Monday, February 8, 2010


Greek Turmoil Unlikely To Delay ECB Exit Plans — For Now

We expect that in February the ECB will leave the main policy rate unchanged. As already suggested by Mr. Trichet, the ECB probably will not present more details on the exit from the non-standard policy measures in February. However, with more news regarding an ongoing economic recovery in the euro area at hand, the ECB might turn somewhat more optimistic in its assessment of financing conditions and the outlook for the economy. To us, this increases the chance that the ECB will announce in March the end of the unlimited funding in its open market operations in April. In the Q&A part of the press conference, the main focus probably will be again on Greece. As in January, we expect that President Trichet will emphasise that Greece has to do its homework and the ECB will not make concessions to Greece.
Only three weeks after the January meeting, and without having the usual midmonth meeting, the Governing Council is unlikely to make a huge change in its assessment of the economic environment. Since the last meeting, sentiment indicators have been mixed. In January, the composite PMI declined for the first time since February 2009, while the European Commission survey showed a further increase in sentiment to the highest reading since June 2008. Furthermore, the rebound in industrial orders in November by 2.7% MM suggests that the recovery will continue. Overall, the latest data signal that the ECB currently is too pessimistic on growth (expecting GDP growth of just 0.8% in 2010). But, we do not expect a change on the macro view before the next update of the ECB’s staff projections, which are due in March. Note that, this week, the IMF revised up the euro area GDP forecast for 2010 from 0.3% last October to 1.0%.

On the inflation side, the flash estimate for the January inflation reading of 1.0% YY was below expectations, but this is not likely to alter the ECB’s view on inflation. Note, the ECB expected inflation around 1% in the first months of 2010. We also expect that the ECB’s latest Survey of Professional Forecasters (SPF) – which the Governing Council will have at hand at the meeting – will be little different to November. Back then, the SPF’s long-term (five years ahead) inflation forecast was 1.9%. This suggests that the ECB is unlikely to change its outlook of low inflation over the medium-term any time soon.

With this outlook of moderate growth and low inflation, we expect that the ECB will regard the current level of interest rates as appropriate. We do not expect that in this environment the ECB is likely to increase its policy rate this year. However, in this macroeconomic environment the ECB probably will go ahead with the exit from the non-standard measures. In our view, developments in financial markets and financing conditions will be most important to define the speed for this exit.

Although the latest monetary data showed that lending remained weak, the flow data signal that the worst contraction of loans is probably over. In December, there was a second consecutive increase in net-transaction of bank loans. As in the previous month this was led by an increase in flow of loans to households. But, the contraction of loans to non-financial companies continued (see Figure 3). While the broad-based improvement in economic sentiment probably contributed to the bottoming-out of the loan downturn, there are also indications that less-tight lending conditions by euro area banks have started to feed through to higher lending activity.

Amid another very dramatic week for Greek financial markets, market attention started to focus also on another eurozone country whose public finances look severely strained: Portugal. The Portuguese government released its FY2010 budget this week, which showed a higher-than-expected deficit for 2009 (at 9.3%, rather than 8% previously projected) and a planned reduction in the deficit by 1pp of GDP for this year. So Portugal joins other eurozone countries with strained public finances (e.g., Greece, Ireland and Spain) which have already started the fiscal consolidation process rather than waiting until 2011 like the core countries. While we think more fiscal tightening is required (and will probably be delivered) to stabilise the debt ratio, we reckon that the most worrying problem for the Portuguese economy is its poor competitiveness.
Raising its growth potential is the road Portugal should take to grow out of its debt.

A few comments, we think, are worth making on 2010 Portuguese budget.

• First, it revealed a wider starting point for the deficit in 2009 (at 9.3%) than previously projected by most forecasters (around 8%). We reckon this was probably due to a larger-than-expected deterioration in the public balance in the last few months of 2009 (see Figure 9). The target for 2010 is still a very high deficit of 8.3% of GDP, which makes the planned adjustment to bring the deficit down to 3% by the end of 2013 less likely than before.

•Second, the consolidating measures are mainly focused on cuts in the public sector wage bill — the area of major slippages over recent years. This is a step in the right direction as deficit-reducing expenditure cuts are usually more effective in fiscal consolidation episodes than tax rate increases. And, recently, spending cuts have been more welcomed by EU institutions and markets as a way to reducing the deficit than increases in revenues.


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