Vol 8 (2011) - Issue 6

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The What? So What? Now What?

Events in Europe continue to dominate. The late-October triple whammy of the Greek and Italian political crises and the disappointing G-20 outcome dampened the hopes for the successful implementation of the 27 October summit.

The question we address is whether the global economy will decouple from the Euro zone, which appears to be falling into recession. We are encouraged by several developments we discuss below. But first, where do we stand?

The 'What'? On 9 November, Italian yields reached above the 7% level, a level that forced bailout monies for Ireland, Portugal, and Greece.

The 'So What'? Two adverse developments are likely if no action is taken:

– Italy would drift further away from solvency.

– Market liquidity drops, volatility rises and counterparty risk produces renewed credit-crunch and contagion effect by affecting entities and regions dependent on European banks for funding.

The 'Now What'? Aggressive monetary and rebalancing policies must secure the integrity of the Euro zone.

– Large scale ECB bond purchases, i.e., quantitative easing (QE), are necessary in our opinion. For now, that is unlikely, as the ECB continues to buy limited amounts of Italian bonds, constrained by the European Treaty. In doing so, it plays a crucial 'safety-net' role but one that is not enough to restore growth. Hence the rising risk of recession.

– Wider regional and global rebalancing between creditor and debtor countries must take place. Germany and other creditors should be more aggressive and action should be taken in quickly increasing the fire-power of the EFSF. Finally some reversal of global capital flows is part of the longerrun solution. It would take the form of IMF-led emerging market capital injection and/or more specifically emerging market (Chinese) foreign direct investment. We suspect China is not necessarily interested in adding European sovereign bonds to their US bond-laden portfolio, unless it is the first step toward purchases of European real assets. Chinese official reserves have risen dramatically over the last decade (Exhibit 1) as have their FDI outflows (Exhibit 2). While China FDI outflows are now the fourth largest in the world, they are still small in absolute terms.