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Global Economic Research

July 26, 2010
July 26, 2010

Tuuli McCully

1 (416) 863-2859 tuuli_mccully@scotiacapital.com

European currency and debt markets maintain a strengthening tone

UK and euro zone on robust growth trajectory for now

Seven out of 91 banks fail EU banking sector stress tests

European currency and debt markets maintain a strengthening tone

The euro (EUR) and the British pound (GBP) continue in recovery mode following the release of Euro- pean bank stress test results (please see commentary below) on Friday afternoon that allowed inves- tors to digest the results over the weekend. While testing methodologies received plenty of criticism for not being stressful enough, the results seem to have relieved some concerns vis-à-vis the health of the European banking sector. Moreover, encouraging data regarding solid economic recovery in the euro zone and the UK are further underpinning investor sentiment. The EUR is currently hovering near the US$1.30 mark while the GBP reached US$1.55 this morning; the EUR has rebounded by 9% against the USD since early June, while sterling is up by 8% since its recent low in mid-May. Never- theless, uncertainty over global growth prospects will remain elevated in the near term while rapidly changing investor sentiment continues to cause volatility in the financial markets; therefore, we expect that both the EUR and the GBP may be subject to another bout of weakness this summer. Market sentiment towards European debt assets continues to improve gradually, with bond yields in the highly indebted euro zone countries lower from last week. European equity securities markets have started the week on positive trajectory; the major European stock exchanges, the German DAX, British FTSE100 and French CAC40, are up by 0.5%-0.8% on the day, led by the financial services industry.

UK and euro zone on robust growth trajectory for now

Economic recovery in the United Kingdom is proving stronger than previously anticipated – at least for now – with the manufacturing sector being the driving force. The preliminary data show that real GDP jumped by 1.1% q/q (1.6% y/y) in the second quarter of the year following a 0.3% q/q growth rate (-0.2% y/y) in the January-March period. If output growth (in quarterly terms) were to remain flat for the rest of the year, carry-over effects from the first two quarters would take real GDP expansion to 1.2% this year; we expect the economy to reach near-1½% growth in 2010 as a whole. Output details show a broad-based expansion across the services, manufacturing and construction sectors. Retails sales depict a similar story, rising 0.7% m/m in June. Nevertheless, we expect that forthcoming fiscal con- solidation, in the form of tax increases and reduced government spending, will dampen growth pros- pects in the medium-term. Indeed, housing sector data are hinting that households are already be- coming more cautious, with mortgage approvals declining in June from the month before and house prices falling for the first time in fifteen months in July. Accordingly, British monetary policymakers will likely keep the benchmark interest rate – the Bank Rate – unchanged at 0.5% until the second quarter of 2011; minutes from the most recent Monetary Policy Committee meeting in early July reveal that members voted 7-1 in favour of maintaining stable interest rates, with one member supporting higher rates.

The euro zone economy continues to recover, with both manufacturing and the services sector moving further into expansion mode in July, according to the ‘flash’ purchasing managers’ indices. Similarly, new industrial orders in the euro zone jumped 3.8% m/m (and 22.7% y/y) in May, pointing to further activity in the coming months. Germany continues to be the engine of growth in the region; the closely followed IFO index on the country’s business conditions surged in July to the highest level since mid- 2007, proving that the German economy continues to benefit from euro weakness and strong demand for the nation’s exports. Concerns regarding the impact from the turmoil in Greece and in other highly

Global Economic Research

Global Economic Research

July 26, 2010

Global Economic Research Global Economic Research indebted euro zone countries are showing signs of eas- ing

indebted euro zone countries are showing signs of eas-

ing with euro zone consumer confidence improving in

July. Nevertheless, with many of the euro zone econo-

mies starting to focus on fiscal consolidation, growth

prospects will likely ease in the second half of the year.

Moreover, regional growth dynamics – particularly in

the export sector – will be additionally affected by a

slowdown to more sustainable rates in the US and

China in 2011.

Seven out of 91 banks fail EU banking sector stress

tests

The process of financial stabilization in Europe is gath-

ering speed following Friday’s release of the European

bank stress test results by the Committee of European

Banking Supervisors (CEBS). While the results imply

that the banking sector in the European Union (EU) is

fairly resilient, they revealed some weaknesses as well.

The CEBS together with the European Central Bank

and national supervisory authorities conducted stress

tests on 91 European financial institutions that together

represent 65% of the EU’s banking sector. In addition to

testing major cross-border banking groups, the cover-

age also included many domestic credit institutions,

such as the Spanish cajas.

