Month: June 2018

Trade and Politics Start To Take a Toll

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By Thomas Cooley, Charlie Nusbaum, and Peter Rupert

European Politics

During the first quarter of 2018, the EU has been marred by both political and economic uncertainty. Increasing tensions between the U.S. and its European allies have resulted in the looming threat and subsequent imposition of trade tariffs. Moreover, Germany and Italy, the largest and fourth largest economies in the EU, respectively, were struck by the emergence of the populist, Eurosceptic wave washing over Europe. Indeed, the Social Democratic Party polled its lowest during the German election since World War II whereas the Alternative for Germany party, the nationalist insurgency, gained entry into the Bundestag for the first time with the third largest number of votes. Angela Merkel’s Christian Democratic Union party lost a total of 55 parliamentary seats. Despite the conclusion of the German elections in late September of last year, a formal coalition was not formed until March.

In Italy, a similar story played out during 2018Q1. In late December, President Sergio Mattarella dissolved the parliament and called for new elections to be held in early March. In the run-up to the election the Five Star Movement, a right wing populist party which has supported abandoning the Euro and leaving the EU at various times, surpassed the consistently pro-Europe Democratic Party to take the top spot in opinion polling while Lega, the more fervent anti-Europe party, maintained its fourth position in such polls. The results of the election showed the Five Star Movement winning the popular vote and Lega placing third.

Uncertainty surrounding Brexit, however, lessened as the deadlock in the first round of negotiations broke. In fact, the United Kingdom entered 2018Q1 having just reached an interim agreement surrounding three key issue: free movement across borders, the rights of UK citizens abroad and EU citizens in the UK, and a financial settlement to be paid to the EU. While preliminary, it served as an important step in resolving some of the uncertainty surrounding the crucial transition period of the Brexit process.

The resolution surrounding Brexit was rewarded by the markets with all four major stock indices in the EU seeing gains towards the end of the year. These gains were quickly lost, however, when it became clear that the uncertainty surrounding tariffs, Italian elections, and the formation of a coalition among Germany’s major political parties were a potential threat to Europe. In fact, all four indices showed largely horizontal movement throughout 2018Q1. These trends beg the question: Is the European economy robust enough to withstand such bouts of uncertainty?

Economic Growth

Overall, the EU28 and EA19 both saw a minor slowdown in growth during 2018Q1, ticking down from 2.71% and 2.83% during 2017Q4 to 2.43% and 2.54%, respectively. Moreover, both were outperformed by the U.S., which saw a year-on-year growth rate of 2.78% according to the BEA’s second estimate. The Eastern European countries by and large outperformed the rest of the EU, while Cyprus continued to break from its Greek neighbors and boasted year-on-year growth above 3.5% for 6 straight quarters. This is quite a turnaround for the small European island given that just four years ago it struggled to pull itself out of a two year contraction. On the other hand, the four largest economies in the EU underperformed.

Indeed, France, Germany, Italy, and the United Kingdom all saw a decrease in growth during 2018Q1. For the United Kingdom, this continues a long term trend that began in 2015Q1 and was restarted during 2017 following the Brexit vote. For France, Germany, and Italy, however, this marks one of the first signs of weakening in this regard over the past year and a half.

Europe lagged behind the United States slightly in terms of investment growth with real fixed capital formation growing by 4.19% and 3.59% in the EU28 and EA19, respectively, compared to 4.45% in the U.S. Here again, the Eastern European countries fared best while Cyprus saw a severe contraction in investment. Going forward, this trend may inhibit Cypriot growth and break its impressive streak of exceptional growth.

The Unemployment rate in most European countries remained low during 2018Q1. Indeed, only Spain and Greece maintained unemployment rates above 10%, with values of 16.2% and 20.5%, respectively. Across the EU28, the unemployment rate decreased slightly to 7.2%. The European labor market remains behind the United States, which boasted an unemployment rate of only 4.1%, in this regard.

Still, the European labor market is heading in the right direction despite the uncertainty revolving around the European political status quo. Those countries whose labor market struggled the most continued their long run trends of declining unemployment. While Finland, France, and Italy have seen the least dramatic movement in unemployment, a slight downward trend still presents itself. Not pictured below are the first and second largest EU economies: Germany and the United Kingdom. Germany and the United Kingdom both display a similar downward trend, though they boast unemployment numbers of 3.5% and 4.2%, respectively. Both of which are on par with the United States.

