As Euro area policymakers continue to ‘muddle through’ the crisis, everyone's favorite FX Strategist - Goldman's Thomas Stolper, summarizes the decline in the EUR so far as due to slower growth and easier monetary policy, together with growing EUR short positions. Whether the latter have resulted from the desire to hedge or were motivated by speculation is not easy to distinguish, and of secondary importance. Of course, the root cause of both developments is the political crisis in the Euro area. The uncertainty about the stability of the institutional framework of the Euro area forces front-loaded fiscal tightening, which in turn damages growth. In response, the ECB eased policy more than expected, while the Fed, for example, did not ease as much and or as early as many projected. Despite today's ecstacy in EURUSD, Stolper believes the EUR is unlikely to strengthen materially as long as this situation persists especially as the potential for the ‘fiscal risk premium’ to rise on the back of daily headlines that are dominated by disagreement and dispute remains. In an effort to clarify his thinking, Stolper identifies eight key issues that will determine the outlook for the Euro. Most of them relate to the Euro area crisis. The most interesting ones are possibly the timing of a recovery in the periphery, the ability of France and Germany to develop a common vision for further integration, and the evolution of fiscal policies in major economies outside the Euro area. He concludes that the risks in the near term remain substantial.
Thomas Stolper, Goldman Sachs: Key Issues that Will Determine the Fate of the Euro
This section tries to lay out what we think will decide whether the EUR will continue to depreciate or rebound. Many points relate to the Euro area crisis and take into account the views of our European team, although we typically add some relative perspective, given that exchange rates are always defined in relation to another currency or a basket of currencies.
Issue 1: Spanish Bank Bailout
The lack of transparency in the Spanish banking sector has been a concern for investors since the beginning of the crisis, which has increasingly undermined the credibility of the Spanish debt sustainability. Although Spanish debt levels are relatively low on an international comparison, tight credit conditions, slow growth and still large deficits undermine investor confidence in Spanish government bonds. Breaking the feedback loop via an EFSF/ESM-funded bank bailout is key. Lifting Spanish banking supervision and regulation to the federal Euro area level would be another confidence-building step. The optimal outcome, in our view, would be if credit conditions in Spain ease and the Spanish government retains full access to capital markets at debt-stabilising funding rates. The EUR22bn bond redemption in October will be critical to watch in that respect. In the next three months or so, we will have more clarity on this issue.
Issue 2: Stabilising Growth in Greece and Italy
Greece—even after the PSI—and Italy remain the two Euro area countries with worryingly high public debt levels. On the positive side, both countries run cyclically adjusted primary surpluses, which suggests they are on a consolidation track. But debt sustainability calculations critically depend on the long-term growth outlook. When judged by the experience of IMF programs in history, the likelihood of faster trend growth after a batch of painful structural reforms is high. But the evidence needs to be seen. The moment Greece and Italy start to grow again will therefore be an important milestone. In Italy we expect this to happen by Q1 next year. Although we do not forecast Greek GDP, we think it would be reasonable to assume a similar outcome there as well. The IMF projects small positive growth for the Greece in 2013 as a whole. Almost as important as the actual growth performance will be the market response. Bond yields will ultimately only come down on a more sustained basis if market participants start to believe that debt sustainability has indeed improved.
Issue 3: Euro area Banking Union
It is now clear that national bank regulators in the Euro area have been insufficiently independent and objective, as Chancellor Merkel admitted in the German Bundestag. The consecutive stress tests conducted by national regulators did not signal the extent of Spanish banking sector recapitalisation that has now become necessary. That said, the German Landesbanks have been an ongoing concern since the Global Financial Crisis (GFC) exposed the asset quality of their balance sheets. A strong independent regulator at federal Euro area levels is therefore a critical tool to build confidence in the quality of bank and government balance sheets. The ability to wind a bank up or to recapitalise banks directly via the ESM and under the supervision of the new regulator are additional key features. A federal Euro area deposit insurance scheme would have to follow at some later stage, although this is not essential currently because for now the ECB effectively provides unlimited funding for the Euro area banking sector. Following the latest Euro area summit and Eurogroup meeting, the Banking Union may become a reality in the first half of next year, but negotiations are ongoing and some countries have voiced new concerns.
