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Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines – Bernhard Eschweiler

– Euro area woes remain key market concern: watch Greek bank deposits

– But global expansion stays on track

– German growth to bounce in Q2 after stronger-than-expected Q1 results

Persistent stress and uncertainty in the Euro area continue to weigh on financial markets. As we go to press, no new government has been formed in Greece and negotiations between France and Germany about the fiscal pact and a new growth pact have yet to start. The risk of Greece leaving the Euro has increased, yet a radically new European policy approach is unlikely. Germany will probably agree to a stretching of fiscal targets and some additional growth measures without dropping the principal ideas of the fiscal and structural reform agenda. A positive surprise was today’s better-than-expected German Q1 GDP data, which rounded up last week’s strong March figures. More broadly, there are positive signs that the global expansion will stay on track.

Heading for Delphi or straight for the door?

Predicting developments in Greece from the distance feels impossible and even those closer struggle. Never-theless, markets are right to put a higher probability on Greece leaving the Euro. We believe Greece will be better off staying in the Euro, but the political developments make this difficult. Greece may be able to get some small concessions from its Euro-area partners, yet the threat of default is losing its punch – although the collateral damage will probably be bigger than some like to believe. Whoever will be in charge could decide to leave the Euro or provoke a stand-off with the Euro-area partners, that ends with Greece defaulting. Both outcomes assume that politicians call the shots. The reality may be different.

Financial markets have by now limited leverage to force a decision in Greece. The people of Greece, on the other hand, do. So far, Greek residents have withdrawn more than EUR60 billion of deposits from local banks. The resulting funding gap was bridged through ECB liquidity operations. Despite the bleeding, more than 150 billion

Euro-denominated deposits from residents still sit with Greek banks. People will probably rush to withdraw their remaining deposits if they see an increased risk of Greece leaving the Euro. That in turn would force the banks to seek more central bank funding.

Whether the ECB will continue to provide the extra funding is not clear. The ECB will make that decision in close consultation with the Euro group and the IMF, yet the argument not to throw more good money after bad will weigh heavily when everyone is running for the door. A simple trick to turn off funding would be to tighten collateral standards. We still believe that the majority of Greeks sees the value of staying in the Euro, but watch those deposits and the ECB in case we are wrong.

Pact terminology

Euro-area policymakers are unlikely to drop Greece easily, but even French president Hollande lacks the domestic support to go out of his way. More important for policymakers is to protect the rest of the Euro area and get their economies growing again. This is to be achieved through the ‘growth pact’, which is to supplement the ‘fiscal pact’. Even German chancellor Merkel is talking about the need to promote growth. The ideas, however, are very different. France and some others hope to boost growth through extra spending, mostly on infrastructure. Germany and its allies view structural reforms, such as in the labor market, as key. Recent election results have given the ‘socialist’ approach more popular support, but German chancellor Merkel is not without allies. In fact, more governments still seem to support her (notably Spain, Portugal, Italy and Ireland).

The result is likely to be a fudge, which allows both sides to claim they prevailed. France will probably accept the fiscal pact, if Germany agrees to a growth pact and the stretching of the deficit reduction targets. Germany, on the other hand, will probably accept additional spending through the EU structural funds and the European Investment Bank, if the structural reform targets remain in place. To make this all work, more funds will be needed. German resistance to Eurobonds still seems strong. Less strong is the resistance to the introduction of a financial transaction tax.

Maintaining and reviving growth

Important for the outcome in Europe is the global growth backdrop. In the middle of last year, markets feared that global growth could collapse. That would have been a disaster for Europe. Fortunately, it has not happened for reasons we have pointed out before. Nevertheless, global growth is not automatically assured. Markets have been worried over the recent moderation in the US and further softness in China. Last week’s jobless and consumer confidence figures for April suggest that the US economy remains on expansion course. This was also supported by stronger exports. The Chinese data, on the other hand, was disappointing. In response, the central bank cut the reserve requirement. It now seems the Chinese authorities have fallen behind the curve. That they will catch up just like they did with inflation last year, however, still is the most likely outcome.

Germany on track for 1.5% growth in 2012

Good economic news also came from Germany. First-quarter real GDP growth was much stronger than expected (2% q/q annualized vs. 0.4% consensus). March output, trade and order figures last week exceeded expectations as well.

– The surge in March output was exaggerated by weather effects in construction (payback for February cold-related weakness), yet manufacturing was strong as well. Importantly, the March surge creates a strong base for the second quarter. March output was 23% annualized above the Q1 average.

– The biggest boost came from construction, but exports were also doing well. Exports increased 11% annualized in Q1 and March was 14% annualized above the Q1 average.

– The outlook is also improving as seen in the order data. March orders were 22% annualized above the Q1 average. Foreign orders were up 35% despite orders from the Euro area down 13%.

The latest figures are consistent with the more optimistic sentiment reflected in the Ifo index and support our view that Germany could reach 3% annualized growth in the second quarter. With that reacceleration overall 2012 growth should reach at least 1.5%, which has been our forecast since November last year, even if the economy slows again in the second half.

Disclaimer

This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 15 May 2012, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

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Frankfurt am Main, 15.05.2012