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Last week Europe economy review and analysis (June 18, 2010)

By Daniel Stewart & Co

The Dutch elections were never expected to produce a single party majority and the Liberal Party ended up as the largest party and looks like forming a centre-right coalition that is more inclined towards fiscal austerity. This would involve, however, teaming up with the controversial Geert Wilders whose Freedom (anti-Muslim) party also won more seats. In the Netherlands it is reckoned to take three months to form a coalition but this looks ambitious in Belgium following its election last week. Big gains for the separatist New Flemish Alliance at the expense of the other Flemish parties make it the largest party. As the next largest party is the French-speaking Socialist Party it may be that the country breaks up into federated or even independent provinces.

Last Tuesday saw civil servants in Spain walk out in protest at the austerity programme but there is a wide discrepancy between government and union estimates of the numbers involved. Some 25,000 people protested in Berlin and Stuttgart on Saturday and the opposition Social Democrats are calling for a general election. Rome also saw protests on Saturday. This Tuesday there were new protests in Paris in anticipation of proposals to raise the retirement age. Trade Union leaders are now talking about pan-European action as governments and the EU Commission step up the calls for ever greater austerity.

Calls are easier than cuts, however, and it is very difficult to know how seriously to take all this. The German phased ‘cuts’ of ?80bn represent a relatively manageable proportion of GDP, are not all immediate and the deficit was always likely to be kept under strict control. The proposed French cuts of ?50bn will be put before parliament in the autumn and may not all be approved. Mr Sarkozy does not like ministers to use the word ‘rigueur’ in this context. Nevertheless, he has proposed that the retirement age is increased gradually from 60 to 62 (reversing the 1981 move down from 65 and lagging the German plan to move from 65 to 67). He is also trying to get away with not replacing up to half of retiring civil servants and squeeze spending in central and local government and state-owned organisations. It is fair guess that the unions are on his case and will fight him all the way to the 2012 election. Ever the showman, Mr Sarkozy has been talking of making it legal to incur a deficit on current expenditure but this may be more directed at Mrs Merkel, from whom he has been somewhat estranged of late. She was not interested in his EZ economic government idea (i.e. Sarko lui-meme calling the shots, including leaning on the ECB) and wants all 27 EU countries to collaborate (i.e. she wants the UK to help restrain Sarko and the Club Med.). They have, however, come together to call for a tax on banks.

Meanwhile, the latest Industrial Production and Trade Balance figures continue to show Germany to be faring much better than the rest of the EZ (and most other places too). Finland has dipped back into recession after only one quarter (Q4 2009) out of it, which is somewhat tough on the only EZ member other than Luxembourg to comply with the 3% deficit target. The Greek government stoutly maintains that it is ahead on both spending cuts and tax revenues but the rating agencies (quite bravely considering all the guns pointing at them) are not convinced. Fitch had already cut the Greek sovereign rating to its lowest investment grade of BBB- and last week Moody’s went further and cut by four levels to junk at Ba1. This is further evidence that a Greek rescheduling is expected sooner or later and it may now just be a matter of timing to save the EZ leaders’ face. Spain, of course, represents a much bigger problem and the more denials about this being on the EU summit agenda the more convinced the market becomes that ‘something is up’.

The ECB left rates unchanged last week but it did announce 90-day unlimited collateralised deposit auctions to be held in July, August and September (maybe more after that) to help cope with the expiry of the 12-month deposits next month. Mr Trichet says he is concerned about blockages in the transmission of money rather than liquidity and is unrepentant (not to say tetchy) about the (distressed) government bond purchase programme (now standing at ?40.5bn). Banks are becoming increasingly unwilling to lend to each other, preferring to deposit overnight at a much lower rate with the ECB. Some, especially smaller Spanish banks, are being forced to turn to the ECB for funding.

The numbers on bank exposures are rather scary:

- EU banks have $1.6trn of loans outstanding from the PIGS ($832bn from Spanish borrowers) and a further $1trn from Italian borrowers.

- French banks have $493bn outstanding from the PIGS (of which ?106bn is sovereign risk) and German banks $465bn ($68bn of sovereign risk).

- Disclosure so far rather thin but Societe Generale and Credit Lyonnais are thought to be among the most exposed.

State-owned (rescued) Hypo Real Estate Bank has a staggering $97bn in sovereign debt from the PIGS and Italy. Rescheduling is a well-trodden route for many countries and investors and the EZ now have to face the possibility that several member states will have to take it. The problem is that unlike their US and UK counterparts most major EZ banks have neither raised new capital in the markets nor received government bailouts. They are already suffering from write-downs and lobbying hard to delay the implementation of Basel III. The (dare one say?) Quixotic move by the Spanish government to publish the results of the stress tests on banks will not have gone down very well in either France or Germany.

There need not be a run on any banks but any problems from Spain would almost certainly trigger a spate of recapitalisations, including state funding.

Thursday update: at least some of these banking worries have been priced into euro exchange rates. After slumping to 4 year lows in the previous week the euro was beaten down further in Asia to $1.1876 very early on Monday 7th but by Friday had clawed its way to $1.215. Despite wobbling on Friday 11th it closed at $1.2094. This week it was able to push up above $1.235 but, as rumours about Spain circulate, could be subjected to some profit-taking. Last week we highlighted the euro’s vulnerability to the Swiss franc and there was indeed something of a correction but the rate was unable to hold above Sf1.40. The Swiss National Bank seems to have given up selling francs and the EUR/CHF rate has fallen back quite sharply.