CICC - The Big Dark Cloud by riteshbhansali


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									                                                                                                              Macro Brief
  July 9, 2012                                             Overseas Economies                                                     RESEARCH
Michael CHUI                       Jieyun WU
SFC CE Ref: AYC483                 SFC CE Ref: AXQ260                     The Big Dark Cloud is Still Hanging  
                                                                                         Over the Euro Area
The sentiment in the financial markets has continued to improve amid a large black cloud of uncertainty hanging over
the global economy. In Bank of England Governor Mervyn King’s words: “The black cloud has dampened animal spirits, so
that businesses and households are battening down the hatches to prepare for the storms ahead. The result is that lower spending
leads to lower incomes and a self-reinforcing weaker picture for growth.” Indeed, incoming data suggests that global growth
momentum is loosing steam. This has prompted the European Central Bank and the Bank of England to loosen their policies last
week to boost growth. While central banks have been at their innovative best to diffuse the dark cloud, decisive actions from the
governments are still required to completely restore market confidence. In this sense, the meeting of the euro area finance
ministers on Monday will be a key event to watch as markets are expecting some further details about the financial assistance to
Spanish banks as well as the roadmap on the banking union. If the meeting conclusions fall short of market expectations, that
could trigger another bout of volatilities.

Market sentiment has generally improved but nervousness remains in some sectors. The outcome of Greece’s general
election and the euro area summit agreement have contributed to a significant improvement in investor sentiment. Equity and
credit market uncertainties, as measured by the option-implied volatilities of equity indices and investment-grade corporate CDS
spreads, have declined markedly since early June (Figures 1 & 2). Ireland even managed to return to the bond market for the
first time in almost two years and sold €500mn of 3-month government bills at a yield of 1.8%. However, as the week wore on,
investors appeared to be getting increasingly frustrated about the lack of details in the euro area summit agreement. The news
that the Finnish and Dutch governments might oppose the European Stability Mechanism (ESM) to buy sovereign bonds in the
secondary markets has exacerbated the investor nervousness. Consequently, 10-year benchmark Spanish and Italian government
bond yields rose back to ~7% and ~6% on Friday respectively (Figure 3).
   Figure 1: Option-implied volatilities of equity indices                     Figure 2: Investment-grade corporate CDS spreads

                          Stoxx 50             S&P 500                                         CDX North America         iTraxx Europe




                                                                         20                                                                     100

                                                                          10                                                                     50
    2008/01    2008/10   2009/07     2010/04    2011/01   2011/10   2012/07     2008/01   2008/10   2009/07   2010/04   2011/01   2011/10   2012/07

   Source: Bloomberg                                                           Source: Bloomberg

Meanwhile, incoming data suggests that the weakness in the European economic outlook continues. The euro area
manufacturing purchasing managers’ index (PMI) remained unchanged at 45.1 in June (Figure 4). A reading below 50 signals a
contraction. Importantly, the heightened tensions in the euro area appeared to have impacted on Germany’s economic prospects.
Germany’s PMI fell to a 3-year low of 45 in June and the country’s new orders for Germany’s plant and machinery industry fell
6% YoY in May. Meanwhile, the euro area labour market conditions continue to deteriorate with the overall unemployment rate
rising to 11.1% in May – a euro-era record. Whereas Germany’s unemployment rate stayed at 5.6%, while Spain’s rose to 24.6%

                              Please read carefully the important disclosures at the end of this report
                                                                                                                       CICC Research: July 9, 2012

  Figure 3: Italian and Spanish 10-year government bond                                Figure 4: The euro area and Germany manufacturing
  yields                                                                               PMI
                                   Italy       Spain                                                                 Euro area        Germany                     70

                                                                                 7.0                                                                              60


                                                                                 6.5                                                                              50


                                                                                 6.0                                                                              40


                                                                              5.5                                                                                 30
    2012-06-01   2012-06-08   2012-06-15   2012-06-22     2012-06-29   2012-07-06       2008            2009           2010               2011         2012

  Source: Bloomberg                                                                    Source: Bloomberg

Against the backdrop of the fragile financial market and weak economic outlook, the ECB and the Bank of England
loosened monetary policy further to boost growth. As widely expected by market participants, the Bank of England kept its
interest rate unchanged but announced further quantitative easing. The ECB governing council decided unanimously to cut its
benchmark interest rates by 25 basis points, taking its main refinancing operation rate and interest rate on deposit facility to
0.75% and 0% respectively.

