Even Good Monetary Policy Cannot Solve Europe’s Problems

Mario Draghi, European Central Bank President Photograph: Mario Vedder/AP
Mario Draghi, ECB President (Image: Mario Vedder/AP)

After the European Central Bank (ECB) cut interest rates into negative territory in June, we asserted that central banks act when expectations miss to the downside. Once again, today was the rule and not the exception. The ECB cut interest rates further, notably lowering the interest rate on the deposit facility to -0.20%. In addition, it announced purchases of private sector asset-backed securities (ABS) and covered bonds. In the midst of markedly below-target inflation, downward revisions to eurozone real GDP growth, and geopolitical tensions in Ukraine, Europe desperately needs a boost. While these measures will help to hold the euro to a more competitive value, they confirm that the eurozone’s growth will not impress in the next 1-3 years.

Is this quantitative easing (QE)?

Any outright central bank purchase of assets, whether government or private sector, constitutes quantitative easing. However, the size and nature of the monetary policy tools announced today will not make up a similar program to that introduced by the United States Federal Reserve in 2012. While the size of the program remains undetermined, ECB President Mario Draghi stated that the central bank’s intention is to restore its balance sheet back up to 2012 levels. This would suggest a ballpark of € 1 trillion in monetary fusions, about half of which could be ABS and bond purchases. Other estimates suggest a much smaller program of around € 100 billion. Compared to monetary infusions of US$ 13 trillion, this program is much more modest, particularly considering that only a small portion of available ABS is built from loans made to the SMEs that constitute the core of European growth.

Why asset purchases?

The ECB is attacking precisely the right eurozone problem: contracting credit. Outright asset purchases, along with the ECB’s previously announced targeted long-term refinancing operations (TLTROs), are intended to improve the flow of credit from banks to the private sector. This year’s rate cuts are designed to encourage banks’ participation in the TLTRO program right away, as opposed to holding out in hopes of further cuts. Within the eurozone’s still fragmented banking sector, this new channel of funding to the private sector is meant to open a new channel of funding to households and businesses, improving their ability to invest in additional capacity, hire more workers, and boost eurozone growth as a whole.

Will this monetary policy work?

The ECB has gone about as far as it can go within the confines of European monetary policy, and it is too little too late. There is no hope for repeating a US-like quantitative easing program, as political opposition to pan-European sovereign bonds is too high. Draghi’s statements today asserted that there is no scope for further rate cuts. And, where further purchases are concerned, the ECB is limited to the highest quality debt, the European market for which is comparatively small and illiquid.

Therefore, although the ECB has taken the right measures, Draghi’s statements encouraging fiscal activity confirm this point: monetary policy in Europe has reached its limits, and it is too little too late. Japan’s failure to act quickly or sufficiently to ease monetary policy during its 1990s recession is a staunch example of what is to come for the eurozone. Deflation is taking a strong hold in many countries, which will cause companies to struggle improving profitability or investing in additional capacity. Demand for products throughout EMEA will remain muted as a result, failing to compensate for a slowdown in major emerging markets such as China and Brazil. We thus are urging our clients actively to manage expectations for growth, which will not improve notably for the next 1-3 years.

If you wish to read more about the increasing financial risk in the eurozone FSG clients can read our latest report: Eurozone Financial Weakness.  Not a client? Contact us for more information.

Trouble in Portugal reminds us that the eurozone’s woes are far from over

Executives should be wary of headlines for recovery in Western Europe, and prepared for the heavy downside that Europe’s fragile political and economic order could experience. Although news media highlight positive aggregate growth (the eurozone is forecast to grow 1.2% YOY in 2014), Western Europe remains plagued with high public debt loads and thus highly susceptible to volatility in financial markets.

In our latest Western Europe outlook, we warn senior executives about the impact that unrest at banks or in politics could have across European markets and MNCs’ performance in the region. Specifically, any uptick in political risk could manifest itself in higher borrowing costs for the government in question and across southern Europe. The increase in borrowing costs could also make business in those markets more expensive and would destabilize local governments as their cost of high debt loads rises, reducing confidence and the production and jobs growth that would spur Europe to recovery.

