x Abu Dhabi, UAEThursday 27 July 2017

Euro zone's year for resolve and recovery

Daunting challenges remain, but if leaders can keep their nerve, and avoid complacency as gains are made, 2013 could bring an end to the long-running crisis.

European leaders have laid the groundwork for the euro zone to emerge from its sovereign debt troubles. Alex Domanski / Reuters
European leaders have laid the groundwork for the euro zone to emerge from its sovereign debt troubles. Alex Domanski / Reuters

This year could be a watershed in the euro-zone debt crisis. There is a real chance of the region overcoming the market volatility and fragmentation of the past few years, we believe. And there is also the possibility of an active return of so-called "programme" countries to the capital markets, as demonstrated by Ireland's recent bond issue.

European leaders have laid, or at least announced, much of the groundwork for the euro zone to emerge from its sovereign debt troubles. From today's perspective, it appears that two events last year helped to begin to restore credibility in euro-zone policy.

The first was the June summit that granted flexibility to the European Stability Mechanism (ESM) and started plans towards a banking union. The second came in September with the European Central Bank announcement that it would introduce 'outright monetary transactions' (OMT).

The euro-zone's success in improving its creditworthiness depends, in our opinion, on national and pan-European policymakers' responses to the euro-zone's continuing economic, political and social risks.

Achieving this will take a disciplined and transparent response from policymakers both at national and European levels. We believe they have a challenging but achievable agenda, although implementation risks loom large, given that the ESM and OMT have yet to be used. These risks are the main reason that the majority of our outlooks on our euro-zone sovereign ratings are still negative.

The effectiveness of the OMT, which essentially leverages the ESM, will, critically, depend on the willingness of the governments of borrowing member countries to carry through with measures that will likely be politically and socially contentious.

We believe that the risks for the credibility of the ECB could be significant should a situation arise in which conditions were breached because of a lack of political resolve. This emphasises our opinion that the key to a lasting solution lies with national politicians, not with the ECB. Without resolute and sustained reform progress, the ECB by itself can achieve only temporary respites.

Another key risk, in our view, is any complacency developing along with improving market conditions. This could lead to fragile policy agreements unravelling if some policymakers then believe that the euro zone's troubles have passed and that previously agreed actions can be shelved or watered down. The slower-than-expected process towards a banking union could be interpreted as a waning sense of urgency.

It is too early to conclude that complacency has taken hold, but we believe that the consensus among European policymakers may be more brittle than generally appreciated.

Investor confidence will only return, in our opinion, if member states continue to make progress in rebalancing their economies, both through stabilising public debt and by further reducing external deficits.

We believe that this process of economic rebalancing has still some way to go and will seriously challenge political leaders. But we also believe there is no viable alternative to the rebalancing of the euro zone's troubled economies. The credit-fuelled growth model has gone and the volume of outstanding credit to the private sector is now falling in many affected member states. Achieving rebalancing is a complex and slow process, often taking ample doses of political courage.

The economic and social costs of economic rebalancing could be more easily contained, we believe, if the burden was shared more evenly between the euro zone's core external surplus and the peripheral deficit countries, rather than most of the burden falling on the latter. Safeguards to the social contract may also be necessary in those member states suffering from high unemployment, excessive private leverage, and stagnating or falling living standards.

With the key to a successful crisis resolution in the hands of governments, the electoral calendar remains vital. The elections last year in Greece, France, and the Netherlands resulted in governments that took a generally overall constructive view on crisis resolution.

These elections, in our view, reduced the possibility of contentious discussions among policymakers that could have undermined the delicate confidence of market participants. It is likely that the elections we consider the most important this year - Italy next month and Germany and Austria in the autumn - will similarly lead to a continuation of the current policy path.

All things considered, we believe the challenges in the euro zone remain formidable. We expect this year to be critical in determining whether the downwards trajectory of sovereign ratings in the zone, which had already begun in 2004 with the downgrades of Greece and Italy, willcome to an end.

If the previously mentioned risks do not materialise and we see disciplined policy implementation, progress in economic and fiscal rebalancing and social cohesion, the prospects would indeed be realistic for us to conclude that euro-zone sovereign creditworthiness had "bottomed out".

 

Moritz Kraemer is the head of European sovereign ratings at Standard & Poor's Ratings Services.