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Solvent but structurally flawed: Europe lies at a crossroads

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In his latest Market Perspectives research note, Russ Koesterich (pictured), Global Chief Investment Strategist at iShares, argues that whilst reform is politically difficult, and investors are likely to be periodically frustrated along the way, there are economic solutions to Europe’s challenges…

The good news is that the European Union is solvent, at least in aggregate. By lowering bond yields the European Central Bank (ECB) has bought politicians time, but they must use this respite to address the structural flaws that hamper growth and leave the banking system at risk.
 
Can Europe’s political class move fast enough to satisfy financial markets and address economic realities? We see three main requirements for further reform in Europe:
 

  1. Closer fiscal union: Europe needs to move towards a tighter fiscal union, and must come together on a mechanism that at least partially pools sovereign obligations. While the term Eurobonds has gained in popularity, there are many versions this arrangement can take. The concept will only work though if creditors can extract significant and binding constraints on the budgets of more profligate countries. Although most governments will ultimately acquiesce to this deal, given the implied loss of sovereignty it will be a slow, tortuous path to get there. 
     
  2. Banks must be recapitalised and regulation synchronised: The fragmented nature of the European banking system means Europe’s banks will remain its Achilles heel. Whatever improvement we’ve seen in bank liquidity can be attributed almost entirely to the ECB, and banks need a more permanent solution. To address this, Europe must agree to a realistic recapitalization plan, rules for common banking regulation and a euro-wide deposit insurance scheme. 
     
  3. Europe simply must grow faster, by addressing structural impediments to growth: Southern Europe needs to address structural rigidities in labour markets, which have hampered competitiveness and growth for more than a decade. In Italy for example, one major obstacle to growth is the public sector, which is grossly inefficient and too often an impediment to private sector initiative.

 

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