Photo: Banco Espirito SantoImage: Bloomberg News

In the most acute case of the European sovereign debt crisis in recent months, Banco Espirito Santo International SA, a Portuguese bank, delayed payments on some securities, following a warning in May that its parent company faced a “serious financial situation” that “could be damaging”. While southern European government bond yields have remained fairly stable, their decline, sustained since summer 2012, is unlikely to continue. European stocks saw a broad decline, notably 1.90% for Italy’s FTSE MIB and 1.98% for Spain’s IBEX 35. Portugal’s PSI 20 took the worst hit, sinking 4.18% on the news. The biggest question now is whether the delays will result in government involvement, which could spark a much more serious financial market reaction and increase borrowing costs across Europe.

That European banks have not been in the news does not imply that they are healthy, or even improving. As they undergo stress tests, European banks are pulling capital onto their balance sheets, leaving less resources available to lend to businesses. Bank lending to non-financial corporations has declined an average of 2.9% YOY in the first five months of the year. In fact, credit contractions in 2013 and 2014 are the worst since the crisis began. What’s more, Moody’s downgraded 82 European banks in May in response to a new EU law that makes banks mutually responsible for risks in the event of another crisis. The majority of these banks were not southern European, but rather from creditor nations such as Germany (12), France (10), and Austria (8), highlighting the breadth at which Europe’s banking crisis has sustained its reach.

In response to this broad European macroeconomic trend, companies can monitor a few important indicators of change:

  • Loan growth: credit growth would imply positive trends in supply and demand for the funds that fuel consumption and production growth
  • Unemployment: gauge which economies are most at risk for austerity fatigue and thus political unrest
  • Bond yields: an increases could indicate market perceptions of increased political risk
  • Results of bank stress tests in Q4 2014: while disruptive, any major bank failures will help companies to identify which countries’ recoveries are likely to lag behind

FSG clients can find out what this means for their business and how to respond in our latest Western Europe regional outlook, and in our Western Europe team’s recent blog posts and podcasts.

ECB’s negative deposit rates will leave eurozone to muddle along

Central banks act when expectations miss to the downside; today was the rule and not the exception. The European Central Bank (ECB) cut interest rates, notably lowering the interest rate on the deposit facility into the negative territory of -0.10%. The ECB’s response to very low price growth is too little too late, but it sends an important message to markets that Europe’s head economists understand the eurozone’s downside risks and are willing to act against them, at least marginally. Europe’s growth will not be improved as a result of today’s action, but the ECB has helped the economy dodge the vicious market correction that inaction would have prompted.

Considering the practical effects of negative interest rates, banks effectively will be charged for any reserve cash they hold over reserve requirements. A reduction of interest rates for banks doesn’t necessarily translate into a reduction of rates for Europe’s business and household savers ─ that’s a decision that banks make on an individual basis and concerns their own margins  ─ but sustained low profits make it likely that banks will carry the cut over to their business and consumer customers.

Lower rates, and even negative rates, will not spur banks to lend, which would provide the much-needed boost for European business which relies heavily on bank lending for their corporate financing. Near-zero rates for years have not improved lending activity, and European bank stress tests will discourage banks from shedding any capital from their balance sheets. Perhaps more importantly, demand for loans will not improve as a result of these measures, nor will banks suddenly decide to trust businesses and households.

Lending is contracting at the fastest rate since the crisis as of Q4 2013
(Loans to non-financial businesses and households, %YOY)
ECB Rate Cut

The ECB assuredly recognizes this shortcoming, and thus announced its intent to intensify the preparatory work related to outright purchases of asset-backed securities (ABS). In other words, quantitative easing (QE) is still on the table for the next meeting on July 3. Although it is not yet clear what assets the ECB can buy within its mandate, quantitative easing would be a large step toward boosting the European economy, reducing the value of an overpriced euro and encouraging export growth in most European markets, creating jobs and reducing inflationary risk.

