A European summer vacation

At the least until the latest news about the Catalonian bail-out request in Spain, it looked like the European crisis had taken something of a summer vacation.
Even the bond yields of the most challenged peripheral euro zone nations had come down a tad and Italy managed to conduct a Treasury auction on more favorable terms than expected.
Most of the credit for this relative stability will have to go to the European Central Bank (ECB) which, while not doing much by way of concrete policy steps, has suggested that it will take necessary measures to ensure market calm.
The ECB at this point can in fairness point to a track record of somewhat effective measures, most notably interest rate cuts and some EUR1trn worth of three-year loans to shore up the European banking system.
There seems to be a sense of similar optimism even more globally as lackluster, but not disastrous, economic data has led more and more people to expect more central bank action along the lines of quantitative easing.
The ECB has historically been hamstrung by its limited mandate but expectations are growing that it would engage in selective sovereign bond purchases in order to alleviate pressures in the most challenged member states.
While not quite quantitative easing, this would counteract recurrent bouts of speculation by reducing market stress at critical times.
However, such purchases are supposed to be strictly conditional on the beneficiary countries abiding by the rules set by the euro zone bail-out mechanisms.
The bank has to date bought EUR210bn of peripheral government bonds under its Securities Market Program.
How likely is the good news to continue? Not very as a number of factors now point to something that could well prove a rude awakening after the holiday seasons.
Greece is struggling to meet its savings targets and the next review by the Troika is due in September when the new government is hoping to renegotiate the latest support package.
Portugal’s economic performance has disappointed and negotiations for new support may have to commence in September.
Such steps have in the past significantly increased market tensions.
Both Italy and Spain will have to auction long-dated bonds in September.
Spain has already turned to Europe for assistance and even an Italian bailout is recognized as increasingly inevitable, even by the government’s own admission.
Due to this, much energy is likely to be expended in the coming weeks on delaying it.
To potentially add to the drama, the German Constitutional Court is due to vote on the legality of the ESM on 12 September and anything beyond the generally expected positive verdict could prove highly disruptive.
Quite beyond the near-term challenges, both cyclical economic and political trends seem to be turning against the Euro-zone, not to mention potential new challenges by credit rating agencies.
Moreover, bank lending has contracted as banks can make more money by the interest rate differential between ECB loans and investments in peripheral government bonds.
This in turn pushes up the interest rates facing borrowers.
But the downward pressures are above all due to the fact that, having resisted the calls to contain the boom, policy makers are now forced to deepen the recession by imposing new taxes.
By so doing, they will inevitably discourage consumption, home purchases, and job creation.
At the same time, the ECB has called on countries to reduce wage indexation, job protection, and minimum wages. While such steps would be good for efficiency, they are not only politically toxic bad likely to further deepen the cyclical downturn in the near term.
The euro zone is already clearly relapsing into recession.
The European Commission expects the economy as a whole to contract by 0.3 percent this year.
Euro zone GDP declined by 0.2 percent QoQ in Q2, which corresponds to 0.4 percent YoY.
However, in something of a positive surprise, German GDP expanded by 0.3 percent in Q2 while French GDP was unchanged. Nonetheless, especially in France, austerity is likely to darken the economic outlook going forward.
Although the country has seen a major improvement in its borrowing costs this year, its public debt burden is now on course to reach 100 percent of GDP.
Beyond economic, political uncertainties are mounting with growing indications of a widening chasm between Europe’s challenged periphery and the relatively more stable core.
While the South resents austerity, the North is turning against costly bail-outs. This is manifesting itself in growing anti-incumbent tendencies in elections and even a more general turn against the political mainstream.
The Greek drama of inconclusive elections and fragile coalitions could well play out in other European countries.
Italy is most obviously lined up for a transition next as the technocratic government of Mario Monti is due to relinquish power to elected politicians.
The support for more austerity is understandably dwindling as, after a year in recession following a sharp GDP decline already in 2008-9, Italian GDP could fall back to the level last seen in 2000 by the end of this year.
The government is trying to achieve a cumulative fiscal consolidation of 5.2 percent of GDP between 2011 and 2014.
This is particularly challenging as Italian growth has relied heavily on government spending in the face of an uncompetitive open sector.
Adding to market anxiety are the suggestions that Italy might have a higher chance of benefiting from a euro zone exit than either Greece or Spain.
These fundamentals suggest that, although the global economic crisis just turned five, it is unlikely to go away any time soon.
The unusually high number of uncertainties means that a wide range of options between continued muddling through and renewed crisis-bail-out sequences is possible as September rolls around.
But, more central bank action, or not, the global growth outlook will remain lackluster at best.
For the GCC, this will likely mean a continued heavy reliance on domestic growth drivers and a growing attention to Asia.
— Jarmo T. Kotilaine, chief economist, National Commercial Bank, Jeddah, Saudi Arabia.