Issue 4: Franco-German Vision for a Political/Fiscal Union
In the history of the European Union, starting with the Robert Schuman declaration in May 1950, almost all major initiatives towards deeper integration have been driven by joint Franco-German sponsorship. Important institutional elements for deeper integration are still lacking, including a Euro area parliament. Former ECB President Jean-Claude Trichet recently also proposed a selective loss of fiscal sovereignty for individual Euro area countries in the event their actions (or lack of actions) affect citizens in all other member countries. In these cases, a Sparkommissar (or fiscal commissioner), democratically appointed by all Euro area citizens, should be able to run fiscal policy temporarily. This is only one of many proposals currently floating around Euro area policy circles. What is notable, however, is that there is no well-defined and shared Franco-German position on further fiscal and political integration currently. The fact that the Hollande administration in France has only just come to power may be a factor. It would therefore be wrong to dismiss the possibility that such a shared vision could materialise at some stage. But admittedly the time frame remains highly uncertain.
Issue 5: Continued Strong BBoP Position
Moving away from the Euro area crisis towards more economic factors affecting the currency market, one of the strongest support factors for the Euro has been its solid external position. Despite the steady deepening of the Euro area crises and plenty of evidence of capital flight WITHIN the area, there has been no evidence of widespread capital flight out of the Euro area so far. There have been inflows into Switzerland, Denmark and other currencies with historically low FX volatility to the Euro, but relative to the size of the Euro area these flows have been rounding errors. Our preferred measure of commercial net demand for a currency, the BBoP (=current account + FDI + portfolio flows) remains in marginal surplus on a 12-month trend basis, while the latest April number showed a surplus of EUR7.8bn in seasonally adjusted terms. We think of the BBoP position as the primary support factor that has prevented much faster depreciation so far. That said, the intensification of capital flight out of the Euro area and BBoP deterioration put more downward pressure on the Euro. We do not think this is the most likely scenario, however, as long as capital flows into the core Euro area remain unconstrained to provide a safe haven for risk-averse investors.
Issue 6: More Fiscal Tightening Outside the Euro area
In terms of fiscal consolidation after the GFC, the Euro area is far ahead of most other regions and nations. The latest Fiscal Monitor suggested that the Euro area is the only major region that is already running a cyclically adjusted primary surplus (0.7% of GDP). This in turn means that additional fiscal tightening in the Euro area in aggregate is likely to remain quite limited. On the other hand, cyclically adjusted primary balances will have to shrink substantially in most other parts of the world and are indeed projected to do so. From 2013 onwards, the Euro area will likely experience a less negative fiscal impulse than many other major economies. The IMF projects that the cyclically adjusted primary balance will improve by 0.5% of GDP in 2013 (from +0.7% in 2012 to +1.2% in 2013). The equivalent average fiscal tightening for all advanced economies is estimated at 1.0% (from -2.5% to -1.5%). This would reverse the 2012 experience, when the Euro area experienced more aggressive fiscal tightening than the rest of advanced economies. If these fiscal policy projections materialise, the relative fiscal impulse would switch from being net EUR-negative to net positive. Of course, fiscal policies are still very much in flux, as the debate on the US ‘fiscal cliff’ indicates, for example. It may therefore take longer than these projections before the fiscal impact on the Euro reverses. It is also important to remember that less fiscal tightening in the Euro area on average does not remove the fact that individual countries within the Euro area, such as France, may see very different dynamics.
Issue 7: Monetary Policy Differentials
As we illustrated in the earlier sections, slowing growth and monetary easing in the Euro area have been firmly associated with the recent sell-off in the Euro. It is therefore likely that the fate of the Euro will continue to depend on the outlook for ECB policy. Additional easing via further rate cuts and/or non-conventional measures such as LTROs would likely add to the downward pressures. On the other hand, the monetary policy differential to other countries also matter. Many other central banks have now also started to ease policy again, including the Fed, the BoE and a number of CBs in large EM economies. In terms of monetary policy differentials with the rest of the world, the scope for additional EUR downside pressure may be limited, although it will become more difficult to quantify as central banks increasingly use more unconventional tools.
Issue 8: A Notable Reduction in EUR Short Positions
As we described above, the build-up in speculative shorts and/or hedges in the Euro over the past couple of years has been impressive. This would almost certainly reverse during a period of Euro recovery, although merely as a symptom other fundamental changes. However, the availability of data is useful and would provide an important cross-check for the market perception of the other issues mentioned above. In that respect we will continue to monitor positioning indicators such as risk reversals, IMM positioning or investor surveys on the Euro. The recent period of investor bearishness has been one of the longest and deepest seen since the introduction of the Euro, with no sign of improvement so far.
That said, the Euro area remains under substantial pressure and despite some progress, many issues are as yet unresolved. Stolper's bias remains that a solution for most of these issues will eventually be found during the current ‘muddling through’ process. Whether this results in an immediate EUR rally or whether it will be preceded by further EUR weakness will depend on the close interplay between political progress and market forces. On balance, we think a substantial EUR recovery over the next three months is unlikely from current levels and have decided to lower our Euro forecasts accordingly.