In the meantime, the ECB’s rate cut will serve only as a market signal. The central bank cannot yet engage the highly politicized QE, but knows that markets would lash back at inaction in light of prolonged low inflation. FSG’s base case for growth in Europe thus remains intact: the region will see very low growth in the long term, which will separate outperforming companies from their peers similar to the Japanese experience of the “lost decade”. FSG clients may use the new Western Europe Regional Outlook, to be released June 9, to outline specific opportunities for growth in a low inflation environment.

Global economic headwinds will weigh on eurozone growth

As developed-market monetary policy creates currency volatility in emerging markets, it would be easy for companies turn their attention away from Western Europe. The financial crisis has abated somewhat; eurozone countries hardly make the news.

However, executives should be prepared for problems emerging in the eurozone as a result of weaker emerging markets currencies. For example, emerging markets currency devaluations make euro-denominated exports relatively expensive, decreasing demand for those products. As a result, the efforts that southern European economies such as Greece and Spain have made to reduce labor costs and increase competitiveness do not yield the export growth that they had hoped.

Furthermore, attempts to diversify western European customer bases among emerging markets are now proving in vain, as currency devaluations sweep away the once bright spot of growing demand.  Chronically high unemployment has muted demand in the eurozone as well, the bulk of whose trade comes from consumers and businesses within its own currency union borders.

At the center of this dynamic is Germany, an economy that has long centered its growth on export health. Across the past five years, Germany’s exports to non-eurozone and emerging markets have increased drastically, insulating its economy more and more from weak eurozone demand.

increase in exports from germany

As major emerging-markets currencies lose….


…. Germany’s growth is likely to suffer.

germany gdp growth

Fluctuations in exchange rates and demand will continue to accompany global economic volatility. To manage in this environment, executives with responsibility for Western Europe should consider increasing the flexibility of their annual targets. ​

You may download FSG’s corresponding podcast on Germany’s Quarterly Market Review by clicking here.

Germany’s Minimum Wage is a Bright Spot in an Otherwise Austere Policy Plan

Pending the finalization of the new “Grand Coalition”, the German government will institute some controversial policy changes during Angela Merkel’s third term as Chancellor. On aggregate, these policies will make a positive impact on German consumption, but will not do much dramatically to boost economic growth for Germany or the broader eurozone. In particular, the proposed measures will do very little to solve Germany’s structural problem of permanent underinvestment in public infrastructure and education. However, one exception ─ the decision to move toward a federal minimum wage ─ will provide more positive change that negative impact on competitiveness.

German unemployment statistics mask a story of depressed consumption without a gain in competitiveness

Germany’s pending decision to institute a federal minimum wage highlights the pushback that the government has received about growing inequality. German unemployment currently sits at 5.2%, a full 7.0% lower than the eurozone average. However, more than 25% of Germany’s workforce are “low income”, which is the highest percentage of low earners in Europe after only Lithuania. While minimum wages exist in some industries, a national minimum wage should increase purchasing power for German labor, and in turn increase consumption. This is good news for German workers, as well as for eurozone companies whose painful pivots towards export competitiveness have not been rewarded by German purchases of their products.

Conversely, the federal minimum wage necessarily increases labor costs, which could decrease German competitiveness. Taken at face value, the wage increase will raise German labor costs by about 1.0%. However, how much of this actually ends up in a net reduction of German competitiveness depends on a number of factors, including the relative development of labor productivity and prices in Germany and in partner countries. What’s more, mini jobs, or flexible low-paying employment, have increased rapidly as a percentage of total employment throughout the financial crisis. Still, German labor costs have decreased only 4.0%, less than any other European country. Meanwhile, central and eastern European countries reduced costs 17.8% in the same period, improving their cost competitiveness relative to German manufacturers.

