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..

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

The OECD, bearer of bad news at Christmas?

A quick post on a topic which we have already explored in our internal devaluation paper and plan to look at in more detail in the New Year: competitiveness in the eurozone.

The OECD released it latest assessment of unit labour costs (ULCs) in the eurozone a couple of days ago and they do not make pretty reading for Italy or France and only slightly better for Spain:

(The graph shows ULCs indexed to 100 in year 2000. Greece= light red, Spain= green, Germany= dark red, Italy= blue  and France = turquoise).

ULCs are often taken as a measure of a country’s competitiveness, it is by no means the only measure but it is a useful indicator of the situation. As the graph above shows Italy will have higher ULCs than Spain, Greece and, obviously, Germany at the end of this year. This trend will only get worse and France could well find itself in a similar position in 2013/14 if things continue on their current path.

This highlights a point which we have made previously – for all his good work on the fiscal side, Italian Prime Minister Mario Monti has failed to provide sufficient reform of the labour market or boost productivity and improve the business climate (other areas which would also help improve the country’s competitiveness). Elections in Italy in early 2013 mean there will be little opportunity for reform in the first quarter of the year. That may be irrelevant depending on the format of the new government – there is no guarantee of a stable pro-reform coalition in Italy.

The results are similarly worrying for France which can ill afford to fall behind other eurozone states, not least because many of these countries are also improving their budget and current account deficits, while making significant product market reforms and deregulating – all of which the French government has shown little willingness to do.

As for Spain and Greece the reading is a bit more positive with their adjustments clearly having some impact – although as the OECD notes much of this has come from cuts to employment and falling domestic demand rather than successful reform. It is also clear that there is some way to go before they reach the levels of Germany (or get firmly within the bounds of acceptable differences, as we have pointed out before). With unemployment already sky-high in both places this remaining adjustment is likely to be painful.

Plenty for eurozone governments to ponder over the festive period then.