GLOBAL INVESTOR 1.

14

04

Reform agenda

Toward a less imperfect

monetary union
The Eurozone lacked robust institutions to deal with the fallout from the Greek debt default and the
financial contagion that followed. In response to the crisis, the establishment of such institutions
has begun in earnest. However, the reform and economic recovery process of some of the member
states is far from complete.

TEXT OLIVER ADLER

Head of Economic Research

2014
ong before concrete plans for European Economic and
Monetary Union (EMU) were developed in the mid-1990 s, the
concept of a single currency had been perceived by many
as a means to boost not just economic, but above all political
convergence in Europe. Indeed, it proved easier to reach agreement
on the high-level principle of a common currency than on the nittygritty measures and reforms that would ultimately be needed to make
it work such as the integration and coordination of banking regulation and common fiscal policy. Consequently, the euro was launched
in 2002 without most of this crucial institutional structure. Some saw
this as a potentially fatal omission, while others viewed it as a gap
that could not have been filled beforehand, but which participants
would be able to tackle later to keep the euro together.
In the first years of its existence, the serious design flaws of the
monetary union were well disguised: Germany had entered the union
with an overvalued exchange rate, and the periphery generally with
undervalued exchange rates. While Germany struggled to regain competitiveness, the periphery economies were boosted. The economic
upswing in the south, combined with their seemingly cheap assets,
attracted enormous capital inflows not just from Germany, but from
other surplus countries and regions as well.
Credit expansion further boosted economic growth in the periphEU
Countries with euro
EEA
ery, but also drove up wages and prices, and generated asset bubbles
of varying dimensions the Spanish and Irish housing boom being the effectively a major step toward a political union. Contrary to the
most dramatic. By the time the global financial crisis hit, the periphery predictions of many skeptics, the institutions of EMU have been
had become uncompetitive as well as over-levered, and thus highly strengthened rather than weakened by the crisis.
vulnerable to economic or financial shocks. The event that triggered
As we show on the following pages, however, progress in indithe EMU crisis was the insolvency of the Greek government in early vidual member states is far more patchy. Some countries, such as
2010. It not only proved to investors that the rules for enforcing fiscal Spain, have made considerable strides in reforming their labor markets
discipline (the infamous Maastricht criteria) had failed, but also re- and their fiscal institutions. Others, notably Italy, and also France,
vealed the severe lack of stabilizing institutions in EMU.
have a much longer way to go. Meanwhile, a still partly dysfunctional
The history of the EMU crisis depicted on pages 6 to 7 is thus one and far from integrated Eurozone banking system and capital market
of a prolonged struggle between member states over how to construct remains a hindrance to a vigorous and synchronous economic recovery.
the missing institutions, what powers to give them and how to fund That said, the ascendance of the common central bank and financial
them. This process was uneven, but the outcome, in our view, is a regulator should continue to drive this integration process, while also
more complete though still imperfect monetary union and thus KORQUKPIHKPCPEKCNFKUEKRNKPGQPVJGOGODGTUQHVJGWPKQP

05

GLOBAL INVESTOR 1.14

SPAIN
GERMANY
EUROZONE
FRANCE
ITALY
GREECE

'XQNWVKQPQH
IQXGTPOGPVPCPEGU

THE CRISIS

)QXGTPOGPVDWFIGVDCNCPEGKPQH)&2

The crisis in the Eurozone is often regarded as

primarily resulting from imbalances in the member
IQXGTPOGPVUoCEEQWPVUKGCUECNETKUKU6JKU
is only part of the story. In fact, most governments,
with the exception of Greece, were running
HCKTN[NQYFGEKVURTKQTVQVJGETKUKU6JG5RCPKUJ
government, in particular, generated a surplus in
2007
UGG(KIWTG/QTGQXGTVJGUECNRQUKVKQP
of EMU countries was no worse than that of other
advanced economies, such as the UK , not to menVKQP,CRCPUECNCEEQWPVUQPN[TGCNN[FGVGTKQTCVGF
in the wake of the crisis itself. The true story of the
EMUETKUKUKUQPGQHDTQCFGTPCPEKCNKODCNCPEGU

