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Euro-zone – time for Plan B...

The ECB’s decision prior to Christmas to extend QE for another nine months to December 2017, though ‘taper’ it from this April, does not herald an early tightening of economic policy, according to Group Chief Economist Neil Williams in his January Ahead of the Curve. Quite the opposite in fact, with the key deposit rate likely to stay negative in 2017, and the fiscal side activated.

2017’s extra QE easily surpasses the combined GDPs of Greece & Portugal...
Tapering means more QE. By tapering its monthly asset purchases from €80bn to €60bn, it’s still looking to inject an extra €540bn in QE. This easily surpasses the combined GDPs of Greece and Portugal. Central banks can now buy bonds that yield lower than the -0.4% deposit rate.

However, the nuance, is Mr Draghi’s growing encouragement of governments to take the baton back from the ECB. A lesson from Japan is that QE provides cash to lend, but cannot force consumers and firms to borrow. The euro-zone thus looks halfway down the Japan route. It too may be running unconventionally loose monetary policy (QE and negative rates) to get its currency down, but has yet to let go of the fiscal reins.

While helpful in addressing the symptom, deflation, the ECB cannot be expected to solve the underlying problem, a monetary union devoid of economic union. This will take years.

With this in mind, we update our Competitiveness Analysis to show the progress so far. We use the OECD’s estimates to the end of 2016 of a country’s unit labour costs in tradeable goods, relative to its main trading partners’ (RULC). The average is weighted, then indexed to a 2010 base year. A rising index indicates a de facto real effective exchange rate appreciation and falling competitiveness. An index fall signifies the opposite.

First, as an amorphous bloc, the euro-zone is after six years of austerity, regaining competitiveness lost since the euro. Only part of this can be laid at the weaker euro’s door. The zone’s costs between 2000 and 2009 rose 21%, relative to its trading partners. This compared with falls of 19% in the US and UK. Yet, since austerity started in 2010, its costs have fallen 7%. This beats a currency-induced rise of 20% in the US and the UK’s 3% fall.

The euro-zone’s competitiveness gap is narrowing, but will take years to close...
However, despite this overall improvement, shifts in individual members’ competitiveness are still too disparate. Chart 1 shows the absolute competitiveness-shifts by country from 2000 to 2016. With the escape route of currency devaluation closed off, the deciding factor has been whether members undertake the internal, cost adjustment needed to boost competitiveness, thereby generating GDP and tax revenue.

On this basis, the biggest winners still include Germany, which is helpful given it accounts for about 30% of euro-zone GDP. By contrast, most other members have experienced a deterioration. Because of its adjustment, Germany has managed to cut its RULC by 9%. But, countries on the right-hand side of Chart 1 saw theirs climb. Up to 2010, Spain and Italy’s competitiveness deteriorated fastest.

But, Spain and Italy’s deterioration is now correcting, and their shortfall versus Germany reducing. This is shown by the reducing cluster in Chart 1. We highlight the 2000-2010 period by the grey blobs, to highlight progress since austerity. The estimates to 2016 in green thus suggest improvement. Outside the zone, the UK since 2000 has managed to outperform by virtue of sterling’s 23% depreciation - a route cut off to euro-zone members.

Yet, boosting competitiveness via austerity poses its own risks. The difficulty is raising competitiveness via productivity, rather than higher unemployment, falling wages and/or slashing taxes that governments can’t afford. And, after impressive gains, there’s a limit to how far Spain and Italy can reform, given male youth unemployment rates of 44% and 36%. Then there’s Greece. Without debt relief, its €86bn package is only a ‘sticking plaster’. After losing 30% of real GDP since 2010, it too has reform fatigue.

Therefore, tackling the cause of the problem always needed more than just QE. And, despite an improving periphery, it will take years before the converging countries can reclaim their GDP lost - with Italy and Greece’s real GDP, on a net basis, still yet to rise with the euro.

Meanwhile, with 2017 being such a highly-charged political year in Europe, any contagion, unlike 2008, is more likely to be political rather than financial. And, with the monetary engine already overloaded, it looks time to also crank up the fiscal side.

Chart 1: The underlying problem – competitiveness within the euro-zone is still too disparate
Changes from 2000 to 2016 in a country’s relative until labour costs (RULC), vs current account shift as a % of GDP. Grey arrows denote shift since austerity started in 2010

ac-chart-jan-17

Source: Hermes Investment Management, based on OECD data. (*NB: Greece is from 2001 when it joined the euro)

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