The Macro View: Sovereign debt threatens worsening banking crisis

The massive £750bn eurozone rescue package failed to impress the markets. Using “shock and awe” tactics to repel and deter speculative attacks helped the authorities to gain time. But the risk of sovereign defaults and doubts over the euro’s long-term survival reinforce fears over the global recovery. Renewed doubts over banking sector stability and disappointing US news heightened the mood of despondency. Equity markets recorded exceptionally big declines in May 2010. On the currency markets, the euro remains under pressure, but falls against the US dollar remain limited.

Hopes that near-term growth prospects are likely to improve have triggered occasional bouts of optimism; but market rallies have been short-lived. Underlying anxieties and risk aversion have persisted. The initial gains secured by the £750bn package have mostly fizzled out.

In eurozone countries considered vulnerable – Greece, Spain, Portugal, Italy and Ireland – government bond yields were on average higher in early June than immediately after the rescue plan was announced. In Italy and Spain, yield spreads over German 10-year bonds rose to a 10-year high. Hungary’s surprising statement that its economy was in a “very grave situation” – and a default on its debt was possible due to manipulation of official data by the previous government – provoked fears that a debt crisis could be looming in Eastern Europe.

Fitch, the credit rating agency, lowered Spain’s debt rating after the Bank of Spain had taken control of a large regional lender that experienced problems. The downgrade, in line with Standard & Poor’s recent cut, was due to economic factors, from rapid growth in Spanish government debt and labour market rigidities that hamper competitiveness to structural banking sector weaknesses, Spain’s poor growth prospects and, most ominously, fears that political resistance would make it impossible to implement the harsh deficit-cutting measures that Spain requires.

Toxic links
Recent events highlight the potentially toxic links between worsening risks of sovereign default and banking crises, with European banks most vulnerable. Since the Lehman Brothers collapse in September 2008, the market capitalisation of the key European banks has shrunk by about 50 percent, a much bigger decline than recorded by US banks.

Since early May 2010, European bank shares have fallen by 18 percent, much more than the comparable decline in US bank shares. Banking sector fears have also been manifested in renewed money market stresses. Three-month euro interbank rates rose recently to their highest level this year, at a time when official interest rates remain exceptionally low.

The inconclusive UK general election produced a pleasant surprise. Fears that an unstable minority government would result in damaging policy paralysis did not materialise. The rapid establishment of a full coalition between the Conservatives and the Liberal Democrats, and indications of serious determination to deal forcefully with the fiscal deficit, were well received. Even sceptical observers that question the ability of the coalition to survive until 2015 were impressed by the firmness with which the modest £6.2bn initial cuts were handled.

The competent way in which the coalition dealt with its first serious crisis – the forced resignation of chief secretary David Laws – demonstrated surprising political skill. But it is premature to declare victory. Much deeper and nastier cuts will have to be made; these will be very unpopular, and the coalition’s ability to maintain a united front will be severely tested.

The emergency budget on 22 June provided the next important test. The markets, though well disposed to the new government, are still reserving judgement. Britain’s AAA credit rating may be slightly less vulnerable now, but by no means secure.

In the US jobs recorded an increase of 431,000 in May, the strongest monthly figure since 2000. But the figure was weaker than expected and disappointed the markets. There was a 411,000 jump in temporary jobs for the 2010 census.

The very meagre May increase in private sector jobs raises doubts over the future strength of US growth and reinforces fears over a “jobless recovery”, with all the negative political implications this entails. Renewed misgivings over US prospects, while the eurozone crisis is still unfolding, adds to the mood of despondency.

Growth in 2010
There is widespread consensus among forecasters that most economies will record satisfactory growth in 2010, after the appalling declines seen in 2009. But while many governments and official international bodies are expecting growth to strengthen further in 2011 and 2012, most private sector economists and businesspeople are more downbeat about the medium-term outlook.

The factors driving recovery in 2010 are transitory – the rebuilding of inventories and the huge fiscal and monetary stimulus introduced in recent years. But there are huge obstacles to continued rapid growth in 2011 and beyond – namely huge cuts in budget deficits that most governments will be forced to make the need to strengthen banking sectors, and pressures to reduce personal sector debt.

Against this background, medium-term growth in most countries is likely to be well below the historical average. To enable governments to implement deficit reduction programmes without triggering a recession, the Federal Reserve, the European Central Bank and the Bank of England will have to keep official interest rates at their current low level until the until the fourth quarter of 2010 at the earliest. Muted inflationary pressures will help them to maintain an expansionary stance.

David Kern is chief economist at the British Chambers of Commerce