Eurozone: les stress but still tested
I am almost ashamed to admit it: I am a big fan of Michael Bay’s blockbusters. My favorite is The Rock (1996), but a close second is Armageddon (1998). When I envision the latter, I am reminded of the current state of the Eurozone.
Don’t get me wrong. I am not saying that the common currency is on the verge of extinction, about to be hit by a giant asteroid. The metaphor is more subtle. In the movie, there is a scene where the space shuttles sent to destroy the asteroid have to refill at a Russian space station. In this ailing space station, a lonely cosmonaut runs around trying to fix it with duct tape, tightening nuts and bolts and hitting some old and hazardous machinery with a huge hammer whenever it stutters.
For over five years, the Eurozone has been this ailing space station. Jumping from one acute phase to the next and managing to find some quick fixes, usually in the form of a new acronym (remember the EFSF, EFSM, ESM, SPIV, MFF, PSI, OMT, LTRO, EFS aka FST, etc.?) but not addressing the deeper construction flaws of the monetary union.
The latest fix in this long chain of acronyms was the AQR (Asset Quality Review), also known as the “stress test,” aimed at preparing 130 Eurozone banks to enter on 4 November into the SSM (Single Supervisory Mechanism), which will work in tandem with the SRM (Single Resolution Mechanism) under the umbrella of the European Central Bank, practically creating a Eurozone banking union.
The results of the AQR unveiled on 26 October were in line with expectations. Some 25 out of the 130 banks failed it, with a capital shortfall of 25 billion euros. But as many of those banks found fresh capital before the results were published, only 13 banks actually failed, with a capital shortfall of 9.5 billion euros.
Given the benign size of the capital shortfall (only 0.04% of the Eurozone lending system’s 22 trillion euro balance sheet) and the fact that most of the banks that failed are not even listed, there was a sigh of relief. Indeed, there are some reasons to be even a little optimistic about the next couple of quarters for the Eurozone, not only regarding its banking system but also the macro picture.
As I have explained several times here, one of the weaknesses of the Eurozone compared with the US has been the lack of credit growth (even worse, the continued decline in credit activity). In the US, credit growth resumed by mid-2012 and allowed the country to finally return to some kind of business cycle normalization (including a bottoming out of the housing market). The Eurozone is currently lagging the US by two and a half years.
With the uncertainty in the financial sector finally lifted thanks to the AQR, and with the measures announced in September and reiterated in October by the ECB (we expect to learn more at the ECB meeting next week), one can assume that Eurozone banks will be more willing to lend. However, it remains to be seen whether the other half of the bargain, the private sector’s willingness to borrow, will respond to this. Hence, to assess the short-term evolution of the Eurozone, it is crucial to follow all the lending statistics over the next couple of months.
Some critiques say the AQR process was not robust enough. UBS senior economic advisor George Magnus, for example, says it was a “huge omission” for the ECB to ignore the risk of deflation while performing the AQR. “Most of the Eurozone periphery is already in deflation. They can’t just leave this out of their health check. It is a matter of basic due diligence.”
However, while some might view the AQR as another quick fix, we shouldn’t forget that its primary purpose was to bring the major European banks within a European banking union. Hence, while I am still uncertain about the short-term impact, I am convinced that this improvement in the overall architecture of the Eurozone will allow it to fly a little bit longer than without a banking union.