell. Although this component should pick up in the second quarter, the end of the rising cycle for stock and the slowdown in private consumption point to a relatively flat growth trend throughout 2012.
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German and US bonds are the big winners from the search for safety.
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In the case of Spain, the GDP growth figures for the first quarter are not exactly encouraging. A breakdown of the National Accounts system confirms that the 0.4% fall in GDP in year-on-year terms is particularly due to a large drop in domestic demand, deducting 3.2 points from growth, a figure three tenths of a percentage point higher than that of the previous quarter. All the components of domestic demand are in negative figures. Household consumption fell by 0.6% in year-on-year terms, public administration expenditure on final consumption by 5.2% and investment by 8.2%.
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Domestic demand continues to hinder Spain's GDP growth.
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In addition to weak domestic demand, there is now a significant slowdown in foreign demand. The economic slowdown of our main trading partners has damaged exports, down 0.9% quarter-on-quarter in the first three months of 2012. But, unlike what happened one quarter ago, this fall was exclusively due to the decline in the services component. Specifically, this fell by 5.0% quarter-on-quarter after two years of continuous increases. The moderation in the number of foreign visitors to Spain largely explains this fall, which is unlikely to change its tone over the coming months.
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Looking to the future, two elements are still crucial: achieving the goals of reducing the public deficit and dispelling doubts regarding the health of the banking sector. In this respect, the revision made by some autonomous communities of their 2011 deficit made it difficult to achieve the first goal. Moreover, the efforts being made to adjust the central government deficit are having a limited impact at present. The hike in direct taxes, the cutbacks in investment, intermediate consumption and wages have helped these items to fall by 1.9 billion euros in the first quarter of 2012. However, this adjustment was totally wiped out by the rise in interest payments and lower revenue from indirect taxes, particularly value added tax (VAT). The cumulative government deficit for this period reached 1.2% of the GDP expected for 2012, a figure that is 4 tenths of a percentage point higher than the one posted for the first quarter of 2011.
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Controlling the public deficit is crucial to restoring confidence.
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On the other hand, investors had to interpret the financial reform announced by Spain's government. Whereas the main aim of February's reform was to raise the level of coverage for problematic real estate portfolios, May's reform has focused on increasing the generic provisions for non-problematic assets from the real estate development and construction sector. The aim of these new provisions is to prepare the financial system to withstand an extremely adverse scenario and thereby dispel doubts regarding its capacity to resist.
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Two additional far-reaching measures were also introduced. The first establishes that those institutions not supported by the FROB will have to create asset management companies to which they can transfer their foreclosed real estate assets once the relevant provisions have been made. Secondly, two independent evaluations will be requested of the risk of the financial sector's whole asset portfolio. These evaluations will be supervised by the European Central Bank and the Bank of Spain and their aim is to settle doubts regarding the balance sheets of financial institutions.
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29 May 2012
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They therefore cover important issues related to the institutions' degree of solvency but also generate uncertainty associated with the findings to be presented by the two external evaluators and, if necessary, how the government would tackle the requirement to recapitalize the banking system. This new source of uncertainty has been added to a list that has been growing over the last few months and which must be remedied as soon as possible. To this end, tough decisions will have to be taken which will probably transform the current design of Europe's monetary union. If we truly believe in this, then decisive steps must be taken.
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Chronology
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Agenda
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