Downward slide continues

Downward slide continues. German business confidence dropped for the sixth month in a row in October, illustrating the Eurozone’s biggest economy has reached a dangerous stage between soft spell and longer-lasting almost-stagnation. Germany's most prominent leading indicator, the Ifo index, just decreased to 103.2, from 104.7 in September. Both the current assessment and the expectation component slowed down. Particularly the weaker expectation component, which dropped to its lowest level since December 2012, is a reason for further caution. Latest soft data has rather increased than decreased the degree of diffusion, maybe even confusion. While last week’s PMI and consumer confidence indicator had given hope that the economy would slowly recover from the psychological shock waves from the summer, today’s Ifo index is less encouraging. Trying to get some grip on the current state of the economy requires a lot of instinctive feel. At the current juncture, it is still hard to tell whether solid domestic demand can offset weaker industrial activity; and if for how long. While the strong labour market and low interest rates are supporting private consumption and the construction sector, the export-oriented industry is still going through a dry spell. However, the latest reductions in backlogs and optimism stemming from new Chinese bulk orders show that the risk of drying-up is still relatively small. Looking ahead, Germany’s export industry will face several opposing trends in the next months: on the negative side, with France and Italy stagnating, demand from the Eurozone should remain weak. On the positive side, however, the strong US recovery and renewed demand from China bode well for exports. In our view, the German economy is neither near the abyss, nor close to a period of self-complacent honky-dory. It is in a longer-lasting transition period from the end of the positive reform cycle to the challenges an ageing economy is facing. Even if it is does not make sense to use single economic data as a barometer on whether or not the government will decide on growth-enhancing measures, the general need for more domestic investment in Germany remains. Last week’s European Summit, which took place off markets’ radar screens due to the stress test excitement, did not provide any further guidance. While statements in the final summit conclusions like “…the urgency of the prompt implementation of measures to boost jobs, growth, competitiveness…” sounded promising to those hoping for additional fiscal stimulus, the Germanic sentence “structural reforms and sound public finances are key conditions for investment” underlined that the face-off between Germany and the rest of Europe on how to revive the Eurozone economy is far from being solved. In the short run, lower energy prices and the weaker euro exchange rate are already a small stimulus package for the German economy. However, it is a package which will rather delay than advance new structural reforms.

Eurozone - Heading towards Animal Farm?

The latest announcements have shown that the Eurozone is heading towards another showdown on the right balance between austerity and growth.

The Eurozone is preparing for yet another showdown on the right balance between austerity and growth. Italy, but even more so France, laid down the gauntlet to EU partners in recent days, presenting fiscal plans which would clearly be in strong contrast with the Eurozone’s fiscal framework. In addition, the latest comments by the IMF, the ECB and the OECD, all basically calling for more active fiscal stimulus, have also heated up the debate. A new showdown between Italy and France on the one side and Germany plus some fiscal hardliners on the other side is clearly in the making.

The discussion on growth versus austerity has become an almost religious debate. Without choosing sides, let’s have a quick look at what wiggle room the strengthened fiscal framework is offering. For countries with a fiscal deficit below 3% of GDP, read Italy, the fiscal rules offer a decent portion of flexibility. Countries still have to reach balanced budgets in the medium-term and have to stick to their own national debt brakes (if they have implemented them already) but the adjustment pace can be flexible. The flexibility allows for government investments. At least if these are investments in projects co-financed by the EU under regional development policies for poorer regions, European networks, or the connecting Europe facility. Moreover, there is room for major structural reforms that have "direct long-term positive budgetary effects, including by raising potential sustainable growth”. However, the problem is that these reforms actually have to be implemented already.

As regards countries with a fiscal deficit above 3%, read France, the flexibility of the fiscal rules is very limited. As long as countries are still in the so-called excessive deficit procedure, flexibility is limited to extending the deadline to reach the 3%-deficit target. In the case of France, however, the deadline has already been extended twice; in 2009 and in 2013. According to the fiscal rules, such a deadline can only be extended in the case of unexpected adverse economic events. While the financial crisis qualified as such an event, it is hard to see that the failure to implement structural reforms or stagnating growth can be considered unexpected.