The effectiveness of monetary easing is dampened by the dark cloud of uncertainty. Currently, monetary transmission is
severely impaired, resulting in low credit growth in many parts of Europe. Two important factors have contributed to the weak
credit demand. First, the large black cloud of uncertainty has raises households and corporations’ risk aversion, leading to a
general weakness in credit demand. Second, the pressure on banks to rebuild their balance sheets also weighs on banks’ ability
to lend. As we believe that the interest rate cut will at best have marginal effect in easing these two factors, it is unlikely to kick
start the real economy in the area.

But the ECB’s action can provide some breathing space for the troubled banks in Spain and Italy. The reduction in ECB’s
main refinancing operation rate will mean that the banks that borrowed some €1,100bn longer-term refinancing operation
(LTRO) loans will pay less interest. Banks in Italy and Spain, which account for 54% of the total LTRO outstanding, will
therefore benefit most from the cut in the rate (Figure 5). Furthermore, home owners in Spain will also benefit from the rate cut
as most mortgages are floating-rate loans that tie to the ECB interest rate. Meanwhile, Italian and Spanish banks will not be
affected much by the 0% deposit rate as they are not heavy user of the ECB facility. By contrast, deposits by German banks at
the ECB, which represent more than 1/3 of the total, will not earn any interest anymore (Figure 6).

  Figure 5: LTRO by country (€ bn)                                                     Figure 6: Deposits at the ECB by country (€ bn)
         Euro area total         Germany                                     1200              Euro area total        Germany                                 1200

         Spain                   Italy                                                         Spain                  Italy
                                                                             1000                                                                             1000

                                                                             800                                                                              800

                                                                             600                                                                              600

                                                                             400                                                                              400

                                                                             200                                                                              200

                                                                             0                                                                                0
    Jan-09   Jul-09    Jan-10    Jul-10    Jan-11       Jul-11   Jan-12                  Jan-09    Jul-09   Jan-10    Jul-10     Jan-11     Jul-11   Jan-12

  Source: ECB and national central banks                                               Source: ECB and national central banks

                                Please read carefully the important disclosures at the end of this report
                                                                                             CICC Research: July 9, 2012

Facing a weak economic outlook, the Bank of England launched further quantitative easing to boost the economy. The
UK economy is currently in recession. The Bank of England decided to keep interest rates unchanged at 0.5% but increase the
size of its Asset Purchase Programme (ASP) by £50bn to £375bn to boost the economy. This was the second time this year the
Bank of England expanded its ASP. In February this year, the Bank increased the programme by a similar size to a total of
£325bn. For similar reasons to the euro area, the UK economy is suffering severe impairment in the monetary transmission
channels. Thus we believe that the growth impact of the expansion of the quantitative easing will also be marginal.

With existing policy tools losing their effectiveness, central banks may have to be more innovative in developing new
tools to either calm the financial markets or to boost growth. While leaving the door open for further stimulus, ECB
President Draghi hinted that the central bank is unlikely to launch another 3-year LTRO, as some countries’ banking systems are
awash with liquidity. Specifically, he discounted the press speculation that the ECB will scrap the ratings-based collateral
eligibility standards to effectively allow banks to borrow more from the central bank. Furthermore, the interest rate on its deposit
facility is now at zero percent. While practically, the ECB can lower that rate further, i.e., to start charging banks to park money
in its deposit facility, that could have other implications. For example, when the ECB purchase sovereign bonds under its
Securities Markets Programme (SMP), it needs to sterilise the liquidity injection through its deposit facility. But the zero deposit
interest rate is likely to pose problems for the sterilisation operation in the event the ECB decided to resume its SMP. Against the
background of institutional and practical constraints, we expect central banks will become more innovative in their policy
decisions. In particular, we would not be surprised to see more central banks in the developed world to engage in directed
lending to boost growth.

Ultimately, the onus of removing the dark cloud lies within the governments. As long as the large black cloud is still
hanging over the global economy, corporations and consumers will be hesitant to spend while banks are unwilling to lend. And
the uncertainty is created by the twin weaknesses in the balance sheets of governments and banks. To help lower this
uncertainty, governments need to show the public some clear direction. In this regards, the euro area finance minister meetings
on July 9 could bear important consequences on the financial market developments. The ministers should lay out the
conditionality of the proposed bailout of up to €100bn for Spain to recapitalise its banks as well as a clear timetable towards a
banking union. Failing to do so could roil the markets!

                         Please read carefully the important disclosures at the end of this report
                                                                                                                            CICC Research: July 9, 2012

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