A necessary but insufficient ‘compact’
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A necessary but insufficient ‘compact’

Looking beyond the headlines with regards to the UK’s (and others’) participation or otherwise in the proposed changes to the EU Lisbon Treaty, the “fiscal compact” that emerged on Friday was, at the very least, a step in the right direction.   The question is whether it will be seen as enough by the rating agencies and in particular Standard & Poor’s, which put much of the eurozone on review a week ago.

The need for closer fiscal and economic coordination has been recognised for a long time – it is just that leaders have always been too busy fire-fighting to do much about it. The issue we have raised continually, and which still appears to stand, is that the changes proposed do not go far enough. Much of what has been proposed is based on the pillars of the stability and growth pact, which was shown to be severely flawed. Video:

Furthermore, the focus on absolute deficit levels does not enshrine debt-sustainability into tighter regulations and also fails to recognise that external imbalances (c/a deficits) played a key role in the de-stabilisation that was seen. And, the ‘enforcement’ mechanisms for fiscal miscreants look far too polite – for instance, if the European Commission does not like a particular country’s budget plans, then it can ‘adopt an opinion’ and advise that it be altered.

Wow! That sounds powerful, not!  In essence, none of what is proposed crosses the Rubicon into the realm of proper fiscal integration, in other words a degree of common tax and spending that is undertaken by something akin to a eurozone Treasury. And it is far short of what the Germans wanted, namely an EC veto on unacceptable national budgets.

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However politically unpalatable this may be to some, proper fiscal union is one of the major means by which the eurozone can be put onto a more secure footing in the longer term. The EU has promised to look into this and report back in March of next year, but as we know, four months is a very long time in a sovereign debt crisis. The fiscal compact is a step in the right direction, but as it stands it looks likely to be ineffectual, and before too long will need to be strengthened. If Paris wants to save the euro, it will need to give up fiscal sovereignty.


The impossibility of the EBA’s demands. Understandably the focus of attention on Thursday and Friday was the latest ECB meeting and the outcome of the EU summit. Neither was completely convincing, but for now they have done enough to placate both investors and traders. In the midst of this maelstrom, the European Banking Authority (EBA) published its recommendations on how European banks should achieve their recapitalisation needs, and frankly it makes for disturbing reading. In the first instance, the EBA recommends that banks establish “an exceptional and temporary capital buffer” to reflect the deterioration in sovereign debt prices. As well as this demand, banks are also required to establish another “exceptional and temporary capital buffer” to enable their core Tier 1 capital ratio to reach 9% by the middle of next year. According to the EBA, these buffers are not designed to cover losses on sovereign bonds but are instead intended to provide “reassurance” to markets about banks’ ability to withstand shocks. In a breathtaking piece of optimism, the EBA hopes that this one-off buffer for sovereign debt will disappear once the EFSF is let loose on troubled European sovereigns. The EBA also discourages the sale of assets in order to meet the capital-adequacy target, it discourages the use of variations in internal models to alter the risk-weighting of assets and it wants banks to reach these capital targets through reduced bonuses, retained earnings, new equity issues and strong contingent capital. At the EBA, hope clearly springs eternal.   Unfortunately, in the current incredibly tough financial environment this is an impossible wish-list. The regulators want banks to increase their capital adequacy at a time when assets values are tumbling and capital cushions are running down rapidly. In addition, for many banks, the liabilities side of their balance sheets is contracting quickly, such that many only survive out of the grace of access to ECB funding. Against this backdrop, banks are forced to substantially reduce the size of their balance sheets through asset sales and there is very little that the EBA can do to alter this reality. Although its call for increased capital buffers and higher capital adequacy is perfectly understandable, even it must appreciate the impossibility of achieving this in the current environment. After the last stress tests, when the initial demand for a 9% capital ratio was made, many banks rushed to sell assets because they recognised that raising new capital would be extremely problematic. As a result, the EBA actually made the situation worse by accelerating asset sales (including dodgy sovereigns). It needs to be said that the EBA’s job right now is utterly problematic given the extremely challenging financial environment. The pace of deleveraging is simply too rapid. To make matters even worse, there is now a veritable flood of deposits headed out of the south of Europe to the north where banks are perceived to be safer. With the finances of most European sovereigns now in terrible shape, a European version of TARP is rendered superfluous because, in all likelihood, it could not be funded sufficiently. In addition, the EBA’s recommendations will be consigned to the rubbish tip should Europe’s main sovereigns lose their AAA status, as seems very likely.

UK inflation heading lower. We are now entering the period that has been desperately waited in the UK for far too long, that of falling inflation. The next three releases (starting with November data tomorrow) are set to reflect this. Tuesday’s numbers are expected to show headline prices falling from 5.0% to at least 4.8%, although we feel that 4.7% could be on the cards given the wider discounting seen in the face of poor high-street sales. This could well hold true for the December numbers as well, with some pre-VAT price increases from last year also helping in terms of base effects pushing the YoY rate lower.   Then January will see last year’s increase in VAT (from 17.5% to 20%) fall out of the YoY comparison, drawing   inflation down to a 3% handle which remains outside the 1% band around the 2% target but nevertheless will be down to levels last seen a year ago. The fall in inflation will provide some relief for the real economy, reducing the squeeze from negative real income growth.   But the pressure on the BoE to do more QE is likely to remain strong going into February (when the current increase runs out) as the economy could well be back in recession by then.  

The improving UK trade picture.  It has been a long wait, but it is increasingly evident that the trade sector is making a positive contribution to the incredibly painful rebalancing of the UK economy. In October, the trade deficit narrowed substantially to GBP 1.55bln – in 2011 the average monthly trade shortfall has been GBP 2.6bln. In the latest month, export volumes jumped by 8.3% to the highest level since mid 2006 while import volumes fell by 0.5%. Over the past year, the latter rose 0.6%, while export volumes are up by 5.4%. Clearly, given the incredibly troubling situation in Europe, this recent strength in exports will be difficult to sustain but it is encouraging nonetheless. Net exports are on track to make a reasonably positive contribution to GDP in the current quarter. Against the backdrop of sinking domestic demand it might just be enough to prevent the economy registering a fall in GDP.

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