16 June 2010

Eurozone economy: the long and painful squeeze

For my subscribers, this article was sent by mistake very late yesterday: fat finger!

17th June 2010

1. Austerity measures across Europe

The Seoul G20 agreement on nothing exemplified the rift between the Keynesian economic policies followed by the Obama administration since early 2009 and the post-keneysian policies i.e. austerity packages followed in Europe for the past few weeks. As reporter by Bloomberg:
Policy makers are diverging on prescriptions for sustaining the global recovery, with U.S. Treasury Secretary Timothy F. Geithner calling on Japan and European countries with trade surpluses to boost domestic demand, while Europe’s representatives have said reining in budget deficits was the top priority.
The US is still running a large trade deficit and Europe is enjoying a trade surplus, mainly thanks to Germany. Interesting enough, some European leaders (French ones in particular) were, until recently, calling on Germany to stimulate domestic demand: on June 7th, Angela Merkel, the German chancellor, responded by a definitive nein! with the EUR 86 billion austerity package to be spread until 2014. To avoid to be too harshly punished by markets France followed suit  today with a EUR 100 billion (50/50 spending cut and additional tax collection).

Altogether, austerity packages announced  in the euro zone since early May represent approximately EUR 230 billion by 2013, quite a number but is it really enough to at least stabilize the situation?  From my calculation, the PIGS + main euro zone countries have to save in the region of  EUR 300 billion between now and 2013 to reach the 3% deficit/GDP threshold if one believes the EU GDP growth forecasts over the period. We are getting nearer, but still EUR 70 billion are missing, and this assumes that the implementation will be perfect...

Let's assume that all goes well and all euro-zone countries are back to 3% (which I do not believe one minute and not only for PIGS countries- for example how Ireland could divide its deficit by 4 in 3 years or Spain by 3) and therefore find EUR 100 billion a year during the 3 years to 2013, it means that the euro-zone still would have added nearly EUR 1 trillion debt, an increase in the debt/GDP ratio from 80% in 2009 to 92% in 2013, not a decrease.

In addition, nothing will have been done to reduce the competitivity gap between Northern Europe and Southern Europe. All the measure adopted are aiming at avoiding the straight default of several countries and an immediate collapse of the banking sector across the euro-zone.

But this is not tackling the fundamental issues and merely gaining some (and not a lot) time.
The solvency issue is not dealt with, but it is clear that Germany calls the shots (for the time being), and all countries will have to follow its path or markets will be shut down for funding their financial requirements.

2. Debt

As discussed in the previous point, deficits are being addressed to go back to the Maastricht criteria of 3% debt/GDP. I note that nothing is said about the second criteria: a maximum of 60% debt/GDP. Indeed, 3% deficit/GDP is a deficit and therefore increases the amount of debt that countries have to take on.

According to Markets & Beyond calculations, fiscal deficits post austerity packages will amount to a cumulative EUR 955 billion for the 3 years ending in 2013, i.e. EUR 955 billion additional debt to reach EUR 8.5 trillion or 91% of GDP. Within this stock of public euro-zone debt, we could see some countries negatively impacted (Italy and France in particular) if PIGS countries need to tap the EUR 860 billion rescue packages (Greece + remaining euro-zone).

The question is therefore how countries can reduce their debt. Let's review first a very simple equation (Borrowed from John Mauldin's letter):

Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus)=0

By Domestic Private Sector Financial Balance we mean the net balance of business and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.

The implications are simple. The three items have to add up to zero. That means you cannot have both surpluses in the private and government sectors and run a trade deficit. You have to have a trade surplus.

Let's make this simple. Let's say that the private sector runs a $100 surplus (they pay down debt) as does the government. Now, we subtract the trade balance. To make the equation come to zero it means that there must be a $200 trade surplus.

$100 (private debt reduction) + $100 (government debt reduction) - $200 (trade surplus) = 0.

But what if the country wanted to run a $100 trade deficit? Then that means that either private or public debt would have to increase by $100. The numbers have to add up to zero. One way for that to happen would be:

$50 (private debt reduction) + (-$150) (government deficit) - (-$100) (trade deficit) = 0. Remember that we are adding a negative number and subtracting a negative number.

Bottom line. You can run a trade deficit, reduce government debt and reduce private debt but not all three at the same time.
Another equation has to be looked at due to its implications (also borrowed from John Mauldin):

Δ GDP = Δ Population + Δ Productivity (Δ= change in)

It means that in face of a declining population (the case for a number of European countries) you have to increase your productivity even more to keep your GDP growing.

