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News : EU Economy Last Updated: Mar 11, 2011 - 8:26 AM

Europe will work - - But it needs to strengthen governance, fix banks and reform structural policies
By Finfacts Team
Mar 10, 2011 - 5:41 AM

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'Europe will work - - But it needs to strengthen its governance, fix its banks, and reform its structural policies,' is a major 128-page study on the economic and market prospects for Europe, and particularly the Eurozone, published this week by The Japanese-owned Nomura investment bank, which acquired the European and Asian operations of the collapsed Lehman Brothers, the US investment bank, in September 2008.

The report, is optimistic and says while the Eurozone monetary union had design flaws from the outset, there is strengthening evidence that the policies that are to be announced by Europe's leaders in the 'Grand Bargain' on March 24, are likely to fix many of these issues. As a result, Europe stands to become less prone to the sorts of problems that have been afflicting it, and better able to deal with new types of shock should they occur.

The report takes issue with euro-sceptics who argue that the Eurozone has no long-term future. It emphasises that putting in place the requisite policies to ensure the survival and further development of the Eurozone into a robust monetary union depends ultimately on political will. And the evidence is that this is, and is likely to remain, strong. It says it is hard to envisage the Chancellor of Germany and the President of France not taking all possible steps to keep the Eurozone intact. Neither would seem likely to wish to go down in history as having presided over the dissolution of the Eurozone.

The report, is led by Nomura's chief European economist Dr Peter Westaway and consultant economist to Nomura Dr John Llewellyn. Nomura says both deep experience both of economic policy and of financial markets.

Europe will work - - But it needs to strengthen its governance, fix its banks, and reform its structural policies (pdf)

Commenting on the report, Peter Westaway said: "The outlook for Europe is generally strong and we believe that in time Europe will work, however, in the short to medium term, the Eurozone needs to strengthen its governance, fix its banks and reform its structural policies before any further ground can be made."

With investors in mind, Dr Westaway and Dr Llewellyn examine the European project comprehensively, from its historical, economic, policy, and financial market perspectives.

The viability or otherwise of the Eurozone has major implications for investors and producers in the US and Asia, for a range of reasons, including that Europe is a huge economic area holding 32% of world GDP, bigger even than the US which holds 25% of world GDP. In addition, Europe is a major market for other countries' exports with European imports exceeding US imports from China. Any break up scenario would therefore bring chaos to world financial markets, provoking recession in Europe which in turn would be transmitted powerfully through the trade links to the rest of the world.

From a currency perspective, many countries, including Asian countries, the world's biggest savers, have increasingly been looking to diversify their foreign exchange holdings away from the US dollar. Since the euro was introduced in 1999, the euro's share of global foreign exchange reserves has increased from 18.2% to 26.9%. Hence a judgement about the sustainability, or otherwise, of the Eurozone is fundamental to the plethora of decisions that investors, producers, traders, and other agents have to take, both day by day and over the longer term.

The report begins with an examination of the evolution of the Eurozone from an idea to a final plan of European cooperation; and of the honeymoon period following the formation of the European monetary union. This process has spanned more than 50 years.

The report then documents the development of the current crisis, and explains its principal causes in an analytical "anatomy of the crisis," before discussing the wide range of policy mechanisms which need to be put in place.

Three chapters, written by Nomura fixed income and equity analysts, then examine the substantial changes that have already taken place in the markets as a result of the crisis, and set out likely implications for the evolution of these markets, including in particular the banking sector.

Special attention is also paid to Emerging Europe and its importance to Europe's future. With Estonia being the latest country to join the euro and a further eight countries looking to join, the expansion of the Eurozone could bring collective benefits and speed the recovery.

The report concludes that this current crisis may not be the last. Europe being a collection of individual and individualistic nations, achieving fundamental reform usually requires a crisis. But provided that political will remains, Europe will probably continue to proceed stepwise to sustainability.

The report says:

  • The ECB’s Securities Market Programme, the EU/IMF packages, and the establishment of the European Financial Stability Facility have created breathing room for Greece, Ireland, and Portugal;

  • However, should a private and/or public debt crisis engulf Spain, this would be of systemic importance for the Eurozone: Spain is almost twice the economic size of Greece, Ireland, and Portugal combined;

  •  Hence, for the Eurozone finally to turn the corner, policy needs to create a firebreak before Spain. To do this, Europe must deal with its banks, starting in Spain;

  • The cost of recapitalising the Spanish banking sector could be between €43bn and €80bn. Savings banks are the key risk, but if larger banks can raise enough equity, the cost could be as little as €24bn;

  • Beyond that, Europe, in particular the Eurozone, faces longer-term, wide-ranging issues, some new and some old, spanning macroeconomic, structural, and institutional policies and settings;

  • Large fiscal consolidations are required in Greece, Ireland, Portugal, and Spain. Public sector surpluses will have to be sustained for many years to put public finances on a sustainable footing;

  • There are political limits to the feasible scale of fiscal retrenchment. However, further debt relief could be forthcoming once the banks have been fixed, and countries have eliminated their public sector deficits;

  • Economic growth in the periphery economies is likely to be weak for some years because devaluation is not an option, structural settings are weak, and competitiveness cannot be increased quickly;

  • Economic growth is the prime determinant of sustainability. Structural reforms being implemented in Greece, Portugal, and Spain in particular, have the scope progressively to increase growth in the long term.

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