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from MacroScope:

All eyes on Wednesday EU summit

After last week’s hefty losses, European stock gained yesterday and are up up again this morning, denoting some optimism about the Wednesday supper summit of EU leaders, which might well be unrealistic.

The European growth measures that we know are in the works – boosting the paid-in capital of the European Investment Bank and plans for 'project bonds' underwritten by the EU budget to finance infrastructure – might help a little but will fall a long way short of turning the euro zone economy around, so unless we get something more, on either the growth or the building defences fronts, there’s scope for investor disappointment.

Europe’s international partners continue to demand more dramatic crisis action. After the G8 summit, President Obama was out last night with four demands: - firewalls to protect countries from Greek contagion (are the ESM and IMF funds now viewed as insufficient?), - recapitalization of banks that need it (Spain to the fore here presumably), - A growth strategy to run alongside tight fiscal measures (easier said than done), - easy monetary policy to help the likes of Italy and Spain keep cutting debt (the ECB thinks its 1 percent rate is very loose and is unlikely to cut soon with inflation above target and will only flood the system with more liquidity in utter extremis)

Nothing new there but it keeps up the drumbeat of pressure ahead of the EU get-together. We know French President Francois Hollande, with the backing of others, will press the case for common euro zone bonds at the summit and also know that German opposition will not weaken one jot on that score. Spain’s Rajoy is pressing for more ECB involvement, presumably by reviving its bond-buying programme. Given internal opposition to that within the ECB that is probably the least likely measure to be reactivated, yet anyway.

Despite money flowing out of Greek banks, and at least the threat of it spreading more widely if Greece bombed out of the euro zone, there is no hint yet of any planning for any scheme to underwrite bank deposits across the bloc, probably because the ECB and Germany will not countenance underwriting it. The golden rule of this crisis is that red lines have and will be crossed when it reaches breaking point. We’re not there yet.

With so much focus on Greece and Spain, Portugal has been somewhat overlooked in recent weeks but it will quite likely need a second bailout at some stage and if Greece prompts a wave of contagion, it will be firmly and instantly in the firing line.

from Breakingviews:

Greek dilemma might come to head before next poll

By Hugo Dixon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

So the world has to wait until June 17 to find out whether Greece stays in the euro? Not so fast. Things might come to a head even before the next poll if deposit flight accelerates.

Greece’s president said earlier this week that 700 million euros had left the country’s banks on Monday. The pace seems to have accelerated, as savers get more concerned that the political mess will drive Greece out of the single currency. Deposit flight is now running at 1-1.5 billion euros a day according to one senior banker. If it continues at that rate, another 20-30 billion euros could have left before election day.

Such an outflow is probably manageable. After all, Greece’s bank support fund is to inject 18 billion euros of capital into lenders next week. The real problem would be if there was a panic and say half of the system’s remaining 160 billion euros or so of deposits tried to flee.

The European Central Bank has already made 127 billion euros of liquidity available to the Greek banks - both directly through its own refinancing operations and by authorising the Greek central bank to offer emergency liquidity assistance. So it would anyway face massive losses and require recapitalisation in the event of a Greek exit. But if those losses mushroomed in a matter of weeks, the ECB’s credibility would be badly damaged.

But stopping liquidity isn’t attractive either. The Greek government would have to impose capital controls even before the electorate had a chance to vote. That conceivably might concentrate the voters’ minds. But it could also stir up anti-euro feelings in Greece and provoke a panic in other peripheral countries.

from Global Investing:

Three snapshots for Monday

The yield on 10-year  U.S. Treasuries, fell to their lowest levels since early October today, breaking decisively below 1.80 percent. That compares to the dividend yield on the S&P 500 of 2.28%.

The European Central Bank kept its government bond-buy programme in hibernation for the ninth week in a row last week. The ECB may come under pressure to act as  yields on Spanish 10-year government bonds rose further above 6% today.

Output at factories in the euro zone unexpectedly fell in March, the latest in a series of disappointing numbers signalling that the bloc's recession may not be as mild as policymakers hope. On an annual basis, factory output dived 2.2 percent in March, the fourth consecutive monthly slide, Eurostat said, and only Germany, Slovenia and Slovakia were able to post growth in the month.

from Breakingviews:

Euro zone carry trade has limited shelf life

By Neil Unmack and Fiona Maharg-Bravo

The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The carry trade is alive and well in Spain and Italy. Banks are loading up on sovereign debt, thanks to the wave of liquidity from the European Central Bank’s cheap three-year loans. But local lenders can’t fund Madrid and Rome indefinitely, and with markets still dysfunctional, money could run out sooner than expected.

Spanish and Italian banks borrowed 220 billion and 140 billion euros of new money, respectively, under the ECB’s cheap three-year facilities. So far, they have mainly used the cash to replace privately-held bonds that are falling due, or to buy government debt. Spanish banks have bought 85 billion euros of sovereign paper between December and April, while Italian lenders have propped up the state to the tune of 77 billion euros. That’s allowed the two countries to carry on borrowing when international investors are scarce.

