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Bank Stress Tests Will Fall Flat If They Fail To Cheer Asian Investors

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The eurozone is second only to the United States in terms of size. It's also the UK's biggest export destination, of course. So are we now seeing signs of economic life on the Continent? Could the single currency area be on the road to recovery?

Figures just released show the strong bounce-back in eurozone output continuing for the third month in a row. Industrial production across the region rose 9.4pc in May on an annual basis, with manufacturing PMI data pointing to healthy future expansion.

New trade numbers signal that, in the same month, eurozone imports rose 4.2pc as domestic demand strengthened despite a weak currency pushing up the price of foreign goods.

Germany cut its 2010 budget deficit forecast last week from 5.5pc to 4.5pc of GDP and even the most cash-strapped eurozone governments are showing a semblance of fiscal normality. Spain, for instance, just raised almost €3bn of funding, selling 15-year sovereign paper in an auction that saw relatively strong demand.

Most fundamentally, perhaps, the European Central Bank's government bond purchases have slowed sharply – proof, some say, that the eurozone has turned the corner. During the second week of July, the ECB bought only €1bn of bonds, compared to €4bn in each of the previous three weeks.

When the controversial programme began in May, with the ECB entering the secondary market to enhance liquidity amidst concerns over spiralling government debts, weekly bond purchases were unprecedented – exceeding €15bn.

Eurozone bulls argue this latest data is evidence the ECB's fiscal life-support machine is being wound down, with the worst of the eurozone crisis now over. To top it all, the optimists say, having stooped to a four-year low against the dollar in June, the single currency has just hit a three-month high.

It seems to me, though, despite my naturally positive disposition, that each of these arguments falls apart upon even the most cursory examination. For starters, while the latest output numbers for the eurozone as a whole look reasonable, the weakest countries on the region's periphery are still suffering badly.

German industrial production was up 13.1pc year-on-year in May, the Teutonic export machine benefiting from a broader global recovery. But Spanish and Portuguese output barely grew. Greek production is still contracting on an annual basis, even after last year's plunge.

While imports were up quite a lot in May, exports from the Eurozone as a whole rose a paltry 1.6pc. This was despite significant depreciation and the strong German showing. Again, the Club-Med countries' export performance was abysmal.

With the region's trade balance slipping into deficit, the eurozone's growth prospects aren't good. Domestic demand is in line to suffer as the unavoidable fiscal squeeze takes hold. So an export drive is crucial if the area is to generate sustained economic expansion any time soon. Yet, overall, exports are anaemic.

The weakest aspect of the euro-bulls' case is the trajectory of the euro itself. The single currency surged last week only because the dollar fell – in light of the Federal Reserve's verdict that the US remains some way from recovery given "significant downside risks".

Zero interest rates, massive "quantitative easing" and an almighty fiscal stimulus have failed to pull America out of its slump – which is hardly surprising, in my view, seeing as such policies are deeply counter-productive. Predictably, though, the markets reacted to the Fed's words by foreseeing more US money-printing and a much later hike in rates.

Little wonder, then, that the dollar fell – and, in turn, the single currency rose. Does that mean the eurozone is getting stronger? I don't think so. Will the dollar take back these gains, with the euro ultimately heading back towards parity? In my view, absolutely.

The reason I think that is because, despite some flickering of the economic dials, the eurozone's sovereign debt crisis remains very much in swing. Global markets can only focus on one major issue at a time. Last week that issue was the fact that, as the "sugar rush" of Obama's fiscal stimulus fades, the US recovery will fade with it. Flabby Keynesian pump-priming isn't all it's lately been cracked up to be. The only thing it is good for is shielding weak politicians and driving governments ever deeper into debt.

It won't be long, though, before market attention returns to Europe. Spain's recent debt auction, for instance, was far from a resounding success. It was fully subscribed only because the Chinese government, which has no interest at all in a eurozone meltdown, bid for €1bn of Spanish bonds.

Talking of China, the reason ECB bond-buying has slowed recently isn't because the eurozone's sovereign debt problems have gone away, or because all is now bright on Europe's sunlight economic uplands. If only. The reality is that the ECB is keeping its powder dry, buying time before the results of the eurozone's US-style stress tests are made known later this week.

What has that got to do with China? Well, for a long time, eurozone governments resisted the idea of subjecting the region's banks to a decent external audit, highlighting which would fail in the event of an even deeper economic slowdown. Then, at a G20 meeting last month, those same governments changed their tune and said such tests would take place after all.

The current situation - where banks are hiding their losses, with the resulting lack of interbank lending hindering credit creation – is a major impediment to economic growth. While far from the "full disclosure" regime this column has pressed for ever since the "sub-prime" fiasco began with the Bear Stearns collapse in March 2008, European governments deserve credit for taking this stress-test step.

Except they don't. The U-turn happened not because eurozone officials suddenly understood the benefits of courage, leadership and banking transparency. It happened because deep-pocketed Asian investors, who are basically keeping Western government finances afloat at this point, finally put their foot down.

Such investors don't plan to sell their existing stock of Eurozone sovereign bonds. But the word is that China et al threatened to cut, or even halt, future government bond purchases unless serious steps were taken to allay fears about Europe's banks. Quite an illustration of where the power really resides.

The upcoming publication of the Eurozone's stress test results is a big moment. The likelihood is that a number of banks in Greece, Spain and Italy will be shown to be extremely vulnerable - to say nothing of some deeply indebted German Landesbanken.

If they don't, the tests will be dismissed as a whitewash – and the markets will fear the worst, assuming even more serious problems lurk on bank balance sheets. But if the tests do pull the rug from under a few significant banks, that could provoke wider systemic concerns. It is an extremely difficult balancing act for the European authorities to pull off – and one that is almost certain to be met with considerable market volatility.

The real point of these stress tests, though, isn't to reveal the state of the eurozone's banks. It is, instead, to demonstrate once again, just in case there is any doubt, that eurozone governments are indeed prepared to dig deeper, and to attempt to borrow even more, to support the Continent's moribund financial services sector.

In that sense, this week could see not so much the end of the eurozone's banking difficulties but, instead, the next chapter in its crisis of sovereign debt.

Another interesting article from Halligan.

The bank stress test pose an almighty problem for the elite, if all the banks pass the test is seen as a farce and there will be panic. If a number of banks fail and there is panic you end up with a banking crisis. If they go with the banks are fine but need larger capital in case of further problems then where is the capital going to come from?

Still I'm sure the highly paid experts we've got running the show know what they are doing and it will all be contained.

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