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EU Faces Fight as Investors Take Flight

As opposition to austerity measures mounts across Europe, those demanding frugal spending are facing up to a battle with those who dare question Europe’s current grand plan.

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“The backlash against austerity in the euro zone could improve the region’s growth outlook. But it brings new dangers too, not least by putting dissenting countries on a collision course with Germany,” said Capital Economics Chief European Economist Jonathan Loynes in a research note.

With French presidential candidate Francois Hollande campaigning on a pro-growth platform and the Dutch government collapsingover disagreement on spending cuts, core euro zone members are in clear disagreement with German Chancellor Angela Merkel, her government and the German electorate.

This means there is trouble ahead even if a renewed focus on growth helps boost output over the medium term, according to Loynes.

“Notwithstanding the potentially beneficial effects of stronger growth, markets may still respond negatively to any perceived reduction in governments’ commitment to fiscal consolidation,” he wrote.

So if the market does not like what it sees on fiscal consolidation, borrowing costs for euro zone members will rise, as we have seen in Spain over the last few weeks.

“Rising borrowing costs could offset the positive effects on growth of milder austerity,” said Loynes who worries Germany’s commitment to funding future bailouts could wane.

“At the very least, increased resistance to austerity threatens to put the dissenting countries on a collision course with Germany. This could further reduce the latter’s already fading willingness to provide additional support for the indebted economies, be that via bigger contributions to the bail-out fund, support for further action from the ECB, or more decisive steps towards fiscal union,” he said.

Foreign Money Flees Trouble

Another problem facing policy makers is capital flight from both Italy and Spain, according to analysts at Credit Suisse.

“Continued capital flight from the periphery has the potential to derail the adjustments undertaken by these countries by putting enough downwards pressure on the money supply and nominal activity to prevent orderly public and private sector deleveraging,” said Yiagos Alexopoulos, a research analyst at Credit Suisse.

This will manifest itself in lower asset prices and higher real interest rates, according to Alexopoulos, who believes the ECB has helped mitigate the impact of foreign money leaving Spain and Italy.

“Even after the recent sell-off in Italian and Spanish debt, bank and sovereign funding conditions are much improved from the autumn of last year. But if capital flight from these countries continues, then there will be a need for more, not less, of these policies.”

One positive has been the stability of domestic Italian and Spanish investors, according to Alexopoulos, who warns this could well change if things get worse.

“So far, the stability of domestic investors is a positive. The outflows have been narrow rather than broad. And it’s likely that policy measures of financial repression will attempt to hinder domestic funds from leaving their counties, but such policies cannot be absolute," he said.

“So if the crisis was to deepen this year a broadening of the outflows to include domestic investors would mean they’d run at a completely different order of magnitude.” said Alexopoulos.