IMF sees a mixed outlook for Europe - calls for more ECB action and a fiscal union

The IMF today released its latest World Economic Outlook forecasts. As usual the forecasts are not overly different from the previous ones - published in October last year - but there are a few interesting points.

The map above gives a pretty good feeling for just how bad Europe is doing relative to the rest of the world at the moment (click to enlarge).

The IMF warns about the risks of complacency and lack of  implementation of reform and austerity measures in the eurozone, something we touched on here:

Amid reduced market pressure and very high unemployment, the near-term risks of incomplete policy implementation at both the national and European levels are significant, while events in Cyprus could lead to more sustained financial market fragmentation. Incomplete implementation could result in a reversal of financial market sentiment. A more medium term risk is a scenario of prolonged stagnation in the euro area.

This seems to be clear reference to the banking union and the creation of a cross-border resolution mechanism to deal with banking crisis such as the one seen in Cyprus. This is a valid concern - there is huge uncertainty over the banking union.

The IMF also notes that while current account adjustment has been progressing in the eurozone it is not clear whether it is simply cyclical or the result of deeper reform:

Current account balances of adjusting economies have improved significantly, and this improvement is expected to continue this year. This increasingly reflects structural improvements, including falling unit labour costs, rising productivity, and trade gains outside the euro area. But cyclical factors also play a role, notably layoffs of less productive workers, and would reverse with eventual economic recovery.

Further to that point, there is also the interesting table below showing that Greece, Ireland and Spain have had some success in reducing unit labour costs (change is difference between the dot and the diamond). Greece mainly through cutting labour costs but the others also through increasing productivity. But there is some way to go yet, while countries such as France and Italy have made little to no adjustment. It's also worth keeping in mind that, while Portuguese ULCs have fallen from their peak, the trend and some of the fall has now been reveresed.

In addition, there are continued signs of a split in policy approach between Germany and the IMF. Comments such as these are unlikely to go down well in Germany:

Room is still available for further conventional easing, as inflation is projected to fall below the European Central Bank’s target in the medium term.

Greater fiscal integration is needed to help address gaps in Economic and Monetary Union design and mitigate the transmission of country-level shocks across the euro area. Building political support will take time, but the priority should be to ensure a common fiscal backstop for the banking union.

We'd have thought, after three years of being exposed to the politics of the troika, the IMF might be a bit more sensitive to the political intracacies of the eurozone crisis. However, it does highlight that the fundamental choice facing the eurozone has not gone anywhere..

A successful ECB adjustment? Not exactly...

A very technical post, so we apologise in advance, but there is an interesting debate going on regarding the ECB’s decision to cut its deposit rate to 0%.

The move essentially means that banks will no longer receive any return (previously 0.25%) for depositing money (usually excess cash) in the ECB overnight. The hope is that banks will instead lend this money out on the interbank market or use the money to purchase new assets, as they did before the financial and eurozone crises, thereby eventually boosting the level of lending to the real economy.

The past few weeks have seen a debate over what the impact of this move would be. Last night was the first night that the new rate came into effect and, as expected, the level of deposits at the ECB fell significantly – by €483bn. However, the far more important is figuring out where the money went.

As the graph below shows, the money did not in fact make its way to the interbank market or into many new assets, but simply stayed at the ECB but under another heading, ‘current account holdings’.

'Current account holdings' refer to the main financial accounts through which banks conduct their dealings with the ECB. If they wish to access the deposit facility, funds must be transferred from the current account to this facility. Usually this is beneficial as it results in a slightly higher interest rate. However, now both accounts deliver no return.

So clearly, this money has merely been passed from one ECB account to another. That is not to say that it will not leave the ECB and that the deposit rate change will have no impact, but simply that it is yet to happen. After all this is only the first night where the new rate is in effect. That said, we are sceptical of how much impact the new lower deposit rate can actually boost lending, rather than simply boosting demand for already scarce assets (e.g. German short term debt), but we will discuss this in more detail in further posts.