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GLOBAL INVESTOR 1.14 04

Long before concrete plans for European Economic andMonetary Union(EMU) were developed in the mid-1990 s, theconcept of a single currency had been perceived by manyas a means to boost not just economic, but above all political

convergence in Europe. Indeed, it proved easier to reach agreementon the high-level principle of a common currency than on the nitty-gritty measures and reforms that would ultimately be needed to makeit work such as the integration and coordination of banking regula-tion and common fiscal policy. Consequently, the euro was launchedin 2002 without most of this crucial institutional struc ture. Some sawthis as a potentially fatal omission, while others viewed it as a gapthat could not have been filled beforehand, but which participants would be able to tackle later to keep the euro together.

In the fir st years of its existence, the serious design flaws of themonetary union were well disguised: Germany had entered the union

with an over valued exchange rate, and the per iphery generally withundervalued exchange rates. While Germany struggled to regain com-petitiveness, the periphery economies were boosted. The economicupswing in the south, combined with their seemingly cheap assets,attracted enormous capita l inflows not j ust from Germany, but fromother surplus countries and regions as well.

Credit expansion further boosted economic growth in the periph-ery, but also drove up wages and prices, and generated asset bubblesof varying dimensions the Spanish and Irish housing boom being themost dramatic. By the time the global financial crisis hit, the peripheryhad become uncompetitive as well as over-levered, and thus highlyvulnerable to economic or financial shocks. The event that tri ggeredthe EMU crisis was the insolvency of the Greek government in early2010 . It not only proved to investors that the rules for enforcing fiscaldiscipline (the infamous Maastricht criteria) had failed, but also re-vealed the severe lack of stabilizing institutions inEMU.

The history of the EMU crisis depicted on pages 6 to 7 is thus oneof a prolonged struggle between member states over how to construct

the missing institutions, what powers to give them and how to fundthem. This process was uneven, but the outcome, in our view, is amore complete though still imperfect monetary union and thus

TEXT OLIVER ADLER Head of Economic Research

2014

effectively a major step toward a political union. Contrary to thepredictions of many skeptics, the institutions of EMU have beenstrengthened rather than weakened by the crisis.

As we show on the fol lowing pages, however, progress in indi-vidual member states is far more patchy. Some countries, such asSpain, have made considerable strides in reforming their labor marketsand their fiscal institutions. Others, notably Italy, and also France,have a much longer way to go. Meanwhile, a still partly dysfunctionaland far from integrated Eurozone banking system and capital marketremains a hindrance to a vigorous and synchronous economic recovery.

That said, the ascendance of the common central bank and financialregulator should continue to drive this integration process, while also

EE AE U C ou nt ri es w it h e ur o

Reform agenda

Toward a less imperfect monetary unionThe Eurozone lacked robust institutions to deal with the fallout from the Greek debt default and thefinancial contagion that followed. In response to the crisis, the establishment of such institutionshas begun in earnest. However, the reform and economic recovery process of some of the memberstates is far from complete.


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Source: Datastream, Credit Suisse

but rather a balance of payments crisis

Current account balances of selected Eurozone members

Germany France Spain Greece Eurozone

300

200

100

0

100

200

300

1997 1999 2001 2003 2005 2007 2009 2011 2013

100

90

80

70

60

50

40

30

86420246810

Source: Bloomberg, Datastream, Credit Suisse


Economic boom, falling interest rates, easy lending

estate bubbles within the Eurozone. Not all countries wereaffected similarly. Neither the German nor the French

Spain, Ireland or the Netherlands. Tougher regulators

gage rates decline. The latest data also show a slight

Real estate bubbles,busts and stabilization

4

2

0

2

4

6

8

10

12

0 40 80 120 160 200

2007

2014

2011

GERMANYSPAIN

FRANCEITALYGREECE

EUROZONE

Debt less than60% of GDPand budget

below% of GDP

The crisis in the Eurozone is often regarded asprimarily resulting from imbalances in the member

is only part of the story. In fact, most governments,

with the exception of Greece, were running

government, in particular, generated a surplus in2007 of EMU countries was no worse than that of otheradvanced economies, such as the UK , not to men-

in the wake of the cr isis itself. The true story of theEMU

With devaluation and currency risk apparentlyremoved due to the creation of the single

accelerated sharply from the mid-2000 s on

Accelerating import growthneeded to be funded internationally. Givenhigher yields on government bonds and otherinvestments, attracting the funds was quiteeasy. Low global interest rates, promulgatedby the Federal Reserves easy monetarystance, added to the attractiveness of thistrade, while savings surpluses in Germanyand emerging markets were seeking anoutlet and better returns.

its peak in 2008 . As the global recession hit

and the general deleveraging process set in,

contraction only started about a year after the

THE CRISIS

Greek blowup. Private funds dried up as fears

via the central banks Target2 syst em madeup for some of the remaining short fall. Inaddition, demand for external capital droppedsharply in response to the crisis and reces-sion itself.