10

12

Source: EU Commission, Datastream, Credit Suisse

40

300
200
100
0
100
200
300

Source: Datastream, Credit Suisse

1999

2001
Spain

2003

2005

2007

2QTVWICN +VCN[ Greece

With devaluation and currency risk apparently

removed due to the creation of the single
EWTTGPE[ECRKVCNQYUKPVQVJGRGTKRJGT[
accelerated sharply from the mid- 2000 s on

UGG(KIWTG Accelerating import growth

needed to be funded internationally. Given
higher yields on government bonds and other
investments, attracting the funds was quite
easy. Low global interest rates, promulgated
by the Federal Reserves easy monetary
stance, added to the attractiveness of this
trade, while savings surpluses in Germany
and emerging markets were seeking an
outlet and better returns.
6JGQQFQHECRKVCNUQWVJYCTFTGCEJGF
its peak in 2008 . As the global recession hit
and the general deleveraging process set in,
VJGQYUDGICPVQCDCVG*QYGXGTVJGVTWG
contraction only started about a year after the

120

160

200

Real estate bubbles,

busts and stabilization

(QWTSWCTVGTUTQNNKPI
KP'74DP

France

80

)GPGTCNIQXGTPOGPVITQUUFGDVKPQH)&2

Current account balances of selected Eurozone members

1997

2011

but rather a balance of payments crisis

Germany

2014

Debt less than

60% of GDP
and budget
FGEKV below
% of GDP

0QVRTKOCTKN[CUECNETKUKUe

2007

2009

2011

2013

Eurozone

Greek blowup. Private funds dried up as fears

QHCEWTTGPE[DTGCMWRKPVGPUKGF(WPFKPI
via the central banks Target2 system made
up for some of the remaining shortfall. In
addition, demand for external capital dropped
sharply in response to the crisis and recession itself.
In the meantime, the periphery has
started to generate surpluses, i.e. it has begun to export capital. This is, in part, due
to the improved competitiveness and trade
surpluses, but also results from ongoing
private sector deleveraging in the periphery.
Unless domestic demand picks up much
more decisively, the Eurozone as a whole will
continue to generate surpluses and export
capital to the rest of the world, and contribute
to what former Fed Chairman Ben Bernanke
has called the global savings glut.

Economic boom, falling interest rates, easy lending

U VCPFCTFURQUUKDN[EQWRNGFYKVJCNNVQQEQ\[TGNCVKQPUJKRU
DGVYGGPDCPMGTUIQXGTPOGPVQHEKCNUCPFTGCNGUVCVG
FGXGNQRGTURTQXKFGFVJGKFGCNDTGGFKPIITQWPFHQTTGCN
estate bubbles within the Eurozone. Not all countries were
affected similarly. Neither the German nor the French
RTQRGTV[OCTMGVUJQYGFGZRNQUKXGITQYVJNKMGOCTMGVUKP
Spain, Ireland or the Netherlands. Tougher regulators
OC[JCXGJGNRGFCXQKFDWDDNGUKPUQOGEQWPVTKGU9JGP
VJGDWDDNGDWTUVKPVJGYCMGQHVJGTGEGUUKQPTGUWNVKPI
KPTKUKPIHWPFKPIEQUVUCPFVJGTGVTGCVQHDCPMUVJGDQQO
SWKEMN[VWTPGFVQDWUV+P+TGNCPFVJGUNWORTGEGPVN[
U VCTVGFVQIKXGYC[VQTGEQXGT[6JGUCOGJQNFUHQTVJG
0GVJGTNCPFU+P5RCKPCPF+VCN[YGYQWNFCNUQGZRGEV
U VCDKNK\CVKQPVQUGVKPCUVJGGEQPQO[RKEMUWRCPFOQTV
gage rates decline. The latest data also show a slight
RKEMWRKPPGYEQPUVTWEVKQP