I wrote several time that the current crisis is a brutal adjustment to over-indebtedness (public and private): As a family's or country's debts grow, the carrying cost or interest expenses rise. At some point, the interest expense consumes an ever larger portion of the budget. Increasing the debt increases the interest expense eventually to the breaking point. There are limits and we have reached these limits in several countries.

3. Reduce deficits

European countries have realized that there is no way out of the mess politicians created over the past 20 years but reducing fiscal deficits. It is worth mentioning that in today's austerity package, France will cut EUR 15 billion in planned keynesian inspired economic growth measures: Keynes is definitely dead on this side of the Atlantic under the pressure of bond vigilantes and Germany.

This will cut growth (you cannot withdraw hundreds of billions from the economy and hike taxes with no consequence on GDP and employment).

From the first equation, it is however possible to offset the reduction in governments' fiscal imbalances via exports and a deficit increase by the private sector. The competitive devaluation of a currency (or monetizing a currency) is a classical way to improve a trade balance (since the end of Bretton Wood, the US has consistently manipulated the dollar to its advantage). This is not panacea, but probably the least worst choice at this juncture.

Within Europe there is an additional problem: euro-zone uncompetitive economies cannot devalue their currency. In addition, all PIGS's countries have large trade deficits (from 9.4%  for Portugal in 2009 to 14.3% for Ireland). And Spain has an over-indebted private sector and huge unemployment: Spain is the next shoe to drop.

True, the euro has declined vs all currencies from its November 2009 high (~ 20% drop) and it is translating into a better extra euro-zone trade balance which has improved since the beginning of 2010, mainly to the advantage of the traditional exporters, Germany being at the forefront.

However, within the euro-zone, the competitive devaluation of the euro is neutral. Looking at the trade balance structure of the PIGS, in 2009 between 41% (Ireland) and 63% (Portugal) is intra- euro-zone trade; the scope for reducing deficits via an improvement of the terms of trade is therefore limited, beyond the fact that these countries do not have much to export outside agricultural goods, hence time needed to allow them to climb the value chain.

4. Spain: the next stop on the crisis line

Whilst Spain had a deficit/GPD relatively benign at the start of the financial crisis, it is spiraling following huge fiscal deficits.

Why Spain will be the next shoe to drop:
  • Uncompetitive economy: the worst euro-zone track record for unit wage costs (~+50% since 1998 vs ~8% for Germany); wage costs should fall by circa 30% to reach the German level.
  • Structural and large trade deficit: 11.2% in 2009. Spain's exports account for merely 6% of GDP vs
  • Large unemployment and increasing: 20.1% in Q1 2010 and 19.5% for the 20-29 age group (I also read 40% for the 18-25 age group).
  • Debt /tax receipts approaching a dangerous zone at 185% in 2010.
  • Large refinancing in July: EUR 31.5 billion. In addition 43% of the Spanish debt is held by foreign investors (EUR 240 billion) Q4 2009.
  •  The total net international investment position is -93.5% of GDP at the end of 2009 (-82.2% for Greece)meaning that Spain pays interest to foreign investors and the proceeds is not reinvested in Spain to the same magnitude as it would be with domestic investors (it is why the situation of Japan, despite it huge debt/GDP, is less worrying short term with over 90% of its debt held by domestic investors).
  • Hang over in the housing market: 1.6 million unsold properties in Spain, six times the level per capita of the United States whilst prices only dropped by 10%.
  • Total public/private debt in Spain has reached 270 percent of GDP.
  • Fragile banking sector (The central bank seized CajaSur - savings banks are full of mortgage debt)  with the interbank market shut to them. Last month, Spanish banks had to fund themselves with the ECB at the turn of €85.6bn – double the amount lent before the collapse of Lehman Brothers in September 2008 and 16.5% of net eurozone loans offered by the central bank. Today, Spain announced that they want stress tests for Spanish banks to be disclosed, a step towards transparency to alleviate market conjecture.
  • Funding is frozen for most of the private sector.
  • Spain's external debt has reached EUR 1.5 trillion (174% GDP), most of it on short term maturities, with EUR 600 billion due this year.
    All this is resulting into a sharp increase in the cost of funding of Spain as evidenced by Tuesday's auction where yields on one-year debt reached 2.45% compared to 0.9% as recently as April and a surge in the cost of CDS (Credit Default Swaps) close to 250 basis points, not far from the high reach June 7th. The positive note is that Spain can finance itself on markets as exemplified by today's successful bond sales (EUR 3.5 billion).