The institution of a national minimum wage is thus less a threat to Germany’s relative competitiveness than it is a positive step towards increasing Germans’ systemically low consumption. Though a highly flexible labor force contributes to Germany’s competitiveness, the rapid increase in low-paid workers is holding down German consumption without much increase in competitiveness to show for it.

While Germany’s new government will largely hold to the status quo, with little additional support for investment, education, or the broader eurozone economy. Conversely, the institution of a federal minimum wage is a positive step toward providing a baseline for German consumption.

While Germany’s government enjoys safe-haven status, its economy does not. Complacent post-crisis economic and financial policies, such as lack of business and infrastructure investment, are exposing the economy to fluctuations in global economic growth. Germany’s new government will largely hold to the status quo, with little additional support for investment, education, or the broader eurozone economy. However, the institution of a federal minimum wage is a positive step toward providing a baseline for German consumption.

Analyst Insight: Greek Unrest Hinders CEE Growth

From Matt Lasov, Head of EMEA Research:

“Unfortunately, some bad news out of Greece to start the new year. Things are deteriorating and it’s more important than ever to monitor events there.

In Athens, shots were fired into the offices of the ruling party including the Prime Minister’s office. Nobody was hurt but this represents an escalation in social tension. The trend is worrying as bombs were also detonated at other government offices, the homes of journalists and banks during the last week.

The economy is still shrinking under austerity and voters will ask for change one way or another. Banks are still bust and more people are losing their jobs.

Making things worse socially, the Greek government is clawing back some austerity measures for the rich and well-connected, property taxes for example, and arresting reporters who published names of those who evade taxes. The country is ripe for real social unrest. Syriza, the anti-Europe opposition, was ahead in opinion polls until the government secured the most recent round of bailout funding. When that round begins to dry up, Syriza’s case will be even stronger. Ultimately, default is a political decision.

Meanwhile, in Germany, the economy contracted more than expected, 0.5%, in the fourth quarter. With a contracting economy and an upcoming election, it’s hard to imagine that meaningful external support is on the way.

If the eurozone moves back to the brink of breakup, emerging markets that share trade and financial links, particularly in Central and Eastern Europe, will be impacted.

2013 will not be a year of recovery in CEE


Companies need to prepare for a continued deterioration of the macroeconomic environment in Central and Eastern Europe through the end of 2012 and at least the first half of 2013. Demand from both the business sectors as well as the consumers in the region will slow, and public spending cuts will limit opportunity for companies selling into the public sector.

Several drivers are contributing to this bleak picture, all of them linked to the eurozone crisis.

Exports are the main culprit as most CEE economies are highly dependent on export-driven growth and the majority of their exports are destined for the eurozone. In addition, a dependence on lending from the local subsidiaries of eurozone-based banks is leading to a tighter credit market across the region and depriving already struggling local businesses from access to capital. Adding to this, the deeply depressed consumer sectors across CEE further exacerbate the slowdown in regional economies. Finally, regional governments, eager to cut public debt and budget deficits in the face of the sovereign debt crisis, are cutting spending and raising taxes, further depriving their economies of much-needed growth. Together, these trends reinforce each other, creating a perfect storm of weak growth in the region. Because regional governments are unwilling, and some are also unable, to increase spending to break this vicious cycle, CEE’s recovery is largely out of the region’s hands and instead depends on how and when European leaders find a sustainable solution to the eurozone crisis.

While these trends apply broadly to the region, there are differences. Russia, Turkey, and Poland are benefiting from the size of their economies and resilient consumer demand which will support a softer decline in growth. Russia, Kazakhstan, and, to a small extent, Ukraine will also benefit from commodity exports. However, both consumer demand and energy exports stand substantial risk of rapid deterioration of the eurozone crisis, such as may be triggered by an exit by Greece and/or Spain. In this case, no CEE economy will be spared and the starting point of the recovery will be delayed even further.

