Mittelstand: the envy of eurozone amid regional split

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Much of the eurozone economy is in hot water, with corporates complaining about a lack of access to attractively priced capital, but one market in particular has bucked the trend: Germany.

One explanation for the relative effervescence of the bank market in Germany is that German banks, which used to lend to their peers in peripheral southern Europe in the interbank market, have now pulled back, to be replaced by the ECB. In fact, the provision of ECB liquidity means that German banks are no longer taking the country risk that made the trade profitable. This has left a void on German banks’ balance sheets. Rather than keeping cash on their books, German banks have been eager to lend to corporates in the domestic market. Even if German banks are not actively pushing loans at home, it is natural that institutions will be more comfortable lending in Germany than elsewhere. The German economy is in better shape, so the prospects of borrowers being able to repay their debts are higher. The divergence in lending conditions between Germany and peripheral economies can be expressed by the Taylor rule. This expresses the neutral interest rate level for an economy, based on inflation expectations, average growth rates and the output gap – the difference between potential and actual GDP. As a rule, a marked deviation from the rate predicted by Taylor implies conditions are too tight or too loose. According to Toby Nangle, head of multi-asset at Threadneedle Investments, the rate set by the ECB in the period 1999 to 2007 was too tight for Germany – and the rest of core Europe – and too loose for the peripherals (see table below).



Conversely, in 2013, policy is too loose for Germany and too tight for the peripherals. This explains why the ECB policy stance is today encouraging borrowing in Germany, while stifling demand in the peripherals, Nangle says. This is evidenced by substantial imbalances in Europe in confidence, and expectations of revenue growth, which encourages or discourages borrowing. Confidence in future income encourages corporates to borrow for increased consumption, in the expectation of being able to repay their liabilities. Data show that increased volatility in revenue streams leads to declining borrowing, even when overall revenue is higher, says David Watts, senior analyst and European credit strategist at CreditSights. This is because it reduces confidence in the ability to make repayments. Nangle says: “This disconnect in monetary conditions is providing a competitive advantage to core Europe. If German corporates and others made acquisitions and investments in depressed peripheral economies, the rebalancing process could occur with economic growth. But this is difficult, politically.” Closer fiscal and macro-prudential integration between eurozone states would help ensure that these imbalances never become so pronounced that it threatened stability, he adds. “What actually seems to be happening is rebalancing without growth, with German corporates enjoying high levels of profitability, while the periphery deleverages,” says Nangle. “This also means the euro will remain weaker for longer.” There is certainly a scarcity of credit across much of Europe, with plenty of evidence pointing to a lack of supply. It is rational for a bank to decline a loan if the expected interest rate it will accrue, adjusted for default risk and the bank’s own cost of funding, does not make it worth making. But the real issue is on the demand side. CreditSights’ Watts says: “The big problem in Europe is not access to financing, it is a dogmatic adherence to 1920s-style economic formulas that suggest the way out of a deficit is to cut spending.” Cuts are draining confidence and undermining appetite for borrowing, he adds. The issue affects SMEs disproportionately. “There is a 300 to 400 basis point spread between the rates available to SMEs in Germany compared to those in Spain or Italy,” says Rick Lacaille, CIO at State Street Global Advisors. “That is much wider than the underlying economics would justify.” Large caps have better access to the corporate bond market, driven by the technical demand for spread, Lacaille adds. “The good news for the European project is at the large cap level, companies display a much purer reflection of underlying company risk, without the distortion of the problems of eurozone banks,” he says. Already higher than elsewhere in Europe, German borrowing numbers would have been higher still were it not for wages declining in real terms after the implementation of Hartz plan reforms of the labour market. “Borrowing in Germany is broadly in line with pre-crisis levels,” says Watts. Yet with rates close to zero, German corporates should arguably be borrowing more – with wages also increasing. “Rebalancing should be good news for Germany, with wages starting to rise in response to increasing profitability,” says Threadneedle’s Nangle. “That is not happening yet.”

It would be for the good of all of Europe if it started soon.

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