+PCVKQPCFLWUVGFTGUKFGPVKCNTGCNGUVCVGRTKEGU
RGCM
;GCTUDGHQTGRGCM

100

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90
80
70
60
50
40
30

Source: Bloomberg, Datastream, Credit Suisse

10

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+VCN[
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GLOBAL INVESTOR 1.14

06

*QYVJG'WTQETKUKUGXQNXGFsCPFJQYRKGEGOGCNKPUVKVWVKQPUYGTGDWKNVKPTGURQPUG
50

45

Mario Draghi, 26 July 2012

9G
will do
what is
needed

40

Ten[GCTIQXGTPOGPVDQPF[KGNFUKP

5

10 May 2010
EUPCPEGOKPKUVGTU
agree on a temporary
EUR 500 bn facility
VQRTGUGTXGPCPEKCN
stability, the European
Financial Stability
Facility (EFSF), and
on the creation of
a permanent successor
to it, the European
Stability Mechanism
(ESM). The IMF commits
another EUR 250 bn.
The ECB unveils its
Securities Markets
Programme (SMP).

0

25

6 April 2011
Portugal asks for
an EU bailout.

20
&GEGODGT
Fitch downgrades
Greece from
A to BBB +.

5GRVGODGT
Lehman Brothers
NGUHQTDCPMTWRVE[

0QXGODGT
Ireland is bailed out by
the EU and IMF.

15

10

GREECE
ITALY
PORTUGAL
SPAIN

19 October 2009
The newly elected
Greek government announces a budget
shortfall of 12.7%
of GDP, more than
twice what was
initially expected.

Source: Bloomberg, Credit Suisse

SEP 0

JAN 09

JAN 10

JAN 11

GLOBAL INVESTOR 1.14

9 March 2012
Greece reaches
an agreement with
investors to restructure
EUR 200 bn of
its debt.

&GEGODGT
The ECB launches
KVUNQPIVGTOTGPCPEing operation (LTRO),
providing unlimited
credit to banks.

07

Jos Manuel Barroso, 7 January 201

9 June 2012
Spain requests support
from the EU to support
its banking sector.

26 July 2012
ECB President Mario
Draghi pledges to
do whatever it takes
to save the euro
currency.

+VJKPMYG
can say that the
GZKUVGPVKCN
threat against
the euro has
essentially been
QXGTEQOGq

1EVQDGT
The European Stability
Mechanism (ESM),
situated in Luxembourg,
is formally launched.

19 September 2011
S&P downgrades
Italys debt from
A+ to A .

JAN 12

,CPWCT[
Jos Manuel Barroso
declares the euro
crisis is over.

,#0

5GRVGODGT
The European
Parliament approves
the Single Supervisory
Mechanism (SSM)
for banks.
7 February 2014
The German
Constitutional Court
expresses reservations on the ECBs
bond-buying
program OMT but
delegates judgment
to the European
Court of Justice.

5 June 2014
The ECB
launches socalled targeted
long-term
TGPCPEKPI
operations
( TLTROs) to
boost bank
lending to small
and mediumsized companies.

JAN 14

Photos: AFP/Getty Images, Getty Images, NY Daily News/Getty Images, Bloomberg/Getty Images

,WPG
Latvia joins
the Eurozone.

GLOBAL INVESTOR 1.14



ADJUSTMENT REFORM AND RECOVERY

.QUUQHEQORGVKVKXGPGUUGZCEGTDCVGFVJGFQYPVWTP
As noted above, the competitiveness of the periphery countries had
FGVGTKQTCVGFUWDUVCPVKCNN[QXGTVJGTUV[GCTUQHVJGEQOOQPEWTTGPcys existence. Labor costs had shot up substantially, and productivity growth had not kept up with costs. As a result, unit labor costs
among the EMU countries drifted apart: between 2000 and 2008 ,
French, Italian and Spanish unit labor costs had risen relative to
Germanys by 20%, 30% and 35%, respectively. The consequence
was that these economies were affected far more severely by the
global downturn in 2008 09GXGPVJQWIJVJGPCPEKCNUVTGUUGU
within the Eurozone had not yet really erupted. When they did after
2010CPFUECNCWUVGTKV[OGCUWTGUYGTGCFFGFVJGFKXGTIGPEG
was accentuated. Between the trough in the global economy in mid2009 and mid- 2013 , the gap in overall production levels between,
for example, Spain and Germany had widened by a stunning 35%

