A calmer eurozone still faces foreign risks

The financial risks from within the eurozone have declined this year but the external risks have increased, which is largely due to the uncertainty surrounding the Fed’s taper.

According to the European Central Bank, systemic stress in the banking sector has declined further since its May Financial Stability Report and is now at its lowest level since 2011. Although economic activity has, at best, improved only modestly and banks remain reluctant to lend to households or businesses, general conditions in the financial sector have improved.

Austerity measures and structural reforms continue throughout the region, though at an uneven pace across countries. Austerity continues to weigh on growth in a number of countries and will continue to do so into 2014 and beyond.

Many European economies also remain uncompetitive, with relative wages that are too high to compete within the eurozone and an exchange rate that is still a little too high to compete globally. The process of internal devaluation has also been slowed by disinflationary – and potentially deflationary – pressures because differences in relative inflation across countries are the primary way to devalue a country’s currency when they are part of a currency bloc.

The ECB emphasises that this loss of competitiveness must be corrected but it will be a slow and painful process. It would be made a lot easier if there was a little more inflation within the region, particularly if the German government stimulated domestic demand, which continues to be unnecessarily weak given the options available to German Chancellor Angela Merkel.

The outlook for bank profitability is also weak, as banks continue to restructure and often downsize. There is still a significant degree of fragmentation in the availability and cost of bank funding, which is only reinforced by the unwillingness of banks within European countries to lend across borders. The ECB says that to resolve these issues, further progress towards establishing a banking union is required.

The ECB has identified four key risks to financial stability in the eurozone:

1. Economic and financial shocks that affect asset valuations and bank profitability, eroding confidence in the financial sector.

2. Renewed tensions in sovereign debt markets as a result of delayed national reforms, unforeseen bank recapitalisation needs or a rise in global bond yields.

3. Global financial market turbulence, with asset mispricing and low market liquidity.

4. Bank funding challenges in stressed countries that force banks to deleverage excessively.

The ECB sees promising signs that the eurozone is emerging from a business cycle trough, with projections that real GDP will rise by 1 per cent in 2014. Hardly what I would call promising but for many of these economies it has been a long time since they last grew at all. Perhaps more importantly, most of the risks to eurozone economies lie on the downside.

Eurozone banks are increasingly recognising loan losses, and non-performing loans and associated provisions have increased to such an extent that they have been the major contributor to the low return on bank assets since 2009. Despite this, these provisions have barely kept pace with the deterioration in asset quality, which suggests that banks need additional reserves to make them more resilient to additional economic or financial shocks.

Eurozone banks are generally valued lower than their US counterparts, with market valuations below their book valuations since 2009. To some extent this may reflect that US banks are potentially overvalued given the irrational exuberance currently driving US stocks. The ECB says that euro banks need to be more transparent regarding asset quality.

Sovereign debt concerns have eased since May, with bond spreads for a number of financially stressed countries declining. Bond spreads are down 55 basis points in Spain, 50 basis points in Ireland, 30 basis points in Italy and 25 basis points in Portugal since May. Debt levels are still high but the corresponding bond spreads appear to reflect the particular country’s risks now that the danger of a systemic default has declined.

Uncertainty surrounding monetary policy expectations in the United States has increased foreign exchange market and asset volatility. The risks to the eurozone’s financial system from outside the region have grown since May following the Federal Reserve’s talk of tapering its $US85 billion per month asset purchasing program.

Any change in the Fed’s policy will result in adjustments throughout the financial system. The ECB warned that banks, insurers and pension funds need sufficient buffers and/or hedges to withstand a normalisation of yields when the Fed does taper.   

On balance, the ECB stability review is mostly positive. But it is clear that asset quality is still too low and the financial system is failing to allocate resources effectively, which has prolonged the downturn. With austerity still on the agenda and painful internal devaluations required, the outlook for many eurozone economies is still dire and may take years to rectify.

Volatility surrounding US monetary policy is concerning, and depending on how the Fed goes about tapering there could be some significant effects to asset prices – though on the upside it would result in the euro’s depreciation which could boost the eurozone’s economic outlook to some extent.