The state of Europe after the Eurozone crisis - a round up of developments

The longest recession in 40 years in Europe appears to have stabilised, but the search for recovery continues. Greece is taking delivery of a third bailout from the Eurozone, albeit tiny in comparison to previous loans. However, exports, consumer spending and corporate investment are still low, hinting that a recovery is still some way off. 

In the banking sector, Basel III minimum leverage ratios are being welcomed, having been recognised as a buffer against future crises. In the US, for example, minimum leverage requirements well in excess of 3% have been proposed, hinting that the Basel requirements are still seen as inadequate. It does also hint that the implementation of a globally comparable leverage ratio - as set out in Basel III - is unlikely to be met with uniform regulations around the world. 

In the EU, an agreement reached between the Member States on June 27th 2013 on a proposed directive states that in future financial crises, bank and financial institution bail-ins will be the default position, preserving depositors' money and sparing the taxpayer. Bail-outs are not ruled out, however, as the agreement gives national governments substantial flexibility to determine how best to resolve a situation. As such, governments can still determine that a taxpayer-funded bail-out is the best solution, and considering that the agreement on bail-ins is not likely to come in to force until 2018, there is still plenty of time for taxpayers to be left firmly on the hook.  Moreover, S&P considers that EU member governments with sufficient financial capacity will continue to support major creditors of systemically important banks, at least until balance sheets recover, and banks are made more resolvable through structural reforms. 

While mortgage agreements and real estate sales are increasing again in the US, the same is beginning to take place in the UK. US new home sales were up 7.9% in August, and were up 13% on the year. (Source: Census Bureau, from S&P Ratings Direct). Lower interest rates in the UK have been partly responsible for the increase in lending, along with the Bank of England "Funding for Lending" scheme which aims to target lending to the real economy, in particular SMEs. Moreover, the govenrment-backed mortgage scheme, has also aimed to boost lending to those who could otherwise not afford to get on the housing ladder, although this has been met with accusations that it will only fuel, rather than address, the housing bubble.

This all sounds remarkably positive, given the travails of the past few years. However a recent report by S&P on the state of the Eurozone is less optimistic. The report concludes that slowdowns in emerging markets, and an economic rebalancing in China, may "start to reduce the credit support provided by global diversification in recent years". The mantra that a diversified economy will weather economic storms better may prove little use should China - along with other developing economies - slow down their consumption, leaving demand stagnant throughout the global economy.

China's growth has slowed noticeably and perhaps more significantly, expectations for China's growth have also fallen. The consensus is that forecasts have fallen by one percentage point over the last year to 7.5%, however this continues to decline. This compares to a GDP of over 9% in 2010-2011, and although the Chinese leadership seems comfortable with current figures, their focus will be on balancing internal demand and consumption with international trade. 

A Eurozone slump, along with negative US fiscal policy developments, slower growth in China or a disorderly reduction in quantitative easing are currently the top risks for global credit conditions. This has had implications for European sovereign creditworthiness, along with corporate credit ratings above the sovereign. Corporate trends in Europe are still mainly negative. Fifty-six percent of S&P rating actions in the second quarter of 2013 were ratings downgrades, while over two-thirds of industry sectors carry "stable-to-negative" or "negative" outlooks. Moreover, S&P expects the Eurozone to remain in recession for the rest of 2013 and has downgraded its real GDP forecast from minus 0.5% to minus 0.8% for this quarter. The ratings agency expects a weak recovery in 2014 with a GDP of 0.8%, but expects that potential growth will remain impaired long in to the future. Furthermore, according to S&P, there is still a one in three possibility that the Eurozone could experience a sharper and deeper recession in the remainder of 2013 that could last into 2014, seeing the recovery pushed back even further into the future. Owing to the structural nature and depth of the Eurozone crisis, the agency estimates that it is unlikely for a recovery to occur earlier, or for GDP figures to improve substantially in the short to mid term. 

A recent report by Moody's affirms the provisional AA1 rating of the European Financial Stability Fund (EFSF) based on the contractual elements, including the "irrevocable and unconditional" guarantees by the Eurozone member states, as well as their creditworthiness and commitments to the EFSF. The strong political commitment of Eurozone member states to the Fund is also important, as Moody's assesses that any default would entail "significant pecuniary and political costs" for Europe. However, the rating is subject to a negative outlook, reflecting the negative outlooks on euro area sovereigns that are guarantors to the Fund. The three largest shareholders in the fund, Germany, the Netherlands and France, all have negative outlooks, with Finland being the only eurozone country with a stable outlook currently. 

