Sunday, 16 December 2018

Cracking the whip

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  • Cracking the whip

Europe needs to implement reforms if it is to make the most of the signs of life that are being seen in the economy, but each country faces its own particular problems and a uniform approach to growth is bound to fail.

After years of humiliating bailouts, dreary data, soaring debt, and endless economic false starts, the eurozone is finally showing signs of life. The European Commission projects Germany’s economy to grow by 1.9% in 2015, with Spain’s set to swell by 2.8%, the fastest rate of expansion in eight years.

Consumption is rising in almost every regional member state. Quantitative easing has helped to boost exports by initially suppressing the value of the single currency, and by cutting rates to record lows.

Yet now is not the time for the eurozone to rest on its laurels, experts say, but to push ahead with tough but necessary reforms. Only that way can the region ease its debt burden and create the sustainable, long-term growth it so desperately needs.

Indeed, political leaders may not get a better chance to reform the eurozone’s slow, plodding economy, with its obsessive emphasis on procedure and worker’s rights, and on protecting old jobs and industries rather than creating new ones.

Europe’s efforts, said Marcus Svedberg, chief economist at emerging market investment manager East Capital “should be geared towards raising potential growth, and to do that, the region’s focus has to shift towards much-needed structural reforms”.

It is, he said “unarguably easier to solve the region’s manifold problems of high debt and unemployment” when growth rates are closer to 3% (or roughly the projected level of US economic expansion in 2015, according to World Bank forecasts) than 1%.

David Zahn, head of European fixed income at Franklin Templeton Investments, said that only “the introduction of more fundamental structural reforms will end the region’s long-term secular stagnation”.

Yet what reforms – and where, and how? Will painful changes to the way companies operate, and to the rights and benefits granted workers and their families, really be enough to eat into elevated national debt levels, and release the eurozone from its long-term malaise?

Or will it take more – the promise of additional liquidity stemming from the extension of the European Central Bank’s €1.1trn (US$1.26trn) stimulus programme beyond September 2016, along with a drop or two of luck – in the form of, say, long-term lower oil prices?

Distinct sets of flaws

The starting point should be recognising where the need for reform is greatest, as each economy has its own, distinct set of flaws. In Central and Southern Europe, said East Capital’s Svedberg, the onus should be on “labour market flexibility: reducing bureaucracy, and cutting red tape and barriers to exit and entry”.

Anatoli Annenkov, senior European economist at Societe Generale, points to the need for further labour and institutional reforms in both Italy and France, two countries with very different approaches to the subject.

In Rome, Prime Minister Matteo Renzi, a reform-minded technocrat, is keen to overhaul the country’s labours markets and judiciary – though even he has struggled to cut spending, which accounted for 50.5% of the national budget in 2013, against a eurozone average of 49.5%.

In Paris, President Francois Hollande talks of boosting economic growth by “producing more and producing better”. But he shies away from deploying the threat of reform, equated by France’s voters with other unpopular concepts such as globalisation and competition.

Even Germany, which completed a long and gruelling round of labour reforms in the mid-2000s, faces the need to slim the state and cut welfare costs in the years ahead, to cope with a greying population.

“They are facing a very significant demographic shock, with big numbers of people retiring,” said Annenkov. “Either they deal with this, or they risk having to accept long-term growth of less than 1%.”

Reform, while painful, is also merely a word, a means to an end. Since the financial crisis, eurozone leaders have continually stressed the need to tackle the twin ailments undermining the region’s central nervous system: debt, or the abundance of it; and growth, or the lack of it. To many, these maladies are irreparably intertwined. Tackle one and cure both, the thinking goes.

Fear of the pain

But which one first? To SG’s Annenkov, the enduring legacy from the financial crisis was the glaring need to reduce public debt levels.

“Since 2011, I have taken the view that Europe’s debt overhang is so high, it will weigh on growth,” he said. Only by solving its crushing debt burden, he added, could the region return to full economic health.

That won’t be easy. Eurozone leaders know they need to act on debt. But most fear the pain (and the political unpopularity) that accrues from whittling down budgets and slashing comfy welfare provisions. Better to pop the blinkers on and continue to run a painfully high deficit. (France’s budget deficit came in at 4% in 2014, above the EU’s 3% target, with Cyprus at 8.8% and Spain at 5.8%).

