As seems obvious from the market's reaction over the last week, European problems are not solved by short-term liquidity band-aids. In fact, as Goldman notes this week, the same economic and political risks remain even if some funding relief has been put in place. With sovereigns and financials leading one another to new lows since the LTRO, the negative feedback loops remain in full force. Given the difficulties on the road ahead – and significant ongoing differences across governments on how to resolve them – the risk of political miscalculation or errors is unfortunately still very clear. In the limit, those instabilities could still put the union on a path towards a break-up. Economic weakness in the meantime will intensify the challenges for the weaker sovereigns.
Goldman Sachs: Global Economic Weekly - New Questions For The New Year
Does recent European news change our view of Eurozone risks?
Not really. Funding relief was our central case, and the same economic and political risks remain.
The last month since our forecast has seen renewed policy action by the ECB and fresh proposals from Eurozone leaders. The expansion of USD swap lines, easing of collateral rules and the 3-year LTRO all help to assure cheaper and stable funding across the banking system, which should help reduce systemic risks. We have always expected, however, that the ECB would do what was required to prevent a major funding breakdown (and we think they will continue to do so). The larger issues continue to center on how to settle the sovereign funding situation and to reverse the cyclical weakness in the periphery. On that front, the story remains largely the same.
The outlines of the process for dealing with the sovereign crisis have become a little clearer.
The plan is to move towards a set of new fiscal rules, as set out by the latest summit, in exchange for further risk-sharing on the existing stock of sovereign debt both through expanded ECB purchases and some mutual support by governments. But there is still a long road ahead. There is no Eurozone-wide purchasing facility or insurance scheme yet up and running, nor is there likely to be for several months.
The SMP purchases are likely to continue, but we think they are also unlikely to be scaled up significantly given the ECB’s desire to see a new fiscal framework more concretely delivered. And the negotiations over a new fiscal framework are also likely to become more difficult as specifics are agreed and approvals sought.
This means that even the best case for early 2012 is likely to involve volatility around key events – programme reviews, auctions, IMF disbursements and periodic summit meetings – as in 2011. And we remain skeptical that upcoming events (the Merkel/Sarkozy meeting on January 9th or the EU leaders’ summit on January 30th) will give discrete breakthroughs.
Given the difficulties on the road ahead – and significant ongoing differences across governments on how to resolve them – the risk of political miscalculation or errors is unfortunately still very clear. In the limit, those instabilities could still put the union on a path towards a break-up.
Eurozone Feedback Loops: Focus Back On Sovereigns
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Economic weakness in the meantime will intensify the challenges for the weaker sovereigns (Chart above). The good news is that Germany’s data have been better than expected for Q4, which should support Eurozone aggregates. But Italy’s economic picture has remained difficult, Spain’s deficit estimates were recently increased and the commitment to fiscal austerity across the Eurozone is broad-based. Economic weakness and its feedback into public debt sustainability are likely to be even more strongly in focus. The combination of weaker growth and public sector shrinkage is also likely to keep the political landscape in many Eurozone countries turbulent, particularly with elections ahead in France, Greece, Slovakia and Finland in 2012H1.
So our expectation is still that the European growth and market picture will worsen before any more sustainable resolution is achieved.