In his January 2016 Ahead of the Curve, Neil Williams, Group Chief Economist at Hermes Investment Management, explores how the Eurozone is coping with its underlying problem – monetary union without economic union.
With the ECB unable to rely on the US Fed’s gentle tightening path to do the work for it in 2016, expect further forays into the ‘unconventional’, including a step-up in QE and, importantly, even more negative interest rates.
But, while helpful in addressing the symptom, deflation, Mr Draghi cannot alone be expected to solve the underlying problem - a monetary union devoid of economic union. This will take years.
To show the progress so far, we update our Competitiveness Analysis to the end of 2015. As an amorphous bloc, after five years of austerity the zone is regaining competitiveness lost since the euro. Yet, shifts in individual members’ competitiveness within the Eurozone are still too disparate to rule out further pressure (see my chart below).
We use the OECD’s latest estimates to the end of 2015 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 de facto real effective exchange rate appreciation and falling competitiveness. An index fall signifies a relative cut in unit labour costs and, thus, a competitiveness boost. The results are summarised in the chart.
On this basis, Germany is the biggest ‘winner’, and, encouragingly, Spain and Italy’s positions are now improving rapidly. But, France is lagging.
And, after impressive gains, there may be a limit to how far Spain and Italy can reform, given male youth unemployment rates of 48% and 38%. Their real household spending is still 6-10% down on 2008, yet Germany’s is 7% up.
Then there’s Greece, whose deflation improved competitiveness, but exacerbated its real-debt dynamics. Without debt relief, its €86bn package is only a ‘sticking plaster’. After losing 22% of real GDP since 2010, it now has reform fatigue.
A Greece debt restructuring in 2016 thus seems inevitable - though, encouragingly, with 80% of Greece’s liabilities held by the IMF/ECB, the fall-out for private markets should be contained. Either way, the ECB stands ready to act - whatever the US Fed is doing.
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