By Russ Koesterich, global chief investment strategist, iShares
The good news is that in aggregate, Europe is solvent. By lowering bond yields the European Central Bank has also bought politicians time, but they must use this respite to address the structural flaws that hamper growth and leave the banking system at risk.
While Europe’s politicians have shown some resolve in addressing these issues, they will need to act with a greater degree of urgency. The question is: can Europe’s political class move fast enough to satisfy financial markets and address economic realities? We see three main requirements for further reform in Europe which would go towards this. Firstly, Europe needs to move towards a tighter fiscal union, and must come together on a mechanism that at least partially pools sovereign obligations. While the term Eurobonds has gained in popularity, there are many versions this arrangement can take. At its most complete, full Eurobonds would entail that all euro-area sovereign financing be raised through common bonds. The path toward closer fiscal integration needs to be based on an explicit bargain: northerners agree to some form of joint liabilities in return for credible guard rails on spending and budgets of all euro zone members. Given the implied loss of sovereignty it will likely be a slow, tortuous path getting there.
We are beginning to see separatist movements and tensions in countries such as Spain, which will only exacerbate the difficulties. Another area where Europe appears vulnerable is its banking system. Ireland was a cautionary tale of what happens when a country’s banks grow too large compared to the overall economy. Ireland was a particularly acute case, but the problem is endemic throughout much of Europe. Overall European financial debt is 142% of GDP, double the level of Canada or the United States. This highlights that a critical area for near-term reform is the banking sector. In particular, Europe will need to both recapitalise and better regulate its banks. Europe must also simply grow faster. Achieving faster growth will require addressing several labour market and other rigidities that have thus far resisted all attempts at reform. In particular, southern Europe will need to regain its competitiveness and rein in its labour costs. Unit labour costs in southern Europe have been rising at a much faster rate than in the north of the continent. As a result, much of southern Europe has lost its competitiveness with the northern part, particularly Germany. All of these reforms are economically viable, and should ultimately improve Europe’s long-term growth potential, but they will be politically difficult and investors are likely to be periodically frustrated along the way. Politicians face entrenched interests that will seek to slow or block reform. Some reluctance on the part of politicians themselves is to be expected. In one form or another, fiscal union will entail some loss of sovereignty for all of the nations in the European Union. While the political desire for a more integrated Europe may be sufficient to overcome the inertia, it will still take several more years to address all the outstanding issues.
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