As a whole, the EU labor market has shown persistent improvement. Indeed, the EU28 Beveridge curve continues to indicate ever increasing market tightness as is evident by the simultaneous decrease in unemployment and increase in the job vacancy rate.

A key comparative static of Beveridge curves are whether they display an outward or inward shift as they complete their loop. Here, it is clear that the Beveridge curve has seen a drastic outward shift between 2013Q2 and 2018Q1 as compared to the 2006Q1 to 2008Q1 period. This implies that the labor market requires a higher number of unfilled jobs in 2018Q1 than 2008Q1 in order to sustain the same level of unemployment.

An Uncertain Future

In spite of the political uncertainty throughout the continent, the EU largely maintained its positive growth. There are, however, some early signs that the perceived threats to the European experiment are beginning to have a real impact.

It is far too early to sound an alarm, but we take the recent data to be an early symptom that should be watched carefully. Trade policy between the U.S. and the EU is becoming increasingly strained as each side ratchets up tariffs, tension has emerged within the German coalition over legislative priorities and the refugee crisis, and a populist coalition between the Five Start Movement and Lega that many fear will place increased strain on Italy’s finances has taken power. Moreover, the United Kingdom and the rest of the EU must come to a final Brexit agreement in the coming months before the mid-October EU summit. While the EU has shown resilience to the early political events of 2018, increasing uncertainty and an escalating trade war will be a true test of the European economies.

Are Italian politics sabotaging the Monetary Union?

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By Thomas Cooley, Charlie Nusbaum, and Peter Rupert

In the aftermath of the European debt crisis  much has been done to try to improve the safety and stability of the financial system.  It was clear that one key to financial stability was to complete the process of a banking union within the Eurozone (the EA19). To that end they have adopted a Single Supervisory Mechanism centered at the European Central Bank. In 2017 they implemented a Single Resolution Mechanism for addressing insolvent or illiquid banks. Question:  Is a Euro in an Italian Bank, as viewed by the market, the same as a Euro in a German Bank? Until the answer to that question is yes, the banking system remains fragile. A key ingredient to an affirmative answer is a Single Deposit Insurance system. So far the Germans have been steadfast in their opposition to unified deposit insurance for obvious reasons.  The balance sheets of banks in the third and fourth largest economies in the Eurozone carry a lot of legacy risks in the form of non-performing loans and a heavy exposure to the debt of the sovereigns.  We have documented these issues in earlier posts.  The only way out of this bind is for banks to improve the health of their balance sheets. We consider this next.

Stronger Banks in Europe?

One of the major concerns in the European financial sector during 2017Q1 was the mix of outstanding loans. During the first quarter of 2017, the ratio of non-performing loans to all outstanding loans in Greece, Cyprus, Ireland, Portugal, and several Eastern European countries signaled potential trouble ahead. At the end of 2017, these same regions remain the trouble spots in this regard. Indeed, 44.9% and 38.9% of loans from Greek and Cypriot banks are over 90 days past due. The remaining trouble spots have a non-performing loan ratio of 6.5%-15.2%. All of these countries, however, have improved their loan portfolios throughout 2017.

From 2017Q1 to 2017Q4, the ratio of non-performing loans to all loans in Cyprus and Greece has decreased by 4.9 and 1.3 percentage points, respectively. Throughout the EU28, the same decreased by 0.76 percentage points. The only two countries who saw their position worsen in this respect are Estonia and Sweden, though both remain below 2%.

The EU28 financial sector continued to improve its ability to cope with distress. As a whole, the EU increased its liquidity coverage ratio by just under 4%. While several countries saw a substantial decline in this measure, it does not give us pause.

Indeed, despite Sweden, Estonia, and Hungary’s large decrease in their liquidity coverage ratios, they all remain above the 148% coverage ratio in the EU as a whole. The only country not in compliance with the Basel III minimum liquidity requirement rule of 90% for 2018 is Greece, which held only 11% of its 30 day expected net cash outflows in high quality liquid assets. Excluding Greece, every EU member nation is already compliant with Basel III’s final liquidity requirement of 100%, which is set to go into effect next year.

Profitability remains an area of concern, however. As measured by return on equity, the profitability of European banks decreased by 0.78 percentage points. Despite this overall downward movement, over half of the EU28 beat out U.S. banks, which had a return on equity of 8.4% in 2017Q4.

