Fundamentals Update: Euro Zone

Euro Zone Update

Fundamentals Update as at 30 January 2014 by Lorenzo Beriozza

The relative calm in financial market conditions across the euro zone over the last year has resulted both from the policy actions taken by the ECB as well as from lower external financing needs across the periphery.

In addition, shrinking private demand for loans, a tougher regulatory environment, and the possibility of using sovereign bonds as collateral for ECB funding has led many euro zone banks to ramp-up their holdings of sovereign debt of their home countries. This has also contributed to narrower sovereign bond spreads.

This recipe could continue to work for a number of years. However, the combination of weak economic growth, low inflation, large net external liabilities, and still rising government debt might prompt foreign investors to demand higher risk premiums on peripheral euro zone sovereign debt. This becomes a more tangible possibility against the backdrop of higher U.S. Treasury rates.

Higher interest rates would once again raise concerns about debt sustainability, especially in light of the modest results achieved thus far through fiscal austerity and structural reform.

Therefore, other more drastic measures, such as debt restructuring, could not be ruled out from the menu of potential policy actions. But before crossing this bridge, a more resolute response from the ECB is likely to be expected.

Source: TD Economics