It's Finally Happened - Moody's Downgrades the UK

Moody's finally confirmed market rumours this evening and downgraded the UK's government bond rating from AAA to AA1. It cited several factors, including the sluggish growth outlook for medium-long term, anticipating that weak growth will last into the second half of the decade, posing challenges for the government's fiscal consolidation programme. The consequences of this include the government's "high and rising debt burden" which reduces the capacity for shock absorption on the government's balance sheets. Importantly, because of the extended time frame of the fiscal consolidation plans, taking them into the next parliament, the level of risk involved has increased. Now, instead of peaking in 2014, Moody's expects the UK's gross general debt to GDP to peak in 2016 at 96 per cent, which is up from just over 90 per cent now.

Despite these problems, Moody's stresses that the UK still retains high creditworthiness, due to its competitive, well-diversified economy, previous and future fiscal consolidation and robust institutional structure. It's favourable debt structures, bond maturity lengths, and the resulting reduced interest rate risk on UK debt are all additional factors in the UK's favour. Moody's seems to believe that the government's fiscal consolidation plan will, in time, be fulfilled, given the UK's underlying economic strengths. The ratings agency does mention that the UK's exposure to the Eurozone is an issue that may become more urgent depending on how the crisis in that area progresses, however the contagion is stated to be mitigated by the UK's independent monetary policy and the status of sterling as a global reserve currency.

Moody's had changed the outlook from stable to negative in February 2012, however today's downgrade shifts the outlook back to stable. Speaking this evening in response to the downgrade, UK Chancellor of the Exchequer George Osborne took the news as a "stark reminder" of the troubles being faced by Britain, and vowed to "redouble" his efforts to reduce the deficit and maintain historically low interest rates for families. Interestingly, the downgrade comes less than a month ahead of the Chancellor's budget on March 20th in which he will outline fiscal policy for the coming months. 

But will the downgrade actually make any real difference? 

The short answer to this is, well, economically no, but politically, maybe. For a start, bond markets are usually a couple of months ahead of ratings agencies when it comes to anticipating difficulties and slow growth prospects, and sterling has fallen significantly against the dollar over the past few months. This has the advantage of making exports cheaper, helping the UK economy, but it tends to signal that all is not well for economic outlooks (regardless of rumours of currency wars). More to the point, rumours have been circulating for some weeks - some even publicly - that the UK is on the verge of a downgrade. The announcement tonight by Moody's should not have surprised anyone. Will bond yields increase dramatically when the markets open on Monday morning? Unlikely. And considering the role call of countries who have been downgraded over the past few years, the UK is simply the latest to join the list.

But the political issue is slightly trickier. Like other political leaders across the western world, Osborne staked a good deal of political capital on maintaining the AAA rating. I recently posted about the French reaction to their downgrade from AAA. But it's loss in the UK may prove to be a double-edged sword. While it may force reappraisal of fiscal policy, it might also give the Chancellor some room to breathe and reassess his options.

Undoubtedly it marks a recognition by a CRA that the deficit reduction plan is not working as successfully as planned, and that plans for growth haven't produced the desired results. Fiscal policy to get Britain moving after the recession focused around shifting from domestic consumption to an export-oriented base. But as nearly 40 per cent of UK exports are destined for Europe, the ongoing recessions there are less than encouraging. You simply cannot build growth by exporting to contracting economies. The good news is that the markets still appear to have faith in the political and economic ambitions of the UK government. Bond yields remain persistently low, despite some warning of a collapse in the bond markets as seen by Greece. The economic reputation of the UK remains intact, but questions are likely to be asked over the coming days about the political will to stick to austerity, especially given the backlash against pure austerity in other parts of the world, notably Japan and France. It will be interesting to see, therefore, if the Chancellor's "plan A" will be "tweaked" slightly to take account of the latest developments, and shift slightly away from austerity towards growth.

Moody's revises UK and French ratings to "Negative Outlook"

UK sovereign bonds have today been given a "negative outlook" by rating agency Moody's, along with those of France and Austria. All three countries are still rated AAA by Moody's, even though France had lost the triple A rating assigned by Standard & Poor's in January 2012.

Spain was downgraded to A3 from A1 with a negative outlook, Italy was downgraded to A3 from A2 with a negative outlook and Portugal was downgraded to Ba3 from Ba2 with a negative outlook, according to Moody's criteria. The agnecy also cut Slovakia’s, Slovenia’s and Malta’s ratings.

It should be noted that "negative outlook" is not quite as drastic as "negative watch", implying only a one in three chance of losing the top rating over the next 12 to 18 months.