The FINANCIAL — Marvelous progress has been made in 2012.
The FINANCIAL — Marvelous progress has been made in 2012. The doom and gloom scenarios of the downfall of Europe have been avoided through various facilities introduced this year, such as the European Stability Mechanism (ESM) and Outright Monetary Transactions (OMT). The European Union (EU), International Monetary Fund (IMF) and European Commission even managed to narrowly save Greece from a disorderly default, which could have lead to all sorts of unpleasantries. The euro ended the year on a positive note, reflecting these fantastic achievements. The euro moved towards eight-month highs against the US and Canadian dollars, 16-month highs against the Japanese yen, and towards seven-month highs against the pound sterling.
In fact, by the end of the year, Greece obtained a rating upgrade from S&P, out of “selective default” range. The problem for Greece will now be implementation of the agreements that the government made with its lenders. There are still risks that after six years of recession and high unemployment the country can’t take any more. On the verge of such disruption, lenders may have to forgive a part of Greece’s debt, which will likely be called anything but default. While progress has been made, and should be celebrated, reality will likely set in for many investors sometime in the middle of the first quarter of next year, particularly as investors face the uncertain outcome of Italian elections in February.
If Spain continues to drag its feet and not ask for a formal bailout, as bad loans on bank balance sheets build, then contagion fears could escalate once again in debt markets. Further, the Catalonians are still talking about a separatist movement that would see the region pull out of Spain, but not out of the EU.
While the legality of this remains highly uncertain, it is something that even talk of could escalate fears of a bigger break up. The euro zone will continue to face significant debt challenges, and unfortunately politicians/officials who might rise to address these challenges will most probably sit on their hands until the outcome of German elections are known in September. Not only do elections give politicians an excuse to hold off on hard-hitting reforms and cuts, but there are now all these nice little safety nets created in 2012 to fall back on, which may give politicians a false sense of security.
The biggest threat here is France, which could find its balance sheet back under scrutiny in 2013. Expanding growth will be the biggest challenge. Growth would help countries out of debt. A pickup in external demand from the US and China will presumably help the euro zone outlook, but those positive effects on euro zone growth could be offset by ongoing austerity measures.
The European Fiscal Compact is expected to begin this year and will place demands on all euro zone governments. Ten out of a required number of twelve euro zone countries have submitted a so-called international deposit on the compact, after ratification procedures were met in the individual countries. Upon the deposit of a twelfth euro zone country, the compact will enter into force.
Backdating to January 1, 2013 means that even stronger core countries like Germany and Belgium will have to put through measures to cut deficits and debt. Progress on the so-called banking union’s foundation was achieved at the end of last year, but a legal framework still needs to be built before implementation begins, and that is not expected until March 2014.
Without growth, bank balance sheets will continue to suffer, and bad loans build. Weakened banks also face new regulatory measures coming online this year. This will continue to inhibit loan growth, and weigh on any economic recovery. The list of potholes (i.e., political uncertainty, prospects for weak growth stemming from more austerity, additional competitive reform measures) along the road to a sustainable recovery is long and varied, and should help to keep the euro’s upside capped just under the 1.40 level against the US dollar, at least during the first quarter. A European Central Bank (ECB) cut in its primary refinancing rate, which has been penciled in by investors, will give only psychological support. However, a cut in the ECB’s deposit rate into negative territory could help spur banks to move money off the ECB’s balance sheet, which might ultimately help support loan growth.
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