Alberto Gallo – Head of European Macro Credit Research at RBS
Europe’s economy is enjoying its first meaningful recovery since 2008; but it is a slow, stuttering comeback. To secure and accelerate the turnaround, policymakers should focus on how to increase lending to the real economy, filling the funding gap left by the continent’s shrinking banks.
The signs of recovery are broad-based: better growth data, a revived housing market, improving business sentiment and rising exports. Most countries are running a primary surplus and the threat of imminent downgrade no longer hangs over sovereign debt. Further afield, a gathering US recovery is underpinning European export demand and fuelling the purchase of European assets like Vodafone’s US$130bn stake in Verizon and Microsoft’s purchase of Nokia’s mobile division.
The recovery should ease debt pressures, giving governments more time to introduce reforms and lessen austerity. We calculate that debt-to-GDP ratios could fall an extra 5% or 6% in the next four years, if the pickup delivers an additional quarter point of growth, a quarter point more inflation and a half point cut in public deficits per year.
Only a mix of support from the private and public sector can reverse the negative loop of capital flight, higher lending rates, bankruptcies and an increasing sovereign-bank nexus.
The lack of credit to European businesses, however, remains a drag on the recovery. The worst of Europe’s credit crunch may be behind us, but eurozone banks remain deep in the de-leveraging process. They have cut €3trn of assets and 270 billion of loans to non-financial companies since last May, and we think there’s more ahead. These loans will need to be replaced if the recovery is to continue.
Worse still, it is lenders from struggling peripheral Europe who are cutting the most. While bigger European banks are replenishing their capital and liquidity and returning to profitability, mid-tier periphery banks in Spain and Italy remain undercapitalised, exposed to sovereign risk and face rising bad loans. They can’t sell assets at depressed prices, as this would reduce their capital ratios. But at the same time they can’t easily raise capital, as investors remain concerned about their bad assets. It’s a Catch-22 situation.
Negative loop
There is no silver bullet, no one plan that can fill the near-€300bn gap in non-financial lending. Non-bank sources of finance, like bonds and securitisations, are filling some of the funding gap, but the scale of adjustment is huge given Europe’s traditional reliance on banks – 90% of the credit supply compared to 45% in the US. Only a mix of support from the private and public sector can reverse the negative loop of capital flight, higher lending rates, bankruptcies and an increasing sovereign-bank nexus.
A lot still has to go right to secure the recovery, but so far investors are right to buy into the turnaround story.
The ECB’s liquidity operations and last year’s bond-buying pledge have steadied the ship by reducing the sovereign risk hanging over banks in the periphery, while the eurozone’s new bank bail-in regime reduces states’ exposure to the fallout from potential bad banks.
Pro-active policies are now needed to restart lending. The ECB programme of bank stress tests next year promises to improve transparency across banks and potentially to encourage bidders for bank assets. That should start to plug the capital hole that is holding back business lending.
But before banks fix themselves with the ECB’s help, greater public support is needed to help finance business. The European Investment Bank needs to do more to boost lending to SMEs. It lends around €45bn of new money each year, which will go to €60bn next year, but has announced new plans last June for another €55-100bn programme.
This could partially offset the impact of deleveraging. However, public intervention from the EIB hinges on fiscal coordination, and eventually on core European countries. After the September elections, we think the Merkel win could herald a slightly friendlier German stance to the periphery. But the risk of complacency and lack of reforms in Italy, Spain and France remains high.
A lot still has to go right to secure the recovery, but so far investors are right to buy into the turnaround story.
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Alberto Gallo runs the research team leading idea generation across European credit markets at RBS. He writes The Revolver, which combines macro and micro analysis to cover sovereigns, banks and corporates.
