Unappreciated, euro zone ploughs path of reform

LONDON Tue Jan 31, 2012 1:53pm EST

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LONDON (Reuters) - Another European summit, another bland commitment to boost growth and employment that even one of the participants privately dismissed as unimportant.

It is true that communiques do not create jobs.

But investors might not be giving enough credit to governments that, away from the summit spotlight, are at last forcing through long-shunned reforms to increase economic growth and thus tackle one of the root causes of the euro zone crisis.

Italian Prime Minister Mario Monti, a caretaker technocrat, and his recently elected opposite number in Spain, Mariano Rajoy, were both making very encouraging progress, said Riccardo Barbieri, chief European economist at Mizuho International in London.

Italy and Spain matter because of their size. Greece is negotiating a big reduction of its debt as part of a second international bailout and markets fear Portugal might have to follow suit. But together they account for no more than 5 percent of euro zone output.

Spain and Italy, by contrast, have economies that are simply too big to bail out.

"If Monti is allowed to continue his work, given the pace at which he is going, within a year Italy could be a different place in terms of potential," Barbieri said.

PENSIONS SHAKE-UP

Monti, a former European competition commissioner, wants to galvanise Italy's sclerotic economy by deregulating closed professions and services and lowering costs to increase competitiveness.

Financial markets have been riveted by the euro zone's drive to restore fiscal discipline.

However, Gilles Moec, an economist at Deutsche Bank in London, said Italy's problem was not its primary budget balance - before interest payments - but rather how to make its big public debt easier to carry by increasing potential gross domestic product growth. And that was exactly what Monti was doing.

"The problem is you don't see 'structural GDP'. It's very hard to sift out the results of those policies in the short run, so the market will always have trouble pricing in these reforms even if they're extremely important," Moec said.

Take pensions. As a result of Monti's reforms, Italy's retirement age will rise to 67 before Germany's does. And pensions will no longer be linked to a worker's final salary.

"In one shot they did what a lot of us have been advocating for years," Barbieri said. "And ultimately it was swallowed by the trades unions and by everyone. It was a huge step forward."

Joerg Kraemer, chief economist for Commerzbank in Frankfurt, said Monti's reforms could be considered exemplary for many countries, including Germany.

"The reforms will reduce pension expenditure as a proportion of Italian GDP over the coming years, whereas for most of the industrialized countries the opposite is true," he said in a note.

Spain has made equally important progress on a different front: a recent far-reaching national wage agreement between the country's employers and two main unions clearly sets Spain on the path towards restoring competitiveness, Moec said.

Under the pact, wage growth will in principle be capped to 0.5 percent this year and 0.6 percent in 2013, well below the expected inflation rate. Real wages will fall.

Spain and Ireland have led the way in reducing unit labour costs since the onset of the financial crisis, Eurostat figures show.

Moec said investors had also not fully appreciated Spain's progress in cutting its current account deficit from a peak of 11 percent of GDP in 2007 to 3.4 percent in the third quarter of 2011.

"It's a massive adjustment. A lot has already been done and it's something that's probably been missed by the market," he said. "It's not as though the adjustment has to start from scratch."

MARATHON NOT A SPRINT

Elwin de Groot and Wouter Reijngoud, economists at Rabobank, agreed that Spain had made strides in shrinking its external deficit, reducing unit labour costs and raising productivity.

But barriers to doing business and slow innovation continued to hurt its competitiveness. Preventing long-term unemployment from becoming entrenched was also a huge structural challenge.

De Groot and Reijngoud were not overly impressed either by Spain's fellow strugglers on the euro zone fringe.

"Overall, we conclude that the reform pace in the euro zone's periphery has been disappointingly slow and/or ineffective," they said in a report.

To be sure, early successes for Monti and Rajoy are no guarantee of future triumphs.

Monti's acid test will be whether he can persuade labour unions to accept reduced job security in return for a stronger social safety net. Rajoy needs to bolster Spain's banks and rein in the deficits of powerful regional governments.

And they have to do so under the glare of the markets at a time when quasi-recession and enforced austerity are straining the social fabric.

"There is huge pressure on these economies from rising bond yields, the credit crunch, fiscal tightening and a loss of confidence on the part of economic agents: all of this makes for an extremely challenging environment in which to bring these economies back to growth," Barbieri with Mizuho said.

(Editing by Ruth Pitchford)

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