The objective of the exercise was to assess the banking

sector’s resilience in 2010 and 2011, and specifically its

capacity to weather possible credit shocks, such as

those stemming from sovereign risks related to highly-

indebted euro zone countries, and to assess the banks’

dependence on public support measures. If a bank’s

financial strength i.e. its ability to sustain future losses

is not adequate, as measured by a Tier 1 capital ratio

(core equity capital / total assets) of at least 6% (the

current regulatory minimum is 4%), it will need to raise

more capital. The tests included two macro-economic

scenarios: the benchmark scenario assumed a modest

economic recovery in the euro zone (GDP growth at

0.7% in 2010 and 1.5% in 2011) while an adverse sce-

nario was based on a double-dip recession (with real

GDP growth of -0.2% in 2010 and -0.6% in 2011). The

adverse scenario had two components: the first in-

cluded a global confidence shock affecting demand

worldwide, and the second added an EU-specific shock

stemming from a worsening of the sovereign debt crisis.

An upward shift was implemented for the yield curve at

both the short-end to capture interbank liquidity prob-

lems and the long end of the curve to depict dete-

riorated perceptions regarding the countries’ sovereign

creditworthiness. The tests also included valuation hair-

cuts to sovereign bond holdings for each country, rang-

ing between 4.2% (Slovenia) and 23.1% (Greece), how-

ever an outright sovereign default was not considered.

In addition, sovereign-debt losses were mapped for

those bonds that banks trade, rather than those that are

held to maturity.

The impact of the sovereign debt shock varied by coun-

try, reflecting their respective international public sector

exposure. With the addition of the sovereign shock,

seven European banks saw their Tier 1 capital ratios

fall below 6% in 2011, up from five in the case with the

global demand shock only. Furthermore, there were 10

institutions with capital ratios that fell to the 6.0-6.9%

range under the initial adverse scenario, increasing to

17 with the inclusion of the sovereign debt shock. One

of the failed institutions is German, and is already

owned by the government, while one is a Greek bank,

and the remaining five are Spanish (one bank and four

cajas). To date, the Spanish government has already

promised sizable funds for recapitalization purposes.

Transparency of the testing mechanism is a key ele-

ment in building credibility and investor confidence; with

plenty of details published regarding testing proce-

dures, investors should be able to scrutinize the credi-

bility of the tests easily. Nevertheless, investor con-

cerns regarding the stringency of the tests will likely

remain in place; macro-economic assumptions fall short

of the economic contraction of more than 4% in 2009,

though two consecutive years of economic decline can

be considered a fairly pessimistic assumption.

Following a relatively neutral market reaction to the

stress test results, we expect that the European sover-

eign debt crisis has now passed one of the key hurdles

and signs of stabilization will start to emerge. Neverthe-

less, with the turmoil mainly driven by rapidly changing

investor confidence, uncertainty remains high at least in

the near term. While financing conditions for many of

the countries in the euro zone periphery remain tough

and achieving fiscal sustainability is vital in order to

maintain investor confidence, the stress test results

support our view that sovereign debt issues will not

cause any unprecedented difficulties for the European

banking sector. Nevertheless, potential for a Greek debt

restructuring remains in place. According to BIS data,

the French banking sector is the largest lender to

Greece, accounting for 35% of total international claims

(as of Q1 2010) on the country, though these claims on

Greece account for only 2% of the French banking sec-

tor’s international exposure. With the Greek public sec-

tor accounting for 46% of all international borrowing, a

debt restructuring would have an adverse – though lim-

ited – impact on French banks. Nevertheless, the re-

sults of the stress tests, that cover nearly 80% of the

French banking sector, indicate that the country’s finan-

cial institutions are among the most resilient in Europe.

Global Economic Research

July 26, 2010

Global Economic Research July 26, 2010 INTERNATIONAL RESEARCH GROUP Pablo F.G. Bréard, Head 1 (416) 862-3876

INTERNATIONAL RESEARCH GROUP

Pablo F.G. Bréard, Head

  • 1 (416) 862-3876 pablo_breard@scotiacapital.com

Tuuli McCully

  • 1 (416) 863-2859 tuuli_mccully@scotiacapital.com

Estela Ramírez

  • 1 (416) 862-3199 estela_ramirez@scotiacapital.com

Oscar Sánchez

  • 1 (416) 862-3174 oscar_sanchez@scotiacapital.com