Conditions in Greece Worsening – FSG Analyst Insights

Interview with Matt Lasov, head of EMEA research for Frontier Strategy Group:

“There is a lot of tough talk coming out of Germany after the government approved the Spanish bank loans. Some officials are essentially challenging Greece to leave, claiming that the Greek problem is ring-fenced. It’s mostly rhetoric designed to rile up domestic voters. We are very skeptical that we’ll see German-led action to force Greece out. Politicians are simply jockeying for power as the domestically unpopular Spanish loans created a political opportunity. Forcing Greece out still has the potential to destabilize thinly-capitalized German banks and the broader European financial system.

The next signpost to watch is the upcoming Troika visit. Greece has closed only 12 public agencies from a target list of 120. At the same time, the Greek government is expected to ask for a budget deficit cut extension that will cost the Troika an additional 30-50 billion Euros. This will be hugely unpopular with taxpayers across Northern Europe.

Markets are not taking the news well and, as a result, Spanish 10yr yields shot to a record 7.5% today. A bit more under the radar, 2yr yields shot up to 6.4%, so even rolling over short-term debt will be painful and difficult. When yields spike in Spain on the back of Greek news, it highlights the continued interconnectedness of the European financial system despite German claims that Greece is ring-fenced. A disorderly Greek exit still has the potential to create bank runs and bond strikes in Spain. The market’s response to Italy has been more measured. 10yr yields increased to 6.4%.”


Recession in Europe, Driving Risk of Breakup – FSG Analyst Insights


Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

“The risk of default and devaluation in Europe is still high. Bailout discussions focused on Spanish banks buy time and businesses should use this time to set plans in place to protect themselves against a Spanish exit from the euro.

So what’s changed in Europe since the last update? Not much. The crisis is playing out exactly as anticipated. The likely scenario remains deep recession. The risk of eurozone break up remains high and businesses should continue to plan for this. Greece is off the rails, waiting for elections in the middle of June to determine its fate inside or outside the eurozone. Meanwhile, Spain entered a full-fledged banking crisis that requires a coordinated European bailout.

The bailout for Spanish banks should buy time and avoid a run on banks in the immediate term. It will not fix the structural issues that will plague Spain in the medium term.

It is important to note that the bailout deal is not done. Spain will still have to accept the terms of the agreement, which will require harsh austerity and a transfer of fiscal sovereignty to Germany. Can the Spanish government force this on its people, especially when Prime Minister Rajoy ran on a platform guaranteeing that this would not happen? If Rajoy can push it through, how long will Spain be able to weather a cycle of harsh cuts to public services while unemployment remains at record highs?

Even if the bailout goes through, and we expect that it will, Spain will still require cost cutting of 30-40% to compete globally. This will be immensely painful whether it is done slowly over a decade, as every labor and government contract is renegotiated at competitive rates, or through a quick but highly disruptive devaluation. As cost cutting continues, the economy will shrink, and more debt will go bad because there are fewer available revenue streams that can be used to pay it off. Another bank bailout will be required to clean up the remainder of the debt overhang and the cycle will continue. Some estimates show an additional $300bn euro gap in the medium term. The current package amounts to $100bn euro.

We have seen this movie before. The cycle playing out in Spain is exactly what happened in Greece. Europe stepped in with bank bailout money to avoid imminent implosion of the member state. In exchange for funding, Greece accepted austerity measures which reduced the size of its economy. While the economy shrank, the debt burden with long term maturities stagnated. Debt to GDP ratios soared and Europe called for further austerity. The result for Greece is higher unemployment and extreme social pressures that are leading to an exit.”

China’s North Eastern Provinces Witness High Investor Confidence

Business sentiment in China is weakening due to continued political drama, falling industrial production, and declining growth expectations from export-dependent provinces such as Guangdong and Zhejiang. Nevertheless, northeastern markets such as Tianjin and Liaoning continue to see significant investment from multinationals, suggesting that growth prospects for the region remain strong.

For more detailed insight on major trends on a provincial level in China, find our latest analyst headlines below:

Provincial China