    Officials across Europe are in denial, in a remake of what happened for Greece.

    As noted by Fitch in their 32 pages report:
    "To maintain debt solvency Spain must squeeze public spending: yet this policy undermines the chances of recovery which itself causes further loss of confidence"
    Since Spain cannot devalue the euro to immediately improve its competitiveness, it has to reduce wages, risking to trigger a slow death by debt deflation.

    The choice is either reflation accepted by the ECB (which seems to be the case, at least for the time being) or Spain will be forced out of euro-zone, setting off a catastrophic chain-reaction through north Europe's banking system. The third choice is a debt moratorium for 10-15 years to give time to Spain (and other countries) to adjust their competitiveness.

    Jacques Attali in a recent book "Tous ruinés dans dix ans", proposes to set-up a European Agency that would issue debt in the name of Europe and guaranteed by all euro-zone members. This would imply an automatic solidarity amongst countries avoiding the unprepared cacophony we have heard for 6 months now (the result of a flawed euro-zone construction). However, this would add an other level of debt issuance where each tax payer in each euro-zone country would eventually be responsible for. Refinancing all existing debts at the country level via such an Agency would be a solution to avoid the punishing financing costs of the PIGS countries; it would however mean that Northern Europe would subsidize Southern Europe and therefore Southern Europe should give away some sovereignty to ensure that appropriate reforms are conducted and budgets respected. There is a long way to get there and time is running short.

    Interestingly enough is the CDS spread for France: it has gone up steadily to reach a level more than double what it was late March. Even more striking, France is the only country of the euro-zone where the spread vis-à-vis Germany is at historic high.

    For quite a while, I mentioned that France is in a worse shape than face value, and after Spain, I believe that it is France that will be under pressure as much as Italy, if not more.


    The second leg of the financial crisis is unraveling with the sovereign debt crisis in Europe: we are at the beginning and not at the end.

    The ECB will continue to monetize the PIGS sovereign debt which it will not sterilize despite what has been announced, to shore up French and German banks which together hold EUR 455 billion of Spanish, Portuguese and Greek debt according to RBS.

    A combination of  euro zone economy slow down during H2 2010 and in 2011 compared to previous forecasts combined to substantially higher funding costs for PIGS countries, a freeze of the interbank market for PIGS's banks make a sovereign debt rescheduling inevitable. I do not understand how politicians believe that 20 years of lax monetary policy and over-indebtedness that followed can be solved in 3-4 years in a weak economic environment and structural reform to be implemented: time is needed and insolvency must be faced instead of living in constant denial.

    I re-iterate that Europeans will suffer a markedly decrease in their living standards for probably at least 10 years. In any case, in an open world where goods, people and money are free to move, how Europeans could believe that they could sustain the competition from Asia and Latin America without adjustment? The West as a whole has transferred a massive amount of wealth over the past 10 years to Asia and the Middle East, representing trillions of dollars that were then lent to the West to consume beyond their means: today, we have to pay the bill, and it is very expensive.

    I continue to stay clear from the banking sector and I am considering re-entering euro shorts (probably when we get closer to the Spanish refinancing) together with financial shorts. I remain long gold, commodity and energy stocks. I am contemplating getting into consumer stocks in Asia.

    For the rest, the S & P 500 support level held well which is positive. However, any meltdown (which is a real possibility until euro-zone politicians admit that the EUR 860 billion package did not solve the solvency problem of PIGS countries) within the euro-zone would trigger shock waves to other markets, and among them commodity driven ones and the US are the most fragile.

    Bloomberg: IMF Says Risks to Economy Have Risen ‘Significantly’
    The New York Times:  Merkel Introduces German Austerity Package
    Deutsche Welle: German austerity plan faces widespread criticism
    Eusostat: http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/themes
    VOX: The PIGS’ external debt problem
    Royal Bank of Scotland (RBS): The €2 trillion debt exposure to Greece, Spain and Portugal - 24 May 2010
    The Daily Telegraph: EU denies EUR 250 billion liquidity plan for Spain
    Banco de España: Summary economic indicators