Today, everyone seems to talk about flexibility again. Obviously, some economic common sense should be welcome but at the same time let’s not forget that bending the rules in the early 2000s had laid the grounds for unsustainable and uncontrollable public finances almost ten years later. Of course, there is wiggle room in the new fiscal surveillance framework and it looks as if there is new momentum in the Eurozone to also support the demand side of the economy. However, it will not be an easy balancing act. In this context, the biggest challenge will be to treat Italy and France differently. Treating France differently than other countries in the so-called excessive deficit procedure could damage the long-term credibility of the fiscal framework and would clearly have the scent of Animal Farm: all (pigs) are equal, only some are more equal than the others.

In our view, the situation is more delicate than it looks like. However, the most probable outcome of the current controversy is still a bit of more accommodative fiscal policies, without letting austerity disappear, a bit of German goodwill topped with a bit of European investment (eventually maybe even supported by some ECB QE).

ECB shows some of the money

More questions than answers? At its meeting in Naples, the ECB unsurprisingly decided to keep interest rates unchanged. Moreover, the ECB presented some details of the already announced ABS and covered bond purchasing programmes. ECB president Draghi’s comments at the press conference have increased rather than decreased the likelihood of more action to come. The ECB’s assessment of the Eurozone economy remained unchanged and was almost a verbatim copy of the September assessment. The entire macro-assessment can nicely be summarized with Draghi’s own word: “I have always said that the recovery is weak, fragile and uneven”. Nothing to add here. In ECB language this means that risks to growth remain to the downside. As in September, the ECB stopped giving a direction for risks to the inflation outlook. As regards the ECB’s asset-backed securities purchase programme (ABSPP) and covered bond purchase programme (CBPP3), the ECB presented some technical details after the press conference. The ECB’s purchasing programmes will start in mid-October (covered bonds) and the fourth quarter (ABS) and will run for two years. The details of the ABS programme are limited to purchases of senior tranches and follow more or less the current principles or guidelines of the ECB’s collateral policies. The ECB decided to also accept assets from Greece and Cyprus, but only under certain caveats and additional conditions. In the press conference, Draghi suggested that the ECB would only accept assets from these two countries if they were running under (EU) programmes. This, however, was not reflected in the published texts. Consequently, this could clearly hinder the Greek government’s latest attempts to exit the second bailout programme without a follow-up. The most important issue of the ABS purchasing programme, however, remains unanswered. The controversy about the riskier ABS tranches has apparently not been solved, yet. Remember that several Eurozone governments, particularly France and Germany, had already given the ECB the cold shoulder, refusing to guarantee mezzanine tranches. However, without purchases of the riskier ABS tranches, the programmes will be handicapped before they start. In the official text, the ECB only said that details of purchases of mezzanine tranches will be published at a later stage. In general, the ECB refrained from answering two important questions on the ABS and covered bond purchasing programmes: will there be a country distribution and what will be the total volume? Regarding the volume of all purchases, Draghi made the latest new soft target, the size of the balance sheet, a bit softer. He said that the “potential universe” of all eligible ABS and covered bonds was 1 trillion euro. On top of that come the TLTROs. Returning the ECB’s balance sheet to its size of 2012 (which would require an increase of 1000 billion euro) was an instrument rather than a goal. The ECB obviously sticks to its current strategy of repairing the transmission channel of monetary policy. All measures are aimed at supporting the supply side of the credit economy, ie banks. At several occasions during the press conference, Draghi stressed that monetary policy alone could not restore growth in the Eurozone. He called several times for more (implementation of) structural reforms, the use of fiscal room for manoeuvre and demand-side policies. Whether this was another invitation for Eurozone governments to join another grand bargain, or just another desperate cry in the dark remains to be seen. The experience of the last years, however, tells us that the ECB’s advance payments have hardly ever been matched by equivalent government actions. In this context, the fact that Draghi mentioned the ECB’s unanimous commitment “to using additional unconventional instruments” three times compared with only one time last month is in our view a clear signal that the ECB is determined to do more and even bolder action if necessary.