What the future holds for the single currency zone.
The departure of the UK from the EU in due course should make life easier for the Euro. It was becoming a big difficulty that the UK did not want to use EU budgets, laws and agreements to assist and develop the Euro.
There were endless wrangles about whether an issue was one for the Euro area alone, or one for the wider EU with UK participation. The UK did not want to be part of any of the bail-out mechanisms. It only wanted to be part of some elements of common banking regulation, which fell well short of wishing to join in with any common deposit insurance, or bail out schemes for EU banks. The rest of the EU is now almost coterminous with the Euro area and with the grouping of Euro applicants for later years. Only Denmark stands out as a non-Euro member with a right not to join, and Sweden as a non-Euro member refusing to implement its Treaty commitment to be part of the single currency.
To be more of a success the Euro area needs to demonstrate that it can transfer money from rich to poor and from surplus to deficit areas and countries easily. It needs to show it has well regulated major banks, with a common Euro wide system of deposit insurance and potential financial support for the commercial banks. It has made progress with improving bank balance sheets and creating more common standards, but there are still weak banks in the system and still delays in completing a robust system of deposit protection. It is not so long ago that depositors in Cyprus discovered their Euro deposits were not after all guaranteed. The Euro system now includes bail in provisions which mean bondholders and some large depositors are at risk of losing their money if a bank gets into trouble.
The Euro area as a whole is a large economy supporting a big population with good average living standards. It has an overall balance of payments surplus, thanks in particular to the strength of German exports. It has a total government debt of around Euro 10 trillion, a little over 90% of its combined GDP. This is well above its target of 60% of GDP. Last year its deficit was just 2.1% of GDP, well within its self-imposed 3% ceiling.
Averages, however, can conceal large country differentials. These still matter, as the Euro area has not yet accepted joint responsibility for all member state debts. State debt in Greece runs at 177% of GDP, high enough to create periodic borrowing crises. In Italy it is a high 132%, which is just tolerable thanks to very low interest rates for the time being. Portugal at 129%, Cyprus at 109% and Belgium at 106% are also uncomfortably high. 17 members of the EU are above the 60% debt ceiling. Last year Greece borrowed an additional 7.2% of GDP, Spain 5.1% and Portugal 4.4%, with three other countries at or above 3%. Meanwhile the twin surpluses of Germany on current account and its state budget continued, with the balance of payments surplus at the very high level of 8% of GDP, much of it from exports to deficit countries within the EU.
2015 growth rates were subdued overall. France at 1.2% and Germany at 1.7% dominated the average, aided by Spain at 3.2%. Greece suffered a further loss of output, whilst Italy only grew by 0.8%. Government expenditure was 48.6% of GDP across the Euro area as a whole.
There are many member state governments who would now like the zone to relax its deficit and state spending rules.
The Euro area has strengths. Its balance of payments surplus, allied to much of its trading being amongst its members limits its external vulnerability. This has allowed it to pursue an activist money policy with substantial money creation without suffering unduly on the currency. Any moderate devaluation has reinforced the surplus on trade. There are many member state governments who would now like the zone to relax its deficit and state spending rules. This remains unpopular with Germany, who can point to the fact that at almost half the economy state spending is already high by world standards. State debt is so far above the agreed ceiling that no-one seriously suggests lowering the ceiling sufficiently to permit a big expansion of borrowing.
The large unresolved issue, which the UK departure could assist in resolving, is the extent of mutual guarantees and financial support around the zone. So far laws have been made out of hard cases like Greece and Cyprus. The most recent surveys showed a further deterioration in sentiment in August, with both consumer and industrial sentiment in negative territory. The overall Eurozone Sentiment Indicator fell to 103.5 from 104.5. All this suggests there will be further monetary action from the Central Bank. That in turn means more asset price inflation as the Bank buys the bonds. Gradually the EU without the UK will move to more mutual support. Monetary action has been surprisingly creative given German reluctance. In due course there might also be some modest give on the spending side, with France favouring EU led infrastructure projects. After this year’s big sell off of Euro area shares, they look better value.
The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 2nd September 2016.