It seems that the “Merkozy smirk” shared by Angela Merkel and Nicolas Sarkozy at a Brussels press conference, when quizzed about Silvio Berlusconi’s ability to cope with the debt crisis, has a lot to say about the future of the eurozone.
Despite the recent three-tier agreement, which the European leaders claim will effectively put an end to Europe’s debt crisis, questions have been raised on whether the EU’s 27 members will be able to stop the sovereign debt from spreading, on one hand, and rescue the European banks from the clutches of bankruptcy, on the other.
Prior to announcing the preliminary deal which Sarkozy described that “it will lift a heavy burden on the world”, global markets were shadowed for months by concerns of the eurozone’s unstable financial situation, and talks of troubled banks and the disappearance of the single euro currency became inevitable.
Following the European Commission of the new agreement, which suggests the re-capitalisation of banks, strengthening of the bail-out fund that has received €440 billion so far, and reduction of Greece’s debts by 50 per cent, analysts feel that the coming days will determine whether the eurozone is resilient to shocks, and whether Europe will distance itself, and the world, from the trap of a new economic recession.
“It is possible,” says Jarmo Kotilaine, Chief Economist at The National Commercial Bank in Jeddah.
“The main risk we now face is political. If the European leaders can boost the resources of the stability fund and engage appropriate support from the European Central Bank, we will probably end up with more 'muddling through’,” Kotilaine adds.
While European politicians were harshly criticised for not doing enough to resolve the current crisis, which has fueled instability and resulted in tremendous problems, some observers believe that the European economy has to inevitably pass a difficult test.
“Even if the European banking sector gets bailed out, the credit growth is likely to stay muted for the next few years,” comments Rohit Chawdhry, Head of Equities & Alternative Investments, Bahrain Islamic Bank.
Europe to witness long period of slow growth
According to Chawdhry, the banking sector recapitalisation usually lead to credit crunch, which will consequently mute the economic growth in Europe, and will likely result in a credit crunch, especially for the private sector, indicating that the “S&L or the Swedish banking or the Malaysian banking crisis in the nineties” was a similar case.
“This is not surprising as most periods following banking recapitalisation, witness hesitation towards fresh lending or even refinancing fearing bad loans. Even more critically, if the private sector credit to GDP ratio starts-off at a very high level, such as the case now, banks usually also witness a period of deleveraging lasting for 5-6 years by hoarding cash,” he added.
Meanwhile, despite efforts to recapitalise European banks and restructure Greece’s debt, Jarmo Kotilaine of The National Commercial Bank believes that Europe will witness “a potentially long period of low growth and market volatility.”
As some people see that the process of reaching a decisive solution by euro zone leaders was slow and complex, it seems that the echo of debt-sinking Greece and news of Italy's third most powerful European economy joining the list of affected countries, had the world worried. At an interview on the sidelines of a forum held in Silicon Valley, US President Barack Obama said that the crisis in the eurozone area is “terrorising the entire world.”
Obama indicated that the reason behind European crisis lies in Europe’s inability to reorganise its banks.
“The Europeans did not fully heal from the 2007 crisis, and did not pay attention to the difficulties faced by their banks,” he said, adding that the actions taken by European governments were not as fast as they were supposed to be.
Meanwhile, Kotilaine believes that the best way to save the euro is to keep the eurozone together.
“This will mean handouts to its weakest members, and a period of very loose monetary policy,” he says, adding that “active intervention by the European Central Bank, buying bonds of the most challenged economies, and swift action on boosting the resources of the European financial stability facility to much more than €1trn” are quite needed at this stage.
Greece faces intense monitoring in future
But Tim Fox, Head of Research and Chief Economist Global Markets and Treasury at Emirates NBD, thinks that money itself will not solve the problem, “unless there are also deep and fundamental structural reforms to the institutions of the eurozone. Without these, the cracks in the architecture of the eurozone will continue to widen. Also there needs to be measures taken to help peripheral eurozone economies regain competitiveness. If these kinds of issues are not addressed then the crisis is likely to continue,” he says.