The operating efficiency of European banks as measured by the cost to income ratio showed little change since 2017Q1 overall, decreasing by just 0.33 percentage points. As in 2017Q1, central European countries have some work to do to bring down costs. German and French banks remain the least efficient with cost to income ratios of 80% and 71%, respectively.

On the other hand, over half of European banking systems maintained cost to income ratios around 50%. For comparison, major U.S. banks range from 58% (Morgan Stanley) to 76.2% (Wells Fargo). While measures of efficiency differ depending on the ratio considered, virtually all fall within this range for U.S. banks.

 Inching Toward Stability

Despite the positive signs in many countries, caution remains to drawing an optimistic conclusion regarding the stability of European banks, particularly in the EA19. Two key points to stress are that participation and size matter. What do we mean by participation? Many of the countries that boast a healthy financial system have little relevance with respect to the a healthy monetary union. In fact, 3 of the 5 countries with the lowest NPL ratio are not members of the monetary union while 4 of the 5 countries with the highest NPL are members of the EA19. In addition, 4 of the 5 financial sectors suffering from low efficiency as measured by the cost-to-income ratio are Euro adopters. As a result, the positive trends emerging in Europe are deceiving.

Moreover, the performance of Eurozone banks must be weighted according to their respective sizes. While Italian banks are moving in the right direction, they maintain a cost to income ratio above 60%, a non-performing loan ratio of 11%, and a tier 1 capital ratio of just 13%. As one of the largest economies in the EU, this low performance carries much greater weight than the strong Luxembourg banks. Even more striking is the polarization between Germany, the largest economy among both the EA19 and EU28, and Italy, the 3rd largest EA19 and 4th largest EU28 economy, with respect to their TARGET2 balances.

The TARGET2 system was set up in 1999 as a payment settlement system between European banks. TARGET2 balances can be interpreted in two ways: as a reflection of current accounting financing or as a measure of the capital account. Prior to the financial crisis, TARGET2 balances remained roughly even throughout the the EU. Following 2007, however, German banks began taking on the role of primary creditor in the EU, whereas Italian banks assumed the role of primary debtors. Broadly speaking, these trends can be seen as a reflection of net capital inflow for Germany and net capital outflow for Italy. This picture presents a very clear message: a Euro held in Italian banks is not yet valued equally to one held in German banks. The same story emerges for Spain, the 4th largest economy in the EA19. Until an Italian or Spanish Euro is seen by the market as equal to a German Euro, we hesitate to claim that the European financial sector or EA19 are stabilizing.

While long term systemic shocks are always a concern, improved loan portfolios and high liquidity coverage ratios signal that European banks are improving their ability to cope with short term financial distress. In light of mixed profitability measures, sustained difficulty in Greece, and a persistent divergence of TARGET2 balances among the largest European economies, however, the ECB is right to maintain its holding pattern thus far in 2018 (here, here, and here) until the largest European economies signal stronger, more uniform improvement. Moreover, we see several challenges that must be tackled to resolve the fragility of the European Monetary Union. First, legacy debt and the size of non-performing loans in the larger economies have prevented a willingness on the part of well-performing countries to fully integrate their banking sectors with countries such as Italy and Spain. Reconciling these differences is of first order importance to promoting a sound and robust financial system. Second, a unified deposit insurance scheme must be implemented in the EMU. Until such a policy is implemented, it is difficult for us to see how or when market participants will value a Euro equally across all Eurozone banks.

Finally, recent political events in Italy have caused even greater concern over the state of the Monetary Union. Despite reassurances by Italy’s Economy Minister that it has no plans to leave the Euro, political parties espousing anti-Euro policies have gained a fair bit of traction in Italy with roughly 30% of the voters favoring such an exit (here). Should these policies continue to gain in popularity, it is not unimaginable that the EU could face an Italian BREXIT (exIT). Whereas Britain has always remained on the periphery of the Union, an Italian exit would strike at the heart of the Euro Area. Such a move on the heels of a BREXIT would make it difficult to see how the Eurozone, or EU for that matter, could survive in its current form. Indeed, Italian politics has the potential to make BREXIT look like a tea party.

Click here for an in-depth evaluation of the European banking system and the EMU from the 2018 “State of the Union Conference” held in Florence this past May. Skip to 1:53:30 to see remarks by Thomas Cooley.