UGG(KIWTG. In the less cyclical (but far larger) services sectors,

the divergence was less pronounced and therefore the divergence
in per capita income between the north and south over the course of
the crisis was not quite as dramatic. Yet, the massive gap in industrial production which opened over these years is one measure of
the fact that the economic dominance of Germany within EMU has

been enormously accentuated by the crisis. Even though most

countries have seen more or less clear signs of economic recovery
since mid- 2013 , this gap will take years to close, if at all.
Industrial production
+PFGZ/OQXKPICXGTCIG

120

110

100

90

80

70

Source: Datastream, Credit Suisse

2005

2006

Germany France
Eurozone

2007

2008

Italy

2009

Spain

2010

Greece

2011

2012

Portugal

2013

2014

Netherlands

$CPMKPIWPKQP#MG[DWVJGUKVCPVUVGRHQTYCTF
2TKQTVQVJGPCPEKCNCPF'WTQ\QPGETKUKUUWD
UVCPVKXGECRKVCNQYUCETQUUVJGEMU countries
ICXGVJGKORTGUUKQPQHCHWNN[KPVGITCVGFPCP
EKCNOCTMGVGXGPVJQWIJDCPMKPIU[UVGOU
TGOCKPGFPCVKQPC
 NKPPCVWTG#UPQVGFCDQXGVJG
crisis led to a disruption and fragmentation of
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KORQTVCPVTGHQTOOGCUWTGCVVJGQXGTCNN'WTQ
\QPGNGXGNVQUVCDKNK\GCPFTGKPVGITCVGVJGPCP
EKCNU [UVGOKUVJGETGCVKQPQHCDCPMKPIWPKQP
Common standards and regulation, common
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JGNRGPUWTGVJCVTGPGYGFGEQPQOKEUJQEMU
would not lead to renewed fragmentation.
Agreement in principle to push ahead with
CDCPMKPIWPKQPYCUCEJKGXGFCVVJGGPFQH

DWVVJGRTQEGUUQHDWKNFKPIVJGWPKQP
YKNNDGCXGT[ITCFWCNQPG5QHCTVJGWPKQPKP
XQNXGUQPN[VYQGNGOGPVUC5KPING5WRGTXKUQT[
/GEJCPKUO
SSM HQTNCTIGDCPMU
VJGECB 
CPFCUQECNNGF5KPING4GUQNWVKQP/GEJCPKUO

SRM RQNKVKECNNGCFGTUJCXGPQVDGGPCDNG
VQOWUVGTUWRRQTVHQTVJGETGCVKQPQHCLQKPV
deposit insurance scheme that would pool
HWPFUCETQUUVJG'WTQ\QPGVQGPUWTGVJCVDCPM
runs do not occur. The SSM is to control and
enforce adherence to rules, regulations and
PCPEKCNUVCPFCTFUYJKNGVJGSRM is to ensure
VJCVDCPMUYJKEJCTGWPCDNGVQUVCPFQPVJGKT
own feet are wound down in a timely way and
YKVJQWVIGPGTCVKPIPCPEKCNKPUVCDKNKV[6JCV
said, the SRMKUTGNCVKXGN[YGCMDQVJKPVGTOU

The ECBs new building in Frankfurt is currently under construction.