In theory, this could carry on for a while. RBC estimates Spanish banks have 82 billion euros of ECB cash left over - double the 41 billion euros that Madrid still needs to raise this year. As some investors - particularly domestic ones - are likely to swap maturing government bonds for new ones, Spain may only need 20 billion euros of new money. Italian banks, meanwhile, have 53 billion euros of ECB firepower, according to RBC. If domestic investors play ball, the government’s funding gap this year is around 70 billion euros.

Moreover, despite their recent splurge, banks have room to increase their holdings. Sovereign bonds account for just 7 percent of total balance sheet assets in Spain and 7.8 percent in Italy. In 1999, the share in both countries was over 10 percent. In Japan, it’s 23 percent.

However, larger banks like Santander, BBVA and UniCredit are unlikely to increase their sovereign exposure. Smaller banks face less scrutiny from markets, but also have less spare liquidity. Besides, banks have more pressing needs: Spanish lenders must refinance about 65 billion euros of funding this year, and there’s little prospect of them being able to tap wholesale markets.

from Global Investing:

Poland, the lonely inflation targeter

Is the National Bank of Poland (NBP) the last inflation-targeting central bank still standing?

The bank shocked many today with a quarter point rate rise, naming stubbornly high inflation as the reason, and signalling that more tightening is on its way. The NBP has sounded hawkish in recent weeks but few had actually expected it to carry through its threat to raise rates. Economic indicators of late have been far from cheerful -- just hours after the rate rise, data showed Polish car production slumped 30 percent in April from year-ago levels. PMI numbers last week pointed to further deterioration ahead for manufacturing. And sitting as it does on the euro zone's doorstep, Poland will be far more vulnerable than Brazil or Russia to any new setback in Greece. Its action therefore deserves praise, says Benoit Anne, head of emerging markets strategy at Societe Generale.

(Poland's central bank) is one of the last orthodox inflation-targeting central banks in the global emerging market central bank universe. They are taking action because they are seeing inflation creeping up and have decided to be proactive.

The rate rise  is especially notable given many central banks in developing countries appear effectively to have surrendered their inflation-fighting mandate. Nowhere is the push for lower interest rates more pronounced than in Brazil where the government last week announced plans to scrap fixed-rate savings deposits in a move that is seen paving the way for more agressive rate cuts. Clearly there is tolerance here for higher inflation, which will still end 2012 well above target.

But many analysts such as Manik Narain at UBS consider Poland's decision a high-risk one given the growth issues. Narain sees it possibly motivated by the need to signal Poland will not welcome further currency weakness (the zloty like most emerging currencies has shed much of its early-2012 gain) Therefore a prolonged monetary tightening cycle is unlikely, he says. Indeed many reckon the NBP may find itself, like the European Central Bank last year, reversing an ill-considered rate rise. Analysts at Capital Economics write:

If we are right in expecting growth and inflation to slow by more than most expect over the second half of this year then this may well be the NBP’s “ECB moment”. Recall that having hiked rates twice in the first half of 2011, the ECB was forced to start loosening policy once again by November as the economy weakened. In Poland’s case, we think there is a good chance that today’s rate hike will be reversed by the end of the year.

from Breakingviews:

Let Germany inflate while others deflate

By Pierre Briançon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The Bundesbank keeps raising concerns about a possible surge of inflation in the euro zone. But the fears are premature at best. The European Central Bank hasn’t failed on that front. While the current 2.7 percent inflation rate is above the ECB’s official goal of “below but close to 2 percent”, it expects to be back on target in early 2013. The question is whether sticking to that stubborn 2 percent goal makes sense as recession threatens.

The ECB is keeping its key interest rate at 1 percent, much higher than the near-zero levels in the United States and UK. The economies’ near-term prospects don’t justify the euro premium. The euro zone’s gross domestic product will shrink by 0.3 percent this year, according to the latest International Monetary Fund forecast, compared to 2.1 percent growth in the United States and 0.8 percent in the UK.

The monetary purists at the Bundesbank fear that lower euro rates - or even too many months at the current level - will fuel inflation in Germany. It’s possible, even though in the year ended in March, prices rose by 0.4 percentage points less in Germany than in the euro zone as a whole. Faster growth in Europe’s largest economy could reverse the gap this year, especially if German workers succeed in their demands for higher pay after a decade of strict wage discipline.

Yet higher German inflation shouldn’t be feared, but hoped for. It would make looser monetary policy more effective where help is most needed. Prices are rising slower than the average in troubled euro countries like Greece, Spain or Ireland. Higher inflation in Germany would help them regain some competitiveness. And it would help rebalance the euro zone economy, after a decade when German exporters gained market share throughout the region.

Mario Draghi, the ECB’s president, is unlikely to say so, but in an ideal world he would: inflation in the euro zone is not a threat. And more of it in Germany could be good for Europe.

from MacroScope:

Euro election fever

We will return on Monday knowing whether the Greeks have elected a pro-bailout government and probably to find socialist Francois Hollande – the man leading the growth strategy charge – as the new French president. 

