Analysis: No respite for euro zone in long rebalancing slog

LONDON Tue Jan 22, 2013 3:12am EST

A picture illustration taken with the multiple exposure function of the camera shows a one Euro coin and a map of Europe, January 9, 2013. REUTERS/Kai Pfaffenbach

A picture illustration taken with the multiple exposure function of the camera shows a one Euro coin and a map of Europe, January 9, 2013.

Credit: Reuters/Kai Pfaffenbach

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LONDON (Reuters) - The euro zone crisis is entering a new, treacherous phase for governments, which can only cross their fingers that slow-burn reforms will pay off before voters get fed up with austerity and high unemployment.

On the face of it, 2013 should be a much less traumatic year than 2012 for the 17-nation single-currency area.

Financial conditions have improved enormously since the European Central Bank promised to do whatever it takes to preserve the euro. Yields on the bonds of highly indebted peripheral countries have fallen sharply, bank funding strains have eased and stock markets have rallied.

Countries on the southern rim of the euro zone have made big strides in reducing their budget and trade deficits. They are no longer living way beyond their means. They have also introduced politically touchy structural reforms, notably to make their labor markets more flexible.

But demand is likely to remain weak, while unemployment, already at a record 11.8 percent, is forecast to rise further before it comes down. Recovery will be slow.

"They've taken the medicine, but they're not going to jump out of bed straight away," said Sebastian Barnes at the Organisation for Economic Cooperation and Development in Paris.

"The problem is bridging the gap over the next two or three years when you're putting in place the right policies but they're not quite bearing fruit. So it's a question of managing public expectations," Barnes, adviser to the rich-country forum's chief economist, added.

RISKS REMAIN

Berenberg Bank said all forward-looking indicators point to a resumption of growth this spring, which should further reduce the euro zone's aggregate fiscal deficit to below 2.5 percent of GDP in 2013. It stood around 3.4 percent last year, down from 4.1 percent in 2011.

What's more, Italy, Spain, Portugal, Ireland and Greece shrank their combined current account deficit to an estimated 1.5 percent of GDP in 2012 from 7 percent in 2008 and look set to balance their external accounts this year.

But Holger Schmieding, the bank's chief economist, said the single currency was not out of the woods yet.

"Despite impressive progress, serious risks remain. The euro zone needs growth in its major markets abroad and the political patience to stay the course at home," he said in a note.

A nagging worry is that the euro zone is making up for its economic mistakes through what Barnes calls "bad rebalancing".

So, while rising exports have played a role, the improvement in the periphery's current account has been achieved mainly by slashing imports.

And the reduction in relative wage costs needed to bring about ‘internal devaluation' - the only devaluation available in the absence of exchange rate flexibility - has so far been engineered disproportionately through a rise in unemployment rather than wage moderation.

Ireland is a notable exception - as is Britain outside the euro zone - and Barnes said there were encouraging signs elsewhere, for example in Spain.

Italy, however, has barely touched its wage bargaining system. "The problem there is that wages have run ahead of productivity," he said.

LET'S GET STRUCTURAL

Gilles Moec, an economist with Deutsche Bank in London, also frets about Italy. Italy has its government deficit under control, but Moec sees signs of a growing ‘employment overhang', linked to what he says is extremely slow financial rebalancing by the private sector since the onset of the crisis.

This is reflected in a rise in employee compensation in Italy as a percentage of corporate value-added to 57.7 percent from 52.5 percent in 2007.

By contrast, in Spain, where unemployment of 25 percent is more than twice as high as Italy's, the wage share dropped over the same period to 55.9 percent from 64.7 percent.

Rebalancing, in short, is far from complete. That is true for creditor countries, too. Germany's current account surplus is stuck at a stubbornly high 6 percent of GDP, reflecting weak investment and consumption.

Goldman Sachs has attempted to measure the progress being made in ironing out the imbalances by updating its estimates of the real exchange rate changes needed to bring countries' net debt positions - the result of accumulated annual current account deficits and surpluses - back into broad equilibrium.

In keeping with improvements in their current accounts, Greece, Portugal and Spain now require an inflation-adjusted depreciation that is about eight to 10 percentage points lower than two years ago, Goldman reckons.

Still, the remaining adjustment is huge - about 25-30 percent in the case of Spain and around 15-25 percent not only in Greece and Portugal but also in France, where employers and unions this month agreed on a package of labor reforms to restore competitiveness.

