19 June 2013

Deutsche Bank: Is the high level of uncertainty in the euro area finally receding?

Even though there seem to be fewer acute risks for the euro area, with risk premiums for the crisis countries having fallen, the currency union remains mired in recession. This is partly due to high levels of political and economic uncertainty. At least in that respect, things seem to be looking up.

One of the most remarkable aspects of the current crisis is the obduracy with which it has taken hold of the eurozone. While the biggest risks seem to have been banished for the time being, a positive impetus for the real economy has yet to materialise. On the contrary: both the EU Commission and the ECB had to cut back their growth forecasts for 2013 and 2014. The euro area remains mired in recession and unemployment has risen to 12.2 per cent. Some observers had considered the falling risk premiums for bond issues by the peripheral countries as signalling an imminent improvement, but this proved premature as risk premiums were driven mainly by the ECB's OMT programme and low yields for safe asset classes.

Uncertainty has direct effects on the business cycle. A recent report by the European Commission suggests that the negative effects of heightened uncertainty can depress GDP growth for about one year and the labour market even for as long as two years. At the same time, bank lending also becomes more restrictive as default risks increase. This is exactly what has been witnessed in the euro area lately.

Hence the obvious question is whether political uncertainty has begun to wane since the solution to the Cyprus issue and the formation of a new government in Italy. By definition uncertainty is hard to measure, but one symptom of persisting uncertainty is the "safe haven" effect registered in the bond markets over the past few years. As soon as larger risks became apparent in one of the crisis countries, this led to a parallel increase in risk premiums for all other peripheral countries due to fears of contagion. Investors fled to safe havens (e.g. Germany, Finland and Austria, but also to countries outside the euro area such as the US, Switzerland or Norway) where yields even declined because of excess demand for safe government paper.

The fact that uncertainty plays a role in this context is also evident in the European Policy Index which attempts to depict political uncertainty in Europe. Following a rise in uncertainty during the Cyprus crisis, this index has recently dropped to its lowest level in two years. To be sure, criticism of the EU's crisis management of the Cyprus question may be justified, but the negative effects on other countries were limited and fears of large-scale capital flight, in particular, were not confirmed. With the formation of a new government in Italy, another factor of uncertainty within the euro area has disappeared, at least for the time being. Hence, the current developments can be interpreted as positive signals.

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