Despite the return to growth across much of the region (barring the Baltic States, only Finland and Greece contracted in the first quarter of 2015, according to central statistics agency Eurostat), eurozone debt rose by a single percentage point in 2014, to 91.9%.

Greece tops the list of transgressors, with a debt-to-GDP ratio of 181.9% in 2014, followed by Italy, on 132.1%, then Portugal (130.2%) and Ireland (109.7%). Of that rogues quartet, only Ireland has managed to trim its stock of debt since 2012.

The trouble is, where to start? The paradox here is clear. Debt in some eurozone countries is so high, few see it being resolved without creditors agreeing to a haircut. Yet no one believes this will happen: any attempt to restructure national debt, anywhere within the eurozone block of nations, would be nixed by the European Commission before it got off the ground.

Moreover, any talk of debt restructuring would have to start and end with Greece. But that, said SG’s Annenkov, would “open up a Pandora’s box”, with other indebted nations (not least Ireland and Portugal, both of which paid back their IMF-led bailouts early) asking: “why them, why now”.

“That is why Greece is so interesting,” said Annenkov. “Greece only carries a small weight in the euro area but it is a potential model down the road.”

Every nation state has its own problems. For southern and peripheral states, it’s the sheer weight of their liabilities. For Germany’s ordoliberal economists, debt is a dirty word, along with inflation. But at least Berlin has a plan: to cut its debt-to-GDP ratio down to 60% over a 10-year period.

Italy’s problems, contrary to popular belief, began long before the introduction of the single currency; its debt-to-GDP ratio started rising in the 1980s, and first topped 120% back in 1995.

Ultimately, the only available option open to eurozone countries is to slowly chip away at debt, occasionally pushing through unpopular reforms, and hoping that the next recession can be kicked a little farther down the road.

Moment of respite

In that sense, the next couple of years are likely to prove decisive. Crises do terrible things to long-term planning.

“The worse things get, the bigger the pressure becomes on governments to push ahead with tough reforms,” said Frederik Ducrozet, senior eurozone economist at Credit Agricole. For now at least, QE is helping relieve this pressure by propping up growth and prices while making the single currency more competitive.

That’s good news, of course. Yet this should be the eurozone’s Damascene moment, wherein it recognises the peril in failing to push ahead with reform, just as the pressure to impose painful changes finally starts to ease.

“The eurozone is enjoying a moment of respite from bond market investors,” said SG’s Annenkov. “This is the key moment for European leaders. Over the next two years, they need to take some big steps.”

Do eurozone leaders have the stomach for the fight? Many suspect not. East Capital’s Svedberg believes growth will merely make policymakers “complacent, further delaying structural reforms”.

Others go further. SG’s Annenkov worries that growth will peak sooner rather than later, reaching 1.6% in 2016 before slowly declining through the latter half of the decade.

“While implicitly warning us that this is a temporary recovery, the ECB still expects accelerating growth into 2017 in its forecasts,” he said. “We think this is optimistic, and eurozone governments probably have a maximum of 24 months to really get some serious reforms done.”

Even if that prediction proves too negative, there’s little doubt that this is a key moment. For the region’s crisis-weary leaders, the sun has finally come out after years of dank economic gloom.

Franklin Templeton’s Zahn is not alone in expecting debt-to-GDP ratios to peak across the eurozone in 2015 before declining. QE, by flooding the region with fresh liquidity, is likely to aid that process.

The region’s broad return to growth will, in turn “ease the pressure on countries that have particularly high debt-to GDP-levels”, said William de Vijlder, group chief economist at BNP Paribas.

Yet the drive to cut public-sector liabilities cannot be sacrificed simply because the eurozone has been pampered by a couple of measly percentage points of growth. Debt has to be reduced to a far more manageable level, and that has to happen while the region’s body and mind is in a good place.

For the bad times will, ineluctably, return. “There will be another recession – there always is, sooner or later,” said de Vijlder. “Once that happens, you’ll see budget deficits go up again, so it’s vital that we tackle debt now.”

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