In the meantime, the periphery hasstarted to generate surpluses, i.e. it has be-gun to export capi tal. This is, in part, dueto the improved competitiveness and tradesurpluses, but also results from ongoingprivate sector deleveraging in the periphery.Unless domestic demand picks up muchmore decisively, the Eurozone as a whole willcontinue to generate surpluses and export

capital to the rest of the world, and contributeto what former Fed Chairman Ben B ernankehas called the global savings glut.

Source: EU Commission, Datastream, Credit Suisse


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6 April 2011Portugal asks for

an EU bailout.

Lehman Brothers

19 October 200 9The newly elected

Greek government an-nounces a budgetshortfall of12.7%

of GDP, more thantwice what was

initially expected.

Ireland is bailed out by

the EU and IMF.

10 May 2010EU agree on a temporaryEUR 500 bn facility

stability, the EuropeanFinancial StabilityFacility(EFSF), andon the creation ofa permanent successorto it, the EuropeanStability Mechanism(ESM). The IMF commitsanother EUR 250 bn.The ECB unveils itsSecurities Markets

Programme (SMP).

T e n

50

5

10

15

20

25

0

5

40

45

0SEP 0 JAN 09 JAN 10 JAN 11

Source: Bloomberg, Credit Suisse

Fitch downgradesGreece from

A to BBB+.

Mario Draghi, 26 July 2012

will dowhat is

n eeded

GREECEITALYPORTUGALSPAIN


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ADJUSTMENT REFORM AND RECOVERY

GLOBAL INVESTOR 1.14

Industrial production

120

110

100

90

80

70

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Germany France Italy Spain Greece Portugal Netherlands Eurozone


As noted above, the competitiveness of the periphery countries had

-cys existence. Labor costs had shot up substantially, and productivi-ty growth had not kept up with costs. As a result, unit labor costsamong the EMU countries drifted apart: between 2000 and 2008 ,French, Italian and Spanish unit labor costs had risen relative toGermanys by 20% , 30% and 35% , respectively. The consequence

was that these economies were affected far more severely by theglobal downturn in2008 09

within the Eurozone had not yet really erupted. When they did after2010

was accentuated. Between the trough in the global economy in mid-2009 and mid-2013 , the gap in overall production levels between,

for example, Spain and Germany had widened by a stunning 35% . In the less cyclical ( but far larger) services sectors,

the divergence was less pronounced and therefore the divergencein per capita income between the north and south over the course ofthe crisis was not quite as dramatic. Yet, the massive gap in indus-trial production which opened over these years is one measure ofthe fact that the economic dominance of Germany within EMU has

been enormously accentuated by the crisis. Even though most

countries have seen more or less clear signs of economic recoverysince mid-2013 , this gap will take years to close, if at all.

EMU countries

crisis led to a disruption and fragmentation of

Common standards and regulation, com mon

would not lead to renewed fragmentation.

Agree ment in principle to push ah ead wi th

SSM ECB

SRM

deposit insurance scheme that would pool

runs do not occur. The SSM is to control andenforce adherence to rules, regulations and

SRM is to ensure

own feet are wound down in a t imely way and

said, the SRM

The ECBs new building in Frankfurt is currently under constructio n.

EUR 50 billion at its disposal for the recapital

ESM

SRM . It was also

moral hazard, it could lead to further delays

for EMU

accelerate the cleanup. In t he long run,

economic growth.


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CONCLUSIONS

The SRM and the ESM are the two newEurozone-wide financial organizations thathave the mandate to prevent or rapidlyresolve financial crises li ke the one we have

witnessed over the past years (in contrast,the European Bank for Reconstruction andDevelopment and the European InvestmentBank have the function to foster long-terminvestment in Europe). The ESM and SRM can thus be thought of as a form of fiscal

stabilizer. However, in contrast to how suchstabilizers function within national borders,they do not fulfill their role automatically.

