Real GDP Growth
A November 28th report from the Organisation for Economic Co-operation and Development (OECD), a grouping of 34 of the world’s leading economies, cut the 2012 growth forecasts for its member states to 1.6% from 2.3% six months ago and to 0.2% from 2.0% in the Eurozone. This baseline scenario assumes that monetary policy remains supportive, that the Eurozone sovereign debt crisis is contained and that excessive austerity measures are avoided.
However, the report also highlighted that the principle downside risk for the global economy is a sovereign default in the Eurozone. This would have cross-border effects on creditors, a loss of confidence in sovereign debt markets and could lead to a breakup of the Euro. According to QNB Capital, the Eurozone crisis response falls short of the recommendations of the OECD.
The OECD argued that the recent contagion from the Eurozone crisis threatens a massive escalation in economic disruption if not adequately addressed. The OECD highlighted a number of steps that could be taken in the Eurozone to address the crisis. These steps could lead to a considerably better outcome for the economy than the OECD’s baseline scenario.
The OECD argues that the EU should give a credible commitment to prevent contagion of the crisis with sufficient resources to back the commitment. This would require increasing the resources of the European Financial Stability Fund (EFSF), a temporary bailout fund established in 2010 to help tackle the crisis, and greater direct assistance from the European Central Bank (ECB).
At a meeting the day after the OECD report was released, Eurozone member states agreed to expand the EFSF by two means. The first involves providing a partial guarantee for sovereign debt issues by member states. This would provide a guarantee to investors for 20%-30% of sovereign debt issues. This should encourage investors to buy European sovereign debt, making more use of EFSF funds than if they were used to purchase European bonds directly.
The second method of leveraging the EFSF involves the establishment of a co-investment fund. This would be accomplished with EFSF funds and would aim to attract additional funds from private investors and public investors outside Europe. The fund would purchase sovereign bonds in the primary market, directly from governments as they are issued, and also in the secondary market where bonds are traded. The fund is intended to improve liquidity in sovereign debt markets. Additionally, by purchasing bonds in the primary market the fund would effectively be able to provide funding directly to governments for requirements such as bank recapitalisations.
The EFSF currently has around €400bn at its disposal (€780bn in contributions from member states less the outstanding commitments to the bailouts of Ireland, Portugal and Greece), according to its Chief Executive. Leverage will increase the resources available to a target of €600bn. This is less than the original target of €1,000bn and less than could be needed to meet the refinancing needs of Italy and Spain in 2012 if it becomes too expensive for them to borrow commercially.
Despite these efforts from the EU, they fall short of the OECD’s recommendations because the ECB is unwilling to countenance substantial bond or other asset purchases.
The OECD report also stated that the Eurozone should implement appropriate governance reform to offset moral hazard. This relates to the risk that Eurozone governments will continue to run up larger public debt in the expectation that they will receive external support. Germany has resisted suggestions to increase the resources at the disposal of the ECB as it believes this would remove incentives for countries to cut their debt.
Since the OECD report, the EU has taken important steps towards such reform. The principal agreement to come out of a summit of EU leaders held on December 9th was for a “fiscal compact”, which is intended to prevent EU governments from becoming excessively indebted in the future. All EU member states apart from the UK agreed on the principles for a new treaty, which would enshrine fiscal rules in national constitutions by:
- Introducing a new limit on structural budget deficits of 0.5% of GDP
- Introducing new sanctions on countries exceeding the existing deficit limits of 3% of GDP
- Including a provision to enforce debt reduction in countries with government debt of over 60% of GDP
If the “fiscal compact” can be effectively implemented, it would provide the basis for a long term and sustainable solution to the Eurozone debt crisis, according to QNB Capital. It may also alleviate German concerns that it will be forced to bear some of the debt burdens of other Eurozone countries. This could soften German resistance to increasing the resources at the disposal of the ECB, which, in turn, would help to tackle the shorter-term issues of ensuring that Eurozone sovereigns have sufficient access to debt markets at reasonable rates.
However, the risks remain considerable. The OECD considered a downside scenario in which the Eurozone crisis is not adequately addressed and fiscal consolidation occurs in the US owing to its own debt issues. This would lead to a 2.1% contraction in Eurozone real GDP in 2012 and a 2.3% contraction in 2013. If the proscribed measures are taken an upside scenario is achievable in which the OECD forecasts that Eurozone growth would be 1.3% in 2012 and 3.3% in 2013.