Grexit, QExit and Growth

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Maze labyrinth

There is building evidence that eurozone economic growth is firming. Even a moderate recovery seemed inconceivable to some commentators a few months ago, among all the talk of deflationary spirals. So the cyclical improvement can be considered to be a small victory. However, three big challenges remain. Greece is the most imminent, but managing expectations about the ECB’s eventual exit from QE may become a bigger issue in the coming months. Finally, strengthening institutions to ensure the strucutral reforms necessary to stimulate an improvement in Europe’s long-term economic growth.

The ECB is likely to end its purchases by September 2016 but financial markets will start to anticipate on this much earlier Nick Kounis Nick Kounis Head of Macro Research

The parrot is alive

In October of last year, The Economist Newspaper depicted the eurozone economy as a dead parrot. Referring to the famous Monty Python sketch, Chancellor Merkel was depicted in the background claiming ‘it’s only resting’. The Economist argued that the eurozone economy ‘was marching towards deflation and stagnation’. Six months on, the outlook does not look quite so gloomy.

Economic recovery on the cards

Although business surveys for April published over the last few days were a mixed bunch, the overall picture is encouraging. Germany’s ZEW investor expectations and the eurozone PMIs slipped, while Germany’s Ifo and Dutch producer confidence rose further. However, all of these indicators had risen strongly in previous months. Meanwhile, hard data so far for Q1 suggests growth is set for an acceleration. The fall in prices and the euro and easing financial conditions suggest that a cyclical recovery is underway. Growth will likely surprise on the upside this year.

Challenges remain

ECB President Draghi and his colleagues have been at the forefront of efforts to support demand, by pushing banks to recapitalise and putting in place monetary stimulus. The decline in oil prices that has also driven down consumer prices has also helped. Far from a deflationary spiral, consumers are spending the oil windfall. However, it is no time for a party. Challenges for Europe remain.

Wide gap between Greece and creditors

The most imminent challenge is obviously Greece. Following today’s Eurogroup meeting in Riga, Eurogroup President Jeroen Dijsselbloem said that there had been some positive signs, but wide gaps between Greece and creditors remained to be bridged and time was running out.

Graph - Business surveys signal economic recovery

Default without euro exit?

With Greece running out of cash, one of the subjects of discussions among investors over the last few days has been whether Greece can default, but stay in the eurozone. ECB Vice President Vitor Constancio suggested that they could, rightly pointing out that legally only Greece could initiate an exit procedure. In our view it then would come down to whether it would be bearable for Greece within the eurozone. Would the ECB cut off liquidity for Greek banks? Would the government be able to finance itself even with reduced debt service payments? Theoretically it would be certainly possible for Greece to default and stay in the euro, but there are serious question marks about whether it would in practice.

Greek government still looking for a deal

The Greek authorities have dismissed rumours that they were looking for either for a default or an exit. Greek finance minister Varoufakis said that ‘neither they nor we will let the opportunity slip to arrive at an agreement that’s clearly to the benefit of everyone.’ He added that a failure to reach a deal would be ‘ catastrophic’. However, other European countries are growing impatient at how slow the progress in the talks has been.

More time but not much

We expect to see a deal eventually. An EU official said that the eurozone now sees the end of June as the main deadline for the deal, according to Bloomberg News. Greece is facing severe liquidity pressures and we have serious doubts about whether the country could stick it out for that long without aid. The Greek government has ordered local governments to transfer their cash reserves to the central bank, which amount to around EUR 1.5-2bn. This should allow the government to meet its commitments through to the end of May. It therefore seems that this is the ‘real’ deadline for a deal, especially with commercial banks also continuing to face a liquidity crunch. If such a short-term deal is reached, the next step will be to try to agree a longer term programme this summer.

ECB exit from QE another challenge

Another challenge that Europe’s policymakers – the ECB in particular – will face is how to eventually exit from the current QE programme. Given the ECB’s aggressive asset purchases, which are leading to acute scarcity for core government bonds, yields have become increasingly negative. Indeed, the level of bond yields is far away from fundamentals. The ECB is likely to end its purchases by September 2016 but financial markets will start to anticipate on this much earlier. Expectations about Fed tapering in 2013 led to a sharp rise in bond yields. Clearly, the ECB will have a major communication challenge in 2016 and maybe even before that to try and prevent a significant early tightening of financial conditions.

Graph - Negative yields are spreading

Long-term economic growth

The final issue that the eurozone authorities need to tackle is long-term growth. The ECB’s chief economist Peter Praet has been at pains to stress that the eurozone economy is experiencing a ‘cyclical’ recovery but not a ‘structural’ one. Indeed, trend growth has fallen over recent years, to around 1% according to estimates from various international organisations.

Graph - Eurozone trend growth is low

Economic governance reforms stalled after ‘whatever it takes’

Structural reform is badly need to lift long-term economic growth, yet the eurozone institutions still do not have the teeth to require countries to follow better economic policy. Typically the European Commission has given member states room to delay fiscal consolidation and pass reforms, but they have often not delivered. The process of improving the eurozone’s economic governance has unfortunately stalled. This is a rare negative side effect of Mr Draghi’s ‘whatever it takes’ speech in 2012, which led to a serious easing of financial tensions (and hence pressure).

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