Germany, incidentally, requires a real appreciation of 15-25 percent.

Instead of higher unemployment and lower wages, structural reforms offer a less painful path to rebalancing, Goldman said.

Switching resources to exports from domestic sectors such as construction in Spain and public services in France would reduce the need for further real exchange rate depreciation.

"But adopting such reforms is not painless: the potential loss of political capital from vested groups standing to lose existing privileges can prevent politicians from implementing the necessary reforms. This remains true across most of the periphery, in France and Germany," wrote Goldman economist Lasse Holboell W. Nielsen.

Barnes with the OECD said all countries could do more, but the lack of reform in bigger economies, including France and Germany, was a particular concern.

The OECD's research suggests that, contrary to received wisdom, structural reforms can yield positive results within a year or two, notably by catalyzing investment and jobs. In turn, that can have an impact on public perceptions.

"I don't think in any of these countries the reforms are sufficient for what they should be achieving in the long run," Barnes said. "But just getting reform on the agenda and getting people to recognize that the system needs to change, and is going to change, is very important."

(Editing by Will Waterman)

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Comments (3)
reality-again wrote:
The Euro itself is the problem.
It’s a dysfunctional currency.

Jan 22, 2013 8:04am EST  --  Report as abuse
Eric93 wrote:
With current acount surpluses in Germany and deficits in the other countries, and high productivity in Germany and low in the others, it is obvious that they don’t all belong in the same currency zone. But of course the political buffoons and ‘true believers’ will continue their chcharade till ‘reality’ strikes them down for the final count.

Jan 22, 2013 1:35pm EST  --  Report as abuse
dareconomics wrote:
According to the mainstream media, there is a dramatic rebalancing underway in the Eurozone that should solve all of its problems within a few years. While there has been some improvement in economic numbers, journalists do not understand that the size of these improvements is not large enough to make a dent in the imbalances plaguing the the Eurozone. There is plenty of misinformation in this article that must be debunked. The opening passage of the article is a good place to start.

Countries on the southern rim of the euro zone have made big strides in reducing their budget and trade deficits.They are no longer living way beyond their means.

The PIIGS have reduced their trade deficits, but their budget deficits remain high. The reduction in trade deficits has come primarily from declining imports, because people are cutting back spending in the face of double-digit unemployment rates. With budget deficits ranging from 4% in Italy to over 13% in Ireland, these countries are still living above their means.

They have also introduced politically touchy structural reforms, notably to make their labor markets more flexible.

This is the most repeated misconception in the Eurocrisis. There has been virtually no movement on this front. In Italy, reforms were watered down so that they were rendered meaningless. In Greece, bureaucrats simply ignore legislation passed by Parliament. No matter what these outlets report, it is still difficult to fire workers in all of the PIIGS so that youth unemployment remains high. The only country that has passed and implemented labor reforms is Germany, and Chancellor Schroeder promptly lost his job. Don’t think this lesson has been lost on PIIGS politicians.

Berenberg Bank said all forward-looking indicators point to a resumption of growth this spring, which should further reduce the euro zone’s aggregate fiscal deficit to below 2.5 percent of GDP in 2013.

Believe this only when you see it. PMIs remain below expansion levels in the entire Eurozone. Budget cuts will continue to reduce growth in the large countries of Spain, Italy and France. Moreover, the problem with Eurozone indebtedness is not the total but the divergence between the core and periphery. No one doubts that the FANG have their deficits under control, but the periphery’s are still rising. This information confirms that the euro is driving the countries into two zones. As long as this imbalance persists, so will the Eurocrisis.

Switching resources to exports from domestic sectors such as construction in Spain and public services in France would reduce the need for further real exchange rate depreciation.

This is a great idea except for it being impossible to implement. Every country is trying to increase exports at the same time to improve growth, but there is only so much demand in the world. It’s a zero sum game, unless all of these countries increase their interplanetary trade. I understand that the depreciation of the euro versus the quatloo will result in increases in exports to the rest of the Universe.

Europe is just not doing enough to solve these problems. Internal imbalances have not improved as much as needed, and at the present rate of change will take decades to right themselves. The Eurozone does not have decades, just years and maybe only months.

dareconomics.com

Jan 23, 2013 1:10pm EST  --  Report as abuse
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