Europe: What a Recovery Will Look Like

S&P Ratings says an economic rebound will be uneven, with availability of financing a key concern

By Jean-Michel Six, Standard & Poor's From Standard & Poor's RatingsDirect

Higher costs of capital and the unwinding of excessive leverage burden recovery prospects as Europe emerges from recession. In Standard & Poor's view, the path to recovery will be long and narrow. Consumer demand is likely to be weak in indebted countries such as Spain, the U.K., and Ireland, while the sharp deterioration in public-sector finances across the region looks set to constrain any growth from that quarter. However, the overarching factor weighing on recovery is limited financing.

A Solid Upswing, but Not for All

The latest worldwide economic data generally confirm that activity started to pick up during the summer months and that a fairly solid upswing is currently under way in a number of key economies, notably Germany and France. The Purchasing Managers Indices (PMIs) for October show a well-synchronized lift, with all regions now having crossed the 50 line that indicates a return to positive growth. Meanwhile, initial Eurostat estimates for the third quarter of 2009 show that the recovery within the EU remains uneven, with highly indebted countries remaining mired in recession between July and September. Spain's GDP, for example, slipped 0.3% (after falling 1.1% in the second quarter).

In the U.K., GDP fell 0.4% (5.2% year on year), marking the sixth consecutive quarter of contraction. So far, the U.K. economy has fallen 5.9% from its peak reached in the first quarter of 2008. This is far worse than the peak-to-trough decline from 1990 to 1991, and in line with that between mid-1979 and early 1981. In Germany, Europe's largest economy, on the other hand, GDP rose 0.7% in the third quarter, up from 0.4% in the second quarter. The French economy expanded 0.3% in the third quarter, while that of Italy rose 0.6%.

Overall GDP in the euro zone rose 0.4% from the second quarter, when it fell 0.2%. Year on year, euro zone GDP was still down 4.1%, however, a reminder of the severity of the recession.

Competition for Funding Is Bound to Grow

At the end of October, the European Commission published its latest economic forecasts for EU member states. In this report, the Commission begs the question: What sort of new equilibrium can be expected for EU economies in the coming two years? While acknowledging that with so many uncertainties still prevailing it's still too early to draw a definitive picture, the Commission points to several key forces likely to define the contours of that new equilibrium. In summarizing some of the Commission's main findings below, we will also add our own perspectives.

First, the Commission notes that it's reasonable to expect a higher cost of capital following the financial crisis, mainly due to higher risk premia than in the pre-crisis period. What's more, says the Commission, investors are now aware of the consequences of mispricing risks. Higher financing costs are going to have important implications with respect to the sustainability of public debt in the future. In a period of low or negative economic growth, when interest rates exceed nominal growth, interest payments tend to result in a rising debt-to-GDP ratio, making public debt look less sustainable. Between 1997 and 2007, the gap between interest rates and nominal growth turned sharply negative for countries such as Greece, Spain, Ireland, and Portugal. In the case of Germany, France, and Belgium, the gap was positive, but diminishing between 2004 and 2007.

In the years to come, higher interest rates combined with slower economic growth are going to make public debt sustainability harder to maintain, regardless of the actions taken by the fiscal authorities in terms of reducing their public deficits.

While this is an important consideration affecting future economic prospects, we would also draw attention to another dimension affecting the financing of the current recovery. We will call this the consequences of regulatory uncertainties. Since the beginning of 2008, money supply growth has been steadily decelerating in the euro zone and in the U.K. The major counterparts of money supply—credit to households and to nonfinancial corporations—follow a similar trend, loans to companies declining in September 2009 compared with a year earlier.

Meanwhile, the only money supply component showing constant growth over this period is what's called "credit to the general government," which rose 13.6% year on year in September. Such credit covers the purchase of sovereign bonds by financial institutions. Bonds are still a modest fraction of banks' and insurance companies' total assets; 4.3% in the euro zone and 4.4% in the U.K., compared with 12.5% in the U.S. But with financial institutions subscribing to more than 55% of all new sovereign issuance so far this year, we believe that proportion is likely to grow substantially.

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