Eurozone Forecast - Spring edition
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7 Aprilie 2011 |
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ERNST & YOUNG S.R.L. |
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Uncertain prospects puts higher demand on Eurozone business
The findings in the spring 2011 edition of Ernst & Young's Eurozone Forecast are without doubt a sobering analysis of the situation. Recent events in the Middle East and the catastrophe in Japan increase the uncertainties that business is facing. Companies are waiting to see how the various crises evolve, and they use this waiting time to strengthen their internal structures and their relative competitive position. Business leaders would be well advised to monitor the Eurozone's economy continually and in detail.
For the Eurozone, our central scenario is one of a disappointing recovery — less than we would have expected at this stage of the cycle. But there are a number of present day threats that could knock even our central forecast of a 1.5% increase in GDP for 2011. The catastrophe in Japan, the unrest in the Middle East, possible overheating in the emerging markets and the continued evolution of the Eurozone's debt crisis are all significant events in their own rights. It is impossible to give a precise estimate of how they will affect the Eurozone in their combination.
There are also opportunities for the Eurozone that might come from a more rapid expansion than currently envisaged in the shift in resources into green technologies, or into services to cater for aging populations. On balance, however, the downside risks are dominant.
In this environment, we see very little probability of a sustained increase in inflation, beyond the commodity price effects that are currently lifting headline inflation rates. The rise in oil and commodity prices will affect headline inflation throughout this year, but the biggest impact on the economy will be through lower economic growth, not higher core inflation rates. Looking at supply chains and the continued slack in labor markets, it is hard to see where inflationary pressure might arise.
The European Central Bank (ECB) has already signaled a rise in interest rates, possibly as early as April — although the impact of the Japanese earthquake may force a delay. ECB officials have confirmed market expectations of a year-end policy interest rate of 1.75%.
We think it is unfortunate for the ECB to raise interest rates at this juncture, as this policy poses risks to the Eurozone's economic recovery.
The decision of the 11 March Eurozone summit to extend the size of the European Financial Stability Facility (EFSF) was welcome. But its remit remains restricted, particularly on the purchase of government bonds. A number of proposals on economic governance have been made, which go in the right direction but fall short of a significant move toward fiscal transfers. This underlines the fact that, as yet, there is no all-encompassing crisis resolution path. Individual member countries remain keen to limit their own financial exposure, but the multitude of solutions they offer do not constitute a coherent approach that could explain how and when debt sustainability is likely to be achieved in the Eurozone'speripheral countries.
The same goes for the efforts to resolve the ongoing banking crisis. Last year's stress tests suffered credibility when Irish banks were bailed out only a few months after passing the tests with glory. The new tests remain essentially unchanged in the most important dimensions — no stress test of banks' banking books for sovereign default, and still unrealistically optimistic assumptions about house price developments in the Eurozone's peripheral countries.
A further risk is the impact of the various austerity programs on economic growth. This, in our view, tends to be widely underestimated in national capitals. European governments tend to assume the world remains unchanged as they pursue a solitary austerity program, but this assumption breaks down if everybody does the same.
And finally, we have yet to understand the longer-term impact of the 2009 recession. This is particularly important for future investment decisions by companies. It is likely that some economic activity has been lost for good; for instance, construction sectors that will not return to pre-crisis levels for many years or manufacturing sectors that have shifted production to other locations. On our projections, unemployment will remain at above pre-crisis levels at least until 2015, which augurs increasing social tensions ahead.
A strategic corporate planner, when faced with such an extreme set of uncertainties, would have to take all these developments into account. We are already observing a trend that companies are putting off large strategic investments and focusing on smaller projects, for example, investments in productivity-enhancing technologies. We expect to see this trend continuing.
Excessive restraint exercised by the corporate sector may in itself contribute to the crisis, but it would be wrong to advocate a strategy to completely disregard risks in the pursuit of reward. There is a strong case for companies to use this crisis to rethink their global strategies and diversify away from the Eurozone. There is however, in our view, scope for strategic investments within the Eurozone, in sectors with big growth potential. One important sector is renewable energies, such as solar power plants and wind parks. A trend we have been observing, and are expecting to continue, has been vertical supply chain integration, which is what we would expect when business decision-makers are becoming more risk-averse.
A particular factor to watch is the development of corporate taxes. Policy-makers have so far avoided raising corporate taxes to reduce their deficits. This is undoubtedly good news from the perspective of the corporate sector. But there is concern that this trend may be changing. The European Commission's most recent proposals for a unified tax base are certainly justified from the perspective of an internal market, especially to help smaller companies operate in other European Union(EU) countries. But one has to watch out that these changes will not produce higher overall corporate tax charges. The measures, as designed by the European Commission (EC), would not have such an effect, but a final compromise may only be possible if taxes were raised to overcome political opposition.
The debate about the corporate tax rate in Ireland is particularly important in this context. A rise in corporate tax rates, as demanded by France and Germany, would destroy probably the main chance Ireland has to increase its future economic growth — a precondition for solvency. Ireland, with its skilled workforce and a strong network of high-tech companies, is uniquely placed to benefit from inward investments from US companies. If Irish tax rates were forced to go up, it would be hard to see which alternative strategies the country could deploy to achieve solvency.
Simple tax base harmonization may, however, be different, and Ireland may find it acceptable to agree to the EU's proposals on the understanding that the actual tax rate remains sacrosanct. To conclude, we see a set of uncertainties on the Eurozone market that the business community should take into account for strategic planning:
- The expected rise in interest rates decided by the ECB
- Failure from EU policy-makers to agree on an allencompassing resolution path to solve the debt crisis
- The austerity programs' impact on economic growth
Understanding the economic development, long term and short term, and being proactive are key factors for successful companies operating in the Eurozone. We note that they are keeping track of compliance issues, continuously improving their performance, strengthening their ability to compete by investing in enhanced technique and competences, and securing their operations and growth by choosing a vertical supply chain strategy.
BANKING SECTOR PERSPECTIVES
Policy and regulatory risks
One of the principal objectives of the financial authorities, as they consider the reforms needed to prevent recurrence of the financial crisis and the Basel III reforms, is that banks should be financially more resilient. Basel III will be adopted in Europe through the implementation of the Capital Requirement Directive (CRDIV). In practice, this means there will be much more — and higher-quality – capital as well as tough new liquid asset requirements, and European banks will need to increase their capital; some private sector estimates for this have been as high as €1 trillion. The new liquidity requirements mean that scarce liquid assets will be tied up for regulatory purposes. The impact of these changes will be exacerbated when the ECB and other liquidity suppliers start to withdraw the extraordinary support they have provided in response to the crisis.
The main impact for banks will be a significant reduction in their profitability. Many banks are now publicly reducing their RoE (return on equity) targets and questioning the viability of some business lines – in particular, in derivatives, where capital weights for trading assets are increasing severalfold and the authorities are mandating a move toward central clearing and more standardized contracts. In addition, bank balance sheets are likely to contract further as they become increasingly constrained by tougher capital and liquidity requirements.
But bank lending, particularly to small businesses, has a critical role to play in supporting economic recovery in Europe, and is being strongly encouraged by governments. Banks need to take a more strategic approach to managing their balance sheets so that they can deploy their scarce capital and liquidity profitably and, therefore, continue to attract new investment capital, as well as meeting political demands.