QHRTQEGUUGUsCOWNVKVWFGQHPCVKQPCNCPF
UWRTCPCVKQPCNKPUVKVWVKQPUPGGFVQIKXGVJGKT
CRRTQXCNHQTCYKPFFQYPsCPFGXGPYGCMGT
KPVGTOUQHPCPEKCNRQYGT9JKNGKVYKNNJCXG
EUR 50 billion at its disposal for the recapital
K\CVKQPQHDCPMUVJGUGHWPFUYKNNPGGFVQDG
EQPVTKDWVGFQXGTCPGZVGPFGFRGTKQFQHVKOGD[
DCPMU
VJG'WTQRGCP5VCDKNKV[/GEJCPKUO
ESM EQWNFKPRTKPEKRNGHWPFDCPMTGECRKVCNK\C
VKQPKPVJGOGCPVKOGDWVVJKUYQWNFDGUWDLGEV
VQCITGGOGPVD['WTQ\QPGNGCFGTU+PGHHGEV
pPQTVJGTPqIQXGTPOGPVUKPUKUVGFVJCVPCVKQPCN
IQXGTPOGPVUYKNNEQPVKPWGVQDGTGSWKTGFVQ
RTQXKFGECRKVCNCJGCFQHVJGSRM . It was also
CITGGFKPRTKPEKRNGVJCVRTKXCVGETGFKVQTUYQWNF
PGGFVQVCMGVJGpTUVJKVqKPCDCPMTGECRKVCN
K\CVKQP9JKNGVJKUKUTGCUQPCDNGKPQTFGTVQNKOKV
moral hazard, it could lead to further delays
KPpENGCPKPIWRqDCPMU6JKUEQWNFTGUWNVKPVJG
EQPVKPWGFUWTXKXCNQHp\QODKGqDCPMUYJKEJ
JQNFDCEMVJGGHECE[CPFRTQVCDKNKV[QHVJG
UGEVQTCUCYJQNG0GXGTVJGNGUUVJGETGCVKQP
QHVJGDCPMKPIWPKQPKUCMG[UVGRHQTYCTF
for EMUGURGEKCNN[KHVJGWREQOKPIDCPM
UVTGUUVGUVUIGPGTCVGUWHEKGPVRTGUUWTGVQ
accelerate the cleanup. In the long run,
VJGDCPMKPIWPKQPsVQIGVJGTYKVJQVJGTOGC
UWTGUsUJQWNFJGNRETGCVGCVTWN[KPVGITCVGF
'WTQ\QPGPCPEKCNOCTMGVYJKEJYQWNF
JGNRTGXKXGETQUUDQTFGTPCPEKCNQYUCPF
economic growth.

GLOBAL INVESTOR 1.14

09

CONCLUSIONS
5KIPKECPVTGHQTOUNCWPEJGF in response to crisis
The Eurozone crisis has clearly triggered a series of reform efforts in
many countries. For one, the countries
that were rescued by the Troika (European Union, International Monetary
Fund and ECB ) had to submit to significant reform programs in the context
of the bailout agreements. In other
countries, notably Italy, market pressures and the associated fear of being

subjected to such a formal program

led governments to adopt some
reforms. Finally, the slump in the
economy as well as weak poll results
have added to reform pressure in
countries such as France. In the end,
the proof of the pudding as regards
the reach and effectiveness of reforms will be economic performance.
To assess where countries stand on

reforms, we have devised a reform

heat map
UGG(KIWTG It compares
indicators devised by the OECD and
the World Bank which measure the
overall ease of doing business as well
as the restrictiveness of both labor
and product market regulation. Additionally, we included a direct and
KPFKTGEVOGCUWTGQHUECNEQPUQNKFCtion, i. e. the underlying primary

Reform map
Ease of
doing business

2TQFWEVOCTMGV
regulation

Employment
protection

Minimum wage

balance and the retirement age.

What is apparent from the picture is
that none of the peripheral economies
has gone as far with reform efforts
and market liberalization as, say,
Margaret Thatcher did in the UK or
Estonia implemented after its
post- 2008 crisis.

)GPGTCNIQXGTP
ment underlying
primary balances

#XGTCIG
retirement age

Greece
Ireland
Portugal
Spain
Italy
Estonia
Czech Republic
Hungary
Poland
France
Germany
United Kingdom
5QWTEG1'%&9QTNF$CPM%TGFKV5WKUUG

Reforms
complete/
CFXCPEGF

Reforms
initiated/
Reforms
under way
NCEMKPI

Photos: Helmut Vogler/Fotolia, petra b./Fotolia

9KVJXGT[NKOKVGFUECNWPKQPVJGECB will remain the central anchor of stability

The SRM and the ESM are the two new
Eurozone -wide financial organizations that
have the mandate to prevent or rapidly
resolve financial crises like the one we have
witnessed over the past years (in contrast,
the European Bank for Reconstruction and
Development and the European Investment
Bank have the function to foster long-term
investment in Europe). The ESM and SRM
can thus be thought of as a form of fiscal
stabilizer. However, in contrast to how such
stabilizers function within national borders,
they do not fulfill their role automatically.

