Europe on the brink of calamity
July 2011
Quam parva sapienta regitur mundus
(With how little wisdom the world is governed) – Marcus Tullius Cicero
Europe is on the brink of calamity. The sovereign debt crisis, which emerged in early 2010, has mutated rather than ameliorated as it has spread first from Greece to other small peripheral countries (Ireland and Portugal) and then more recently and ominously the larger southern European countries (Spain and Italy). The crisis has been exacerbated by a lack of leadership, inadequate institutional structures and divergent political agendas of key players. European policymakers have been shockingly detached from market realities and are only now waking up to the gravity of the crisis they are facing. Short-term fixes, hastily cobbled together under market duress and aimed at kicking the can down the road, have not addressed the root of the solvency and competitiveness problems in peripheral Europe. The package of measures hurriedly announced on July 21 2011 laid bare the inadequacy of institutional structures incapable of reacting quickly and decisively to rolling crises and market relief was short-lived.
Throughout the crisis Germany has been criticized for its foot dragging and belligerent attitude, which has undoubtedly aggravated tensions. However, this should understood in an historical context: while the Germans got their way with the European Central Bank, which was spawned in the image of the Deutsche Bundesbank, the French connived to have included in the single currency a number of countries that should never have been admitted in the first place. The combination of a hard core ideological central bank and many weak countries unaccustomed to monetary, fiscal and incomes policy discipline has proven to be a toxic one.
This has all the hallmarks of a perfect storm. Unless Europe can make a quantum leap towards political union – to permanent transfers and supranational control of national fiscal policies – the euro is likely to splinter as the weakest links are forced out. The phoenix that eventually rises from the ashes may be a stronger euro and a more sustainable construct but the transmission will surely be extremely painful and disruptive with potentially dire consequences for the wider European and global economies. The template going forward is more likely to be Lehman-like than Y2K-like. If this is the case we are about to enter another turbulent episode in financial markets.
In recent weeks the crisis has taken on grave proportions as market pressure has shifted to Spain and Italy, hitherto widely assumed to be viable within the euro because they are in fundamentally better shape than Greece, Portugal and Ireland, the countries that have already lost access to global bond markets. However as growth slows down in Europe, Spain and Italy are in grave danger of sliding back into recession and this as much as anything this could bring the crisis to a dramatic climax. Further fiscal austerity could push all of these uncompetitive peripheral economies into death spirals because the devaluation option is not available and these economies are nowhere near flexible enough to adjust on their own without politically untenable output and employment costs.
As peripheral bond spreads have blown out the residual strength of the euro looks anomalous and is in large part the reflection of a chronically weak US dollar. Now that the US debt ceiling issue has been temporarily resolved, and as the more intractable European sovereign debt crisis intensifies, the dollar should strengthen and the euro is looking like a sitting duck.
Introduction and historical perspective
Amidst all the hubris surrounding the launch of the European single currency in January 1999 some observers were taken aback by the manner in which the entry criteria were brazenly manipulated or simply brushed aside. A lonely minority of wise-heads who cautioned that the new single currency may not be viable in the long run without a significant increase in the degree of ‘political union’ were derided as ‘euro-sceptics,’ even regarded as unpatriotic. Objective economic criteria were subordinated to political expediency and the euro clearly did not conform to the notion of an ‘optimal currency area.’
Moreover, highly regulated, ‘sclerotic’ European economies, ridden with nominal rigidities, were manifested ill-suited to surviving in a currency union. In the beginning it didn’t really matter because currencies like the Italian lira, the Spanish peseta and the Portuguese escudo were locked in against the Deutschemark at favourable rates and Germany was widely perceived to be the ‘sick man of Europe.’ While the ‘Club Med’ countries basked in the abundant supply of cheap money, Germany underwent a painful and introspective adjustment. One country that was initially denied access to the club was Greece. Even with the most creative sleight of hand it was impossible to make a credible case for Greece because it would have undermined the credibility of the single currency from day one. But, as its budget deficit fortuitously shrank, Greece only had to look in enviously from the outside for two years before being given the green light to jump on board.
After a decade of excess and flouting of the rules the cracks began to appear, and now 12 ½ years since the launch of the single currency, the euro-zone is facing a very grave and existential crisis. Despite the hundreds of billions of euros thrown at the problem, the crisis has mutated, rather than ameliorated. This is in part because there is no effective leadership in Europe. There is a crisis of governance. Institutional structures are weak and inadequate. Communications have been uncoordinated and undisciplined as key players push their own separate agendas. Festering animosities have re-surfaced as mutual trust has been breached. There has been a reactive rather than proactive approach to dealing with rolling crises, and an unwillingness to countenance radical solutions to get ahead of the problem. There is no ‘Plan B.’ An ideological and truculent European Central Bank, bent on raising interest rates, only serves to add high octane fuel to the mix.
In 2010 financial market participants learned that the euro is the most potent symbol of post-war European integration and were told that euro break up was therefore not an option – the euro was deliberately designed to be a ‘roach motel.’ But as we argued a year and a half ago , the euro was a fundamentally unsustainable construct from day one, and cannot survive in its current form. An irresistible force meets an immovable object, what gives? The answer is that either the euro area becomes a fully-fledged transfer union or the single currency will splinter. There really is no middle ground.
An unsustainable construct – the root of the problem
To understand how this existential crisis in the euro came about an historical perspective is indispensible to show how dysfunctional decision making and political agendas have fatally undermined the foundations of the single currency. As discussed in the introduction, the euro is now in grave danger because politics has always tended to trump economics. At the heart of the problem are diametrically-opposed French and German visions of what the single currency should be.
