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Stop-Gap Liquidity Measures Amid Fading European Economic Growth Prospects
Malaysia Perspective | 28 December 2011

By Yeoh Mei Kei

Major central banks across the world have undertaken a coordinated effort to increase liquidity to financial markets. The Federal Reserve, European Central Bank (ECB), Bank of England, Swiss National Bank, Bank of Japan and Bank of Canada have jointly embarked on a policy to increase the funding of USD to financial markets, aimed at ensuring troubled European banks have an accessible source of dollar funding.

The various central banks have agreed to reduce the cost of current USD liquidity swap arrangements by 50 basis points until 1 February 2013, effective from 5 December 2011. In addition, the central banks have established temporary bilateral liquidity swap arrangements with each other, essentially giving the ECB access to unlimited amounts of USD, which it can then redistribute to its banks which have had trouble borrowing USD as a result of the debt crisis on the European continent.
The ECB also announced that it was reducing the initial margin required for collateral placed with it for access to this facility from 20% to 12%, in an obvious attempt to further ease the on-going liquidity problems in the European banking sector.

What Are The Implications? Buying Time For The Crisis
While the coordinated action saw markets rally, we remain cautious of the view that the response was a watershed moment. We do, however, view the effort as an indication that central bankers have taken away valuable lessons from the financial crisis of 2008, learning that provision of liquidity is critical in easing pressure on the financial system. The provision of liquidity is set to grease the wheels of bank lending in Europe which has seen demand for loans/credit lines by enterprises and consumers decline by approximately -8% and -15% respectively in October 2011. With increased access to funding, loans to businesses will hopefully increase, spurring more business activities and thus providing a boost to regional economic growth.

Nevertheless, the coordinated effort was merely aimed at providing the Eurozone with more time to derive a fiscal solution for its crisis. At the same time, economic data releases for the weeks saw confidence levels for consumer, economic, industrial, and services continue to deteriorate as Europe’s debt crisis continues to sap sentiment.

The Disconnect Between Sentiment & Reality
Early estimates for Eurozone’s 3Q 2011 GDP saw the continent’s economy grow by 0.2% on a quarter-on-quarter basis and 1.4% on a year-on-year basis. This was brought by sufficient expansion in the core economies of Germany and France, which managed to offset stalling Spanish and Belgian economies as well as contractions in Greece, Portugal and the Netherlands.

In France, GDP strengthened on a quarterly basis from a downward revised -0.1% contraction in 2Q 2011 to a 0.4% growth rate in 3Q 2011 on the back of a rebound in consumer spending and improved industrial production. On a year-on-year basis, economic growth measured 1.6%. Despite the seemingly positive news, business investment showed a contraction of -0.3% on a quarterly basis. On a year-on-year basis, the growth rates of several key indicators such as household consumption, business investment and exports decelerated, suggesting a potentially difficult period ahead with budget cuts to come and the spill-over effects of the sovereign debt crisis to deal with.
Germany saw its economy grow by 0.5% in 3Q 2011 following an upward revised 0.3% growth rate in 2Q 2011. Similar to France, household spending drove economic growth while business investment also contributed positively.

Having said that, many of the leading indicators as well as sentiment surveys and purchasing managers index (PMI) across the Eurozone have shown significant declines into contraction territory (a reading below 50 indicates a contraction – refer to Chart 1). Despite these declines in sentiment and surveys, reality has obviously been different with a divergence between these traditionally leading economic indicators and economic data. Despite being in negative territory (not seen since August 2009 and April 2010 respectively), consumer confidence and industrial confidence levels have yet to translate into dampened private consumption as well as industrial production. 3Q 2011 GDP for the Eurozone showed stronger-than-expected consumer spending and industrial production, which were responsible for dragging GDP into positive growth territory, with much of the growth originating from France and Germany.

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As industrial production in Europe had been clearing a backlog of old orders, production levels were able to avoid contraction. Given that new industrial orders are likely to have fallen since 3Q 2011, we continue to remain cautious on a possible reduction in industrial production going forward.

European Growth Prospects Fading, Healthy Growth Delayed

The European Commission and the European Central Bank have likewise downgraded growth prospects for the continent in the face of extremely challenging times. The European Commission has reduced their growth forecasts for 2011 and 2012 from 1.6% and 1.8% in August to 1.5% and 0.5% now respectively.

Looking at our initial forecasts in September 2011 when the Eurozone crisis was at its peak, in retrospect, we were perhaps a tad aggressive in cutting our growth expectations. We have subsequently re-evaluated the various data and factors, and have tweaked our forecasts slightly in light of the latest market information and happenings (refer to Table 1).

Table 1: Revised GDP growth forecast for Eurozone
Source: Bloomberg, iFAST Compilations

Earnings Revised Upwards From Our Initial Estimates

We now expect 2011 earnings to contract by -11.6%, with earnings growth of 3.5% in 2012 followed by a healthy 17.7% rate in 2013. This is in comparison to the -22.8%, 20.5% and 10.8% initial earnings growth estimates for the same time frame. Based on current valuations as of 2 December 2011, Europe’s estimated PE ratio is currently valued at 12.2X, 11.8X and 10.0X for 2011, 2012 and 2013 respectively. Based on our upward adjusted earnings estimates, Europe’s potential upside currently stands at 24.6% by 2013 (as of 2 December 2011) when compared to its fair value PE of 12.5X.

Despite increasing signs of contagion, we remain confident in the ability and political will of key political leaders in Europe, together with the international involvement of various central banks, to resolve the issues plaguing the continent. The move by the European Central Bank to cut rates by 25 basis points in November as well as on-going negotiations to bring forward the launch date of the European Stability Mechanism from 2013 to 2012 lends optimism amid the usually negative headline emanating from Europe. We expect further rate cuts from the ECB as they attempt to stave off or lessen the impact of the impending recession. We also expect progress in the political scene and see a possibility of further political integration in Europe slowly taking shape.

Yeoh Mei Kei is a Research Analyst at

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