Taxes, be they assessed on income or

expenditures, act to stabilize the business
cycle as taxes charged are reduced when
incomes decline in a downturn, and vice
versa. The same goes for fiscal stabilizers
on the expenditure side, such as unemployment insurance. Eurozone -wide tax or
expenditure schemes would act to reduce
the divergence of business cycles within
the zone as a whole, which would, for
example, arise as a result of countryspecific economic disturbances. However,
such common schemes would of course

also imply substantial transfers between

member states. It seems quite unlikely
for the foreseeable future that solidarity
among EMU countries will develop sufficiently to allow for the introduction of
such schemes. This, in turn, implies that
the ECB will need to continue playing the
dominant role in maintaining stability
within the Eurozone. That said, opposition
to tools such as the so-called Outright
Monetary Transactions program of the
ECB will likely restrain the ECB in its
actions to some extent.

GLOBAL INVESTOR 1.14

10

How much growth ahead?

)TQYVJQHDCPMNQCPUVQPQPPCPEKCNEQTRQTCVKQPU
% YoY
40
30
20
10
0
10
20
30

Source: Datastream, Credit Suisse

2006
Germany

2007

2008

2009

2010

France

Italy

Spain

2011

Eurozone

2012

2013

2014

Pronouncing the verdict on the European Stability Mechanism, 2014 .

refinancing operations, i.e. preferential loans to banks to boost their

lending to private sector companies), will aid the recovery. A more
forceful policy stance by the ECB that pushes down interest rates
along the entire yield curve may still be needed.
Second, demographics suggest that the outlook for growth is
rather subdued over the longer term. While projections for population
growth are less dire than in Japan, not least because of still strong
immigration in Europe, demographics will not be a growth driver.
Third, as noted, productivity and employment-enhancing reform efforts
remain patchy in many Eurozone economies. Finally, high government
debt combined with high household debt in some countries (such as
Spain) implies that both the government and private citizens will need
to maintain high savings rates for a prolonged period of time. High
savings would, of course, provide an ever greater pool of investable
funds. So, the ultimate question is whether entrepreneurial spirit
returns to Europe in a meaningful way. Clearly, greater stability in the
monetary union is a prerequisite for higher investment spending, but
it remains to be seen to what extent private investors will pick up the
baton. Given the weakness of both private and especially public sector investment since the start of the crisis, significant and profitable
investment opportunities would certainly appear to exist. In the following sections, our research analysts provide bottom-up insights
KPVQYJGTGUWEJITQYVJQRRQTVWPKVKGUOC[DGHQWPF

EUROPE

FROM CRISIS TO OPPORTUNITY

Photo: Kai Pfaffenbach/Reuters

The economic outlook for the Eurozone has clearly improved since
mid- 2013 , and we expect the economic recovery to gradually strengthen over the coming years, absent major external shocks. That said,
the outlook for both medium- and longer-term growth remains somewhat subdued. Over the medium term, a still very weak banking system is likely to hold back the upturn. With banks still tending to reduce
exposure, and regulators pushing them to raise capital, lending to
the all-important small and medium-sized enterprise ( SME ) sector is
likely to pick up quite slowly. Loan growth was still negative at the
start of 2014 in countries such as Italy and Spain
UGG(KIWTG This may
in part be due to weak demand, and also a result of capital market
finance replacing bank loans. At the same time, interest rates charged
on SME loans are declining only very slowly in the periphery. It remains
to be seen to what extent the measures announced by the ECB in
May, in particular the launch of so-called TLTRO s (targeted long-term