An Hollande victory could cause some jitters given his rhetoric about the world of finance. But we’ve looked at this pretty forensically and there may not be much to scare the horses. Yes he is making growth a priority (but even the IMF is saying that’s a good idea) yet his only fiscal shift is to aim to balance the budget a year later than incumbent Nicolas Sarkozy would. Contrary to some reports, he is not intent on ripping up the EU's fiscal pact and of course the bond market will only allow so much leeway.

The heavyweight Economist magazine may have labelled socialist Hollande “dangerous” but the reality is likely to be that he will rule from the centre and his demands for a dash for growth -- and a change to the ECB's mandate to aid it -- will be tempered. Spain has shown everybody that too much fiscal loosening will be pounced upon by the bond market and while there is a lot of talk about a growth strategy for Europe, what we've heard so far amounts to tinkering.

 While an Hollande victory looks priced in, Greece still has some power to shock the euro zone.

If the two main Greek parties – PASOK and New Democracy – fail to win enough votes to govern together, they may have to turn to a fringe anti-bailout party which would put a big question mark over Athens’ ability to  stick with the austerity terms demanded by its international lenders. However, the threat of contagion, while still alive, has shrunk. With creditors already having taken a massive haircut, most non-Greek banks completely out or at least having written down anything they hold, a 500 billion euros rescue fund shortly to be in place and the IMF raising an extra $430 billion of its own, the power Greece has to start a domino effect in the euro zone is diminished. The caveat to that is, if it has to be cut some slack by the EU and IMF, Portugal and Ireland would presumably demand the same and then the whole austerity edifice starts to look wobbly again.

Despite the much vaunted growth strategy, the focus remains on structural reforms (which will take years to bear fruit) plus reconfiguring of some EU funds and a beefed up European Investment Bank. It will help, or at least can’t hurt, but what’s being discussed so far does not look like anything like a game changer, breaking the spiral of debt-cutting  deepening economic downturns which in turn will make it yet harder to cut debt.

And those who really count -- Merkel and Draghi at the top of the list -- insist the austerity drive must not be dimmed. The markets would probably respond well to growth measures which did not undermine debt reduction. But that's some trick.

from MacroScope:

“There are human beings involved” in austerity debate

The inventors of democracy and its greatest 18th century champions both go to the polls this weekend. Greek and French voters will try to elect governments they hope will help release their economies from the grips of the euro zone debt crisis.

While exercising their democratic vote, Europeans will also be contemplating another key issue: their basic economic survival.

That is why the debate about austerity versus growth has become so important.

Financial markets see fiscal discipline as crucial to get the euro zone's debt burden back to sustainable levels. They are going into the Greek elections favoring triple-A rated bonds over peripheral counterparts.

The premium investors require to hold French debt over German Bunds has also risen in the run-up to the French vote as Francois Hollande became the favourite to win.

But as economies fall deeper into recession and double-digit unemployment hurts prospects for growth, the view that austerity alone will not solve the euro zone debt crisis, seems to be gradually winning over some investors in the bond market – the heart of the crisis.

Sanjay Joshi, head of fixed income at London and Capital, says:

from Global Investing:

Three snapshots for Thursday

The European Central Bank kept interest rates on hold on Thursday.  President Mario Draghi urged euro zone governments to agree a growth strategy to go hand in hand with fiscal discipline, but as thousands of Spaniards protested in the streets he gave no sign the bank would do more to address people's fears about the economy

The divergence between Euro zone countries is starting to impact analyst estimates for earnings. As this chart shows earnings forecasts for Spain and Portugal are seeing more downgrades than Germany or France.

The inflation rate in Turkey rose to 11.1% in April, putting pressure on the central bank to raise interest rates:

from Breakingviews:

Draghi’s growth babble is no retreat on austerity

By Pierre Briançon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Is it still possible to mention the word “growth” without becoming a hostage in the French presidential campaign? Mario Draghi, the European Central Bank president, has been hijacked by the French socialist party because he has called for a euro zone “growth compact”. Presidential candidate François Hollande sees it as a sign that his ideas are gaining ground. But Draghi’s statement to the European parliament wasn’t a seismic shift. More important, what he means by growth compact has nothing to do with what Hollande plans to do if elected.

The upcoming conflict within the euro zone is not, thankfully, whether growth is good or not. Everyone agrees it is. There is also unanimity on the need for fiscal discipline. What sets Hollande on a collision course with Germany, the ECB and most of France’s euro zone partners is his belief that growth will come from the rest of the world while France avoids the painful domestic reforms which are underway in most of Europe.

France has the highest hourly labour costs of any major European economy, according to EU statistics, updated this week. They have risen 39 percent in the last decade, twice as fast as in Germany. True, that data doesn’t take into account productivity, which is high in France, but the deterioration in the current account shows the country’s competitiveness has deteriorated.

If Hollande keeps thinking that this is not a problem, or if he thinks it is but feels obliged to lie to the French about it, there’s no way to find common ground with Mario Draghi. Even though the expression “growth compact” may sound new, there’s nothing there that hasn’t been said, over and over, by central bankers: governments must reform, and the longer they wait, the more painful it will be.

Euro bonds, big investment programmes and German stimulus would all help, but they will not spare France the pain of reform. If Hollande the candidate keeps ignoring that reality, Hollande the president will hit the wall head first.