EY Eurozone Forecast: September 2013
Eurozone private debt ratios have barely fallen
The process of deleveraging will continue for some time yet.
Although 2014 is set to see much less aggressive fiscal tightening than in 2012 or 2013, there is much work still to do over the medium term to try to limit debt levels and keep debt interest payments sustainable. Realistically, this condemns the Eurozone to a decade of austerity and the long-term negative impact on growth that this will entail.
Furthermore, though there has been much focus on reducing public sector debt, companies need to address high private sector debt also before the economy can sustain stronger growth. Unlike the US, and to a lesser extent the UK, Eurozone private debt ratios have barely fallen.
There is much deleveraging still to do in the public and private sectors
Within the private sector, the banks remain the biggest concern, with many Eurozone banks remaining thinly capitalized and over-leveraged. To date, the response of policy-makers has been poor. The asset quality review by the European Central Bank (ECB) is not due to start until early 2014, while the €60b cap on bank recapitalization (equal to just 0.2% of total bank assets) by the European Stability Mechanism (ESM) is far too low. This means that there is still much uncertainty about the actual state of the banking sector and about how to finance recapitalization where it required.
The bailing-in rules bring some clarity about the risk of investing in banks’ shares or bonds. In turn, this will enhance market discipline and help trigger restructuring of underperforming institutions.
The burden sharing that the rules imply is also positive compared with recent years, where taxpayers have borne the whole burden of banks’ restructuring. However, these rules will not come into effect until 2018. Until then, the potentially high costs of bank failures still expose government finances.
Banks are still cautious to lend
Until banks have made more space on their balance sheets, they will remain under pressure to rein in lending. The ECB’s latest bank lending survey reported that credit standards on loans to nonfinancial corporations tightened further in Q2 2013. Although the degree of tightening was the same as in Q1, this maintained the ongoing trend of progressively tighter conditions seen since the onset of the financial crisis six years ago. The survey also reported that demand for credit has continued to contract, with the net effect being a very weak flow of funding to firms.
There are still wide disparities between Eurozone countries. The divergence in interest rates charged on loans to businesses illustrates this best. Having moved broadly in line up until 2011, Spanish and Italian companies are now paying 5.1% and 4.3% respectively on new loans under €1m. Meanwhile their counterparts in Germany and France are paying around 3%.
We have constructed an indicator of external financing costs that comprises interest rates paid on loans as well as the cost of share and bond issuance. This shows that, given Spanish companies’ greater reliance on bank loans as a source of funding (more than 50% of total funding), the rise in interest rates has affected their overall cost of finance particularly starkly. It also shows that little relief has been available from other sources of funding, since Spanish companies have had to pay a higher cost to issue shares than their German counterparts.
The issue is particularly important for smaller firms, which typically have no direct access to financial markets and therefore rely on retained profits or borrowing from banks to finance their investment spending. The European Investment Bank (EIB) has sought to reduce the scale of the problem, raising its 2013 lending target for small and medium-sized enterprises (SMEs) from €14.1b to €17b, as well as increasing its funding for various other schemes. However, the EIB’s new lending target is equivalent to just 0.2% of the stock of lending to non-financial corporations, so will do little to resolve the problem.
A coordinated policy response is required while divergence between the core and periphery remain.
Tight lending conditions have the potential to compromise the recovery on several levels. In the short term, this limits the extent to which the corporate sector can support the recovery by constraining firms’ ability to invest in new machinery or hire extra workers.
There are also longer-term implications. A protracted period of under-investment means that growth in the capital stock will be much slower. This forces companies to lengthen replacement cycles and spend less on research, development and innovation, so compromising the quality of that capital stock. As such, a lengthy period of affordable bank funding scarcity will limit the degree to which productive potential can expand and, therefore, will act as a constraint on the pace of the medium-term recovery.
Coordinated policy response
Banks should be encouraged to speed up their deleveraging to make space on their balance sheets for new lending. Once they have done this, the ECB could encourage banks to lend to SMEs by easing its collateral rules.
This would make loans to SMEs cheaper to use in ECB liquidity operations, and thereby more attractive to banks. The ECB did make a move in this direction in late July, but it extended the pool of collateral that it would accept from banks by just €20b, which, on a theoretical pool of €15t, represents a very small change.