Apparently, Fox is not alone with this approach. Even the German Chancellor Angela Merkel has revealed to the press following a meeting with the eurozone leaders last Wednesday, that Greece, which its bonds share holders from the private sector approved to write off 50 per cent of their belongings, will be subjected to a more stringent monitoring in the future.
“There will be an enhanced monitoring system with regards to Greece’s compliance with its obligations,” she firmly says, adding that it will be documented in a memorandum of understanding.
In the light of the eurozone’s leaders to protect the euro and maintain their single currency, Saxo Bank's Head of Financial Strategy, John H. Hardy, tells Alrroya Aleqtissadiya that all of the solutions rely on the market’s confidence and the hope that officialdom has gone far enough in back-stopping sovereign debt to a sufficient degree far more than the actual deployment of funds.
“Yes, we could see confidence for a time because yes, there may be enough funding for the centre to hold – but the third question is the real challenger down the line. If the confidence fails because more money is needed or more money is needed because confidence fails, the political will for another round of bailouts is unlikely to be there,” he added.
But as EU leaders announce their agreement, boosted by expectations of the International Monetary Fund that Greece is likely to return to the bond market by 2021, foreign exchange markets welcomed Wednesday’s developments, which reflected positively on the performance of the euro against other currencies.
Gaurav Kashyap, Head of DGCX Desk, Aplari ME DMCC, commented: "Initially, at this point, the deal is being well received by markets; the Euro is appreciating and high yielding currencies such as the Aussie are increasing on improved risk appetite following the announcement.”
He added: “The short term prospects for the Euro will be good, and the expansion of the fund to €1trn should see any financial disasters avoided for the next year or so, but the latest EFSF's expansion plans will see it following short in the long term. In the days ahead, we will follow the story of China's involvement, if any, in the EFSF fund and Italy's plans to deliver their budget and deficit reduction plans. We favour more upside moves in the EUR-USD towards the channel between 1.41 and 1.43.”
UK economy not immune to shocks
In its UK Monthly Macro report, Nomura said that the trend for UK equities to outperform the euro area remained firmly in place, as the market added another 1.2pp to the record, which now stands at 12.4 per cent.
“Like much of the rest of the world, the UK’s economy has been resilient in comparison to the euro area,” says Philip Rush, UK Economist at Nomura.
“This is evident in equity markets, where the UK market has outperformed its euro area counterpart by 12.4 per cent in common currency terms over the past four months. But with 40 per cent of UK exports destined for the euro area, it cannot be immune to the continent’s woes and that is why policymakers are compelled to push for a solution to the sovereign debt crisis,” he added.
But to what extent will the euro-crisis curb the growth of the UK economy? And how immune is the UK banking system to neighbouring turmoil?
“The UK economy is a geographical island, not an economic one,” Rush replies.
If the euro area were to plunge back into recession, there would be little that UK policymakers could do to avoid the same fate. Strong ties between their financial sectors also pose risks, even if they are mainly indirect. For example, UK banks have negligible direct exposure to Greece but have strong relationships with the French and German banks, which helps keep the fates of EU members entwined,” he concluded.
Although not a member of the single currency zone, the United Kingdom has insisted that stabilising the eurozone is essential to help the British economy and it must have a voice in decisions over the future direction of Europe.
The British finance minister George Osborne has indicated in his speech at the annual conference of the Conservative Party in Manchester, that the UK government is working on projects in Britain, by maintaining the interest rate in banks at 0.5 per cent, unchanged, adding that the decision to stop the annual increase in real estate tax for a year will cost the British government £805m.
The UK praised last Thursday the agreement reached to resolve the sovereign debt crisis. Following the agreement on Thursday, the banking sector shares in the London Stock Exchange rose between 6 and 10 per cent.
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