Taxes, be they assessed on income orexpenditures, act to stabilize the businesscycle as taxes charged are reduced whenincomes decline in a downturn, and viceversa. The same goes for fiscal stabilizerson the expenditure side, such as unemploy-ment insurance. Eurozone-wide tax orexpenditure schemes would act to reducethe divergence of business cycles wi thinthe zone as a whole, which would, forexample, arise as a result of country -specific economic disturbances. However,such common schemes would of course

also imply substantial transfers betweenmember states. It seems quite unlikelyfor the foreseeable future that solidarityamong EMU countries will develop suffi-ciently to allow for the introduction ofsuch schemes. This, in turn, implies thatthe ECB will need to continue playing thedominant role in maintaining stability

within the Eurozone. That said, opposit ionto tools such as the so- called Outright

Monetary Transactions program of theECB will likely restrain theECB in itsactions to some extent.

ECB will remain the central anchor of stability

Reform map

P h o t o s : H e l m u t V o g l e r / F o t o l i a

, p e t r a b

. / F o t o l i a

Reformscomplete/ Reforms

Reformsinitiated/under way

in response to crisis

The Eurozone crisis has clearly trig-

gered a series of reform efforts inmany countries. For one, the countriesthat were rescued by the Troika (Euro-pean Union, International MonetaryFund and ECB) had to submit to signif-icant reform programs in the contextof the bailout agreements. In othercountries, notably Italy, market pres-sures and the associated fear of being

subjected to such a formal program

led governments to adopt somereforms. Finally, the slump in theeconomy as well as weak poll resultshave added to reform pressure incountries such as France. In the end,the proof of the pudding as regardsthe reach and effectiveness of re-forms will be economic performance.To assess where countries stand on

reforms, we have devised a reform

heat map It comparesindicators devised by the OECD andthe World Bank which measure theoverall ease of doing business as wellas the restrictiveness of both laborand product market regulation. Addi-tionally, we included a direct and

-tion, i. e. the underlying primary

balance and the retirement age.

What is apparent from the picture isthat none of the peripheral economieshas gone as far with reform effortsand market liberalization as, s ay,Margaret Thatcher did in the UK orEstonia implemented after itspost-2008 crisis.

Ease ofdoing business

regulation

Employmentprotection Minimum wage

ment underlying

primary balances

retirement age

Greece

Ireland

Portugal

Spain

Italy

Estonia

Czech Republic

Hungary

Poland

France

Germany

United Kingdom


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The economic outlook for the Eurozone has clearly improved sincemid-2013 , and we expect the economic recovery to gradually strength-en over the coming years, absent major external shocks. That said,the outlook for both medium- and longer-term growth remains some-

what subdued. Over the medium term, a stil l very weak banking sys-tem is likely to hold back the upturn. With banks still tending to reduceexposure, and regulators pushing them to raise capital, lending tothe all- important small and medium-sized enterprise (SME) sector islikely to pick up quite slowly. Loan growth was still negative at thestart of 2014 in countries such as Italy and Spain This mayin part be due to weak demand, and also a result of capital marketfinance replacing bank loans. At the same time, interest rates chargedon SME loans are declining only very slowly in the periphery. It remainsto be seen to what extent the measures announced by the ECB inMay, in particular the launch of so-calledTLTROs (targeted long-term

How much growth ahead?

refinancing operations, i.e. preferential loans to banks to boost theirlending to private sector companies), will aid the recovery. A moreforceful policy stance by the ECB that pushes down interest ratesalong the entire yield curve may still be needed.

Second, demographics suggest that the outlook for growth israther subdued over the longer term. While projections for population

growth are less dire than in Japan, not least because of still strongimmigration in Europe, demographics will not be a growth driver.Third, as noted, productivity and employment-enhancing reform effortsremain patchy in many Eurozone economies. Finally, high governmentdebt combined with high household debt in some countries (such asSpain) implies that both the government and private citizens will needto maintain high savings rates for a prolonged period of time. Highsavings would, of course, provide an ever greater pool of investablefunds. So, the ultimate question is whether entrepreneurial spiritreturns to Europe in a meaningful way. Clearly, greater stability in themonetary union is a prerequisite for higher investment spending, butit remains to be seen to what extent private investors will pick up the

baton. Given the weakness of both private and especially public sec-tor investment since the start of the crisis, significant and profitableinvestment opportunities would certainly appear to exist. In the fol-lowing sections, our research analysts provide bottom-up insights

EUROPEFROM CRISIS TO OPPORTUNITY

Pronouncing the verdict on the European Stability Mechanism,2014 .

% YoY

40

30

20

10

0

10

2 0

3 0

2006 2007 2008 2009 2010 2011 2012 2013 2014

Germany France Italy Spain Eurozone


P h o

t o :

K a

i P f a f f e n

b a c

h / R e u

t e r s

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