Against the tide: Europe is not out of the woods

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By:
David Roche
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Greece will be forced to default and face an exit from the eurozone. That’s when the issue of contagion will rear its head again.

The Greeks have got their second bailout package, supposedly to finance their debt obligations until 2014. And Eurogroup leader Jean-Claude Juncker made it clear that if Greece kept to its fiscal targets, the euro leaders would be prepared to extend the bailout package beyond the current 2014, if necessary.

So is that the end of the euro debt crisis? Unfortunately not. The Greek crisis could reappear before the end of spring if, in the election, parties opposed to the package gain a majority in the Greek parliament. Opinion polls suggest it is possible.

However, the desire of the majority of Greeks to stay in the eurozone might overcome the opposition to austerity. A grand coalition of the parties that are signatories to the troika deal might still win and so avoid Greece becoming any more ungovernable than it is.

That will allow some breathing space for a few months, but down the road Greece is still set to fail well before 2014. It cannot and will not meet the targets on tax revenues and spending set by the troika. When Greece is forced to default and face exit from the eurozone, that’s when the issue of contagion will rear its head again.

That is why the Germans, European Union leaders and the IMF are trying to convince markets they will have a firewall fund in place by the summer. The headline figure is $2 trillion. This assumes that current unused funds of the European Financial Stability Facility (€250 billion) will be topped up with the new European Stability Mechanism funding (€500 billion), followed by the IMF establishing a new emergency fund filled by donations from such countries as China, Japan and the Brics to the tune of $600 billion, on top of existing IMF funds of $350 billion.

This firewall will eventually be put in place, although whether before or after another Greek crisis is anyone’s guess. Once it is, that will mark the end of the euro crisis.

In the European Central Bank’s second tranche of liquidity funding to Europe’s banks, they took another gross €500 billion, which means a net €250 billion to €300 billion after exiting other ECB facilities. In sum, the banks have now received €1 trillion in extra funding and €500 billion net of other facilities no longer used.

ECB liquidity provision
Source: Datastream

With another long-term refinancing operation for Europe’s banks, the Greek package in place and talk of more firepower to stop contagion, the bullish sentiment in equities, peripheral eurozone sovereign bonds and the euro might well continue. And that could be boosted by further moves to inject liquidity by other important central banks globally.

The People’s Bank of China seems to have stopped sterilizing foreign capital inflows and cut the reserve requirement ratio (RRR) for its banks last week. So it joins other central banks on the liquidity roll.

China’s economy is slowing much more than people acknowledge. The locus of the problems is bank lending, both in the shadow banking and main banking sectors. The RRR cut will enable China’s banks to repatriate more of their huge off-balance-sheet loans back onto balance sheets.

It won’t boost credit growth in the real economy. China’s growth will remain weaker than expected, depressed by a collapsing property market.

As well as the PBoC, the Bank of Japan will apply some quantitative easing on top of what it did last week and the Federal Reserve is probably ready to launch QE3 this summer, with the aim of kick-starting the housing market – along with government fiscal measures. The homes market remains a key driver of US consumer recovery.

The joker in the pack is potential conflict with Iran and a resulting hike in the crude oil price. The likelihood of an Israeli attack on Iranian nuclear facilities could reverse bullish sentiment in financial markets.

David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com
If the crude oil price jumped to $175 a barrel, it would cut 2.5 percentage points off world growth, which is nearly all the growth we’ve got. If that happened, equity markets could drop as much as 30%, while commodity prices would plummet. The consensus is that any such attack would likely happen before the end of the summer.