In his latest Ahead of the Curve Neil Williams, Group Chief Economist at Hermes Investment Management examines the potential effectiveness of QE in a euro-zone where monetary union is devoid of economic union and tensions are increasing.
QE will be no panacea. What it will do is reinforce the impact of low borrowing costs, other liquidity injections, and the ECB’s ABS and covered bond purchases. These purchases may be aiding banks’ balance sheets, but the amounts look small, at about 2% of all issuance.
More potent would be the ‘bazooka’ of sovereign purchases: government bonds accounting for one half of issuance. But, even if kick-started by the ECB’s Governing Council on 22 January, QE could be no more than gradual and targeted.
Will the ECB buy ‘Greece’ if it’s threatening to renege on its payments?
Assets such as corporate debt may also be bought. And, once turned on, objections to QE could grow. QE-sceptics like Germany are still nervous of ‘debt mutualisation’; wariness may build of perpetuating the sort of cost-led inflation that proved counter-productive in the US and UK; and political risk is rising, with elections coming in Greece, France (local), Spain and Portugal.
Greece’s snap election on 25 January is an untimely curveball. Though our base case remains that Greece stays in the euro, restructuring risk will stay on the radar. Greece’s radical left coalition (Syriza) seems pro-EMU, and pledges to honour Greece’s market debt, but advocates rescheduling Greece’s official liabilities to euro-zone governments and the ECB. How willing will the ECB be to purchase ‘Greece’ under these conditions?
Some form of targeted QE – weighted by credit ratings, GDP or capital contributions – seems likely, skewed to fiscally-disciplined members like Germany. And especially if, as we suspect, the euro-zone crisis is entering its second (more sinister?) phase, where the macro strains of the periphery are wearing increasingly on the core countries footing the bill.
From periphery to core…
Competitiveness Analysis (Chart 1) to show the extent to which the zone’s underlying problem – a monetary union devoid of sufficient economic union – is being addressed. We used the OECD’s latest estimates to 2014 of a country’s unit labour costs in tradable goods, relative to its main trading partners’ (RULC).
The average is weighted, then indexed to a 2010 base year (= 100). A rising index indicates a real effective exchange rate appreciation and falling competitiveness. An index fall signifies a relative cut in unit labour costs and, thus, a competitiveness boost. See Chart 1.
Shifts in euro-zone members’ competitiveness remain too disparate. The chart shows the absolute competitiveness-shifts by country. With the escape route of currency devaluation closed off, the deciding factor has been whether they undertake the internal, cost adjustment needed to boost competitiveness, thereby boosting GDP and tax revenue.
On this basis, the winners still include Germany, which is helpful given it accounts for a third of euro-zone GDP. Germany saw its unemployment rate rising from 8% in 2001 to over 11% by 2005. But, this pain reaped dividends, and it has since translated cost reduction into current account gains.
By contrast, other members have experienced deterioration in their position. Countries on the right-hand side of the chart saw their relative labour costs climb. Up till 2010, Spain and Italy’s competitiveness deteriorated fastest.
The good news is Spain and Italy’s position is now recovering strongly. This is shown by the reducing cluster as Spain and Italy move back to the left. We highlight the up-to-2010 period by the grey blobs; the estimates to 2014 in green thus suggest improvement during austerity.
The UK has managed to outperform by virtue of its net 12% trade-weighted currency depreciation since 2000 – a route cut off to individual euro-zone members.
This raises hope that euro-zone austerity is paying dividends. It also gives credence to the view that the narrowing in bond spreads generated by ECB president Draghi’s pledge to do is underpinned by tangible improvement. But, it also comes at significant economic and social cost, warning us of more tensions to come.
First, lower trade flows and the drain on resources mean that strains may be impacting the ‘core’ members. Germany’s competitiveness is still improving, but it now looks less ‘bulletproof’ economically as China slows and Russia falls into crisis.
Moreover, France’s triple-A ratings have been lost over its failure to reverse a 7% competitiveness hit with the euro. This dwarfs Portugal’s sub 1% loss, which is a bail-out country rated eight to nine notches below France. France is still vulnerable.
Second, boosting competitiveness via austerity poses its own risks. The euro-zone is now running deflation. Deflation risks the vicious circle of bloating real debt, lowering ratings, lifting funding costs and slowing growth, thereby exacerbating the deflation.
Spain appears between ‘a rock and a hard place’. Further austerity and reform into 2015’s general election could spark social unrest when male youth unemployment is as high as 54%.
The Deutsche Bundesbank president, Jens Weidmann, is thus right to stress that money-printing alone will not tackle the causes of the crisis. This needs years of work. Yet, without QE, some of the growth and tax benefits to Spain, Italy and others from their overdue competitiveness-gains may not be maximised by a weaker euro.