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Weak euro states doomed to slow growth by bailout

Source: Reuters - Fri 14th May 2010

The euro zone's trillion-dollar financial safety net may stabilise markets but it is likely to doom weak countries on the edge of the zone to several years of agonisingly slow growth.

That is causing economists to worry the zone's approach to its debt crisis risks failing, if it deprives weak countries of the growth they need to work through their debts.

"It is not at all clear where strong growth can come from" said UniCredit bank's chief economist Marco Annunziata, adding that alongside the safety net, Europe needed a convincing strategy to boost the competitiveness of weak economies - something which it has not yet produced.

The emergency package announced on Monday offers loans and loan guarantees if necessary to prevent countries from becoming unable to service their debt. The European Central Bank's promise to buy government bonds will help to support investor demand for countries' debt.

But the package does nothing directly to stimulate growth in indebted states such as Portugal, Ireland and Spain. In fact it will probably have the opposite effect; euro zone governments which will fund the safety net have made it clear that countries using it must commit to tough austerity steps to shrink their debts quickly, similar to the steps which Greece pledged earlier this month in exchange for its 110 billion euro bailout.

"The increased government bill associated with this stabilisation package and the tougher fiscal tightening conditionality associated with official loans will depress regional growth and lift unemployment" said Lena Komileva, economist at money brokers Tullet Prebon.

She predicted slower growth in the euro zone would actually damage sovereign credit quality further in the short term -- a realisation which may be limiting markets' enthusiasm for the safety net. The euro jumped 2 percent against the dollar early on Monday but has now dropped back below Friday's close.


The existence of the safety net may keep markets calm enough for countries never to have to use it. Analysts now think the chance of Portugal, widely seen as the next potential "domino" after Greece, applying for emergency aid in the next 12 months is well below 50 percent.

But the nature of the net means that countries will have to focus on austerity in any case.

If they apply for aid, they will face terms similar to those in International Monetary Fund bailouts, senior European finance officials said. If they want to avoid needing aid, they will have to announce enough spending cuts and tax rises to convince investors that they can keep servicing their debt.

So indebted governments, eager to avoid the humiliation and political controversy of an IMF-style bailout, are already pledging fresh austerity.

Spain said on Monday that it would cut its budget deficit by a further 15 billion euros by 2011, reducing its deficit forecasts by 0.5 percent of gross domestic product in 2010 and 1 percent in 2011.

Portugal pledged on Monday to deepen the planned cut in its budget deficit next year by 1.5 percent of GDP, adding that it might resort to tax hikes if necessary.

Even much stronger countries are under pressure to adopt more austerity. The European Union's monetary affairs chief Olli Rehn was quoted in newspaper interviews published on Tuesday as saying Italy and France must step up fiscal consolidation efforts.

In the long term, austerity may be healthy for economies, reducing the share of state spending and making them more competitive. In the short term, however, it is likely to cause weak European states to lag the global economic recovery by a big margin.

RBS economist Nick Matthews said his bank had been expecting economic growth in the euro zone's peripheral economies to slow in years ahead to about a third of the pace they registered in the credit-fuelled decade before the recession of 2008-09

"Now, with greater austerity, they are perhaps going to exert a drag on growth" said Matthews, adding that it could take five years before those countries started to make a renewed contribution to growth in the euro zone as a whole.

That is significant, since Greece, Portugal, Ireland and Spain together account for about 18 percent of euro zone GDP. A Reuters poll of economists in April gave a median forecast for euro zone GDP growth of just 1.0 percent this year and 1.5 percent next year, compared to 3.0 percent and 2.9 percent for the United States.

Austerity programmes may also increase worries about countries' political stability and thus the threat of a debt default. This has happened in the case of Greece.


But when rich euro zone governments put together their financial safety net on Monday, they appeared to give little thought to mitigating the pain of austerity on countries through pro-growth steps.

One such step might be outright fiscal transfers of money to weak states, but those appear politically impossible in donor countries. Another step might be debt restructuring; but policy makers seem unwilling to discuss the idea of even mild debt reschedulings for fear of frightening the markets.

German Finance Minister Wolfgang Schaeuble said last week that any restructuring of Greek debt would cause "exactly the kind of conflagration that we could no longer control".

Nor have policy makers done much to address economic imbalances within the euro zone that are slowing growth. Countries on the southern edge of the zone find it difficult to compete with strong economies such as Germany while sharing one currency and monetary policy.

One solution might be to make Germany's economy less export-focused and more based on consumption. But although governments have made vague statements about increasing economic coordination, they have not agreed on any concrete plan.

Some economists are therefore questioning the logic of the euro zone's austerity-focused approach towards the crisis. In an open letter on Tuesday, 160 mostly European economists said the financial safety net needed to be accompanied by other measures.

They said Germany, Austria and other strong states should commit to maintaining fiscal stimulus policies and ensure that wages there rise faster than productivity for a period. Greece's austerity plan should be redesigned to minimise damage to demand in the economy for the short term, they suggested.

"This is the only way to rebalance the euro area while avoiding the huge risk of a deflationary spiral" the letter said, warning that slow growth and excessive unemployment could "explode the monetary union".

The austerity-based efforts to calm the markets may hurt European growth in another way. To the extent that the financial safety net succeeds in supporting the euro, it prevents currency depreciation that would stimulate exports in weak countries.

Marc Touati, economist at French brokerage Global Equities, said part of the answer to coping with austerity should be having a weak currency.

A euro that traded around $1.20 would help the euro zone benefit from an Asia-led global economic recovery and secure a growth rate of 2 to 2.5 percent, which would outstrip debt servicing costs and thus help to curb Europe's debt, he said.

The euro stood at $1.2700 on Tuesday afternoon, after sliding as low as $1.2520 last week, a 14-month low.

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