One event, more than any other, spurred the push for the single currency, and that was the fall of the Berlin Wall in 1989, which led to German unification in 1990. Before the fall of the wall, the West German economy was roughly the same size as the French, Italian and British economies. But, with the integration of the East German economy, it would become significantly larger, sparking off old anxieties, particularly in France, over German (economic and eventually military) dominance. At the Strasbourg summit in 1990 French President Francois Mitterrand insisted that France would never accept a unified Germany without European economic and monetary union.
The decade that followed saw plans for economic and monetary union fast-tracked with the signing of the Maastricht Treaty in November 1992, which provided the blueprint for the European single currency. The signing of the Treaty followed one of the most turbulent upheavals in the European Exchange Rate Mechanism (ERM), as the German Bundesbank tightened aggressively to counter the inflationary aftermath of German unification, which put pressure on the other currencies in the system, culminating in the ejection of some currencies and a major realignment of others.
In the summer of 1993 ERM trading bands were widened from +/- 2 ¼% to +/- 15% as the French franc and other ‘core’ currencies came under speculative attack. This was the existential crisis in the ERM, because the French franc peg to the mark was regarded as immutable. It was saved after massive, coordinated ‘intra-marginal’ intervention to stave off the speculators and prevent the dream of the single currency from unraveling. The trauma of these episodes strengthened European policymakers’ resolve to press ahead with plans for the single currency posthaste.
The euro entry convergence criteria were the centre piece of the Maastricht Treaty, setting limits for inflation (no more than 1.5% points above the average of the lowest three member states), general government budget deficits (no more than 3% of GDP), general government debt-to-GDP (no more than 60%), exchange rates (two years in the ERM without a devaluation) and long term interest rates (no more than 200bp above the average of the lowest three). There was an immediate problem which undermined the credibility of the convergence criteria on day one, because two countries – Belgium and Italy – had debt ratios of over 100%, and therefore would have no hope of meeting the debt criterion on any foreseeable horizon.
Entry in the euro on January 1st 1999 was based on an evaluation of the convergence criteria for 1997. The debt criterion was fudged to stipulate that if the debt ratio was above 60% it must be approaching the reference level ‘at a satisfactory pace.’ With inflation generally well behaved the focus shifted to budget deficits. The Germans insisted that the letter of the deficit criterion should be respected – in the words of German Chancellor Helmut Kohl ‘three point zero’ – in order to keep out Italy and the other Club Med countries. Italy didn’t seem to have much of a hope on the deficit criterion either, because in 1996 its budget deficit was still north of 6% of GDP.
While Italy might be excluded the idea of a currency union without France was unthinkable, and the problem was that the French finance minister – one Dominique Strauss Kahn - refused to set a budget deficit below 3% in 1997. Amid record post-war unemployment, the French wanted to subvert the deficit criterion to ensure that Italy could be included after all so the euro would not end up being a Deutschmark clone. The compromise was another fudge: In order to meet the letter of the deficit criterion France transferred pension fund profits from France Telecom. The Italians went one better by resorting to a reversible euro-tax. Neither of these wheezes was in the spirit of ‘sustainable convergence.’ The date chosen for the launch of the single currency – January 1st 1999 – was set in stone by political decree. Since it was unthinkable to have only two or three countries in the currency union, the criteria would have to give, and so it happened.
Source: The Economist, April 9 1998
French and German interests, and visions of the single currency, often collided and were almost diametrically opposed. The Germans advocated political union – centralized control of national fiscal and wages policies – and an independent central bank run by technocrats focused on price stability. The French favored the creation of an economic government which would exert political control over the central bank, and insisted on maintaining national sovereignty over fiscal policy.
In 1995 the Germans first floated the idea of ‘stability pact’ in EMU, which would impose automatic fines on countries whose budget deficits exceeded the Maastricht reference level of 3% of GDP. This idea was opposed by France, and after over a year of acrimonious squabbling, French President Jacques Chirac managed to water down German proposals for automatic fines and insisted that growth be explicitly recognized as an objective of policy. So the ‘Stability Pact’ became the ‘Stability and Growth Pact’ (SGP).
Political control over the SGP rendered it toothless. Ironically, this benefitted Germany most initially. Amid Draconian corporate restructuring Germany struggled to grow and hence keep its budget deficit below 3% of GDP in the early years of EMU. The European Council of Ministers failed to apply sanctions to France and Germany for consistently breaching the deficit criterion. This made it rather difficult for Germany to preach fiscal austerity to other euro members.
Percentage of years in EMU in breach of Maastricht deficit and debt criteria
Country Deficit criterion Debt criterion
Austria 33 92
Belgium 17 100
Finland 0 0
France 50 67
Germany 50 83
Greece 100 100
Ireland 25 17
Italy 67 100
Netherlands 25 25
Portugal 58 50
Spain 25 17
Source: IMF
Proceedings were started against Portugal (2002) and Greece (2005) but fines were never applied. In 2005 the SGP was further emasculated to take into account the cyclical position of offending countries, another nebulous concept subject to manipulation and obfuscation. There was no effective sanctioning anymore and no control over fiscal policy, and this sowed the seeds of the current crisis. As we recently discovered Greece used accounting tricks to conceal the extent of their fiscal profligacy. What was remarkably was how long Greece got away with it.
However, not all countries cheated, and some, notably Ireland and Spain laudably ran budget surpluses, and tried to save for a rainy day. Unfortunately for them, their economies were derailed by banking crises. Finland consistently ran large surpluses until the GFC and has never breached either the deficit or debt criterion even during the crisis. Some would therefore argue that the SGP did have some restraining effect and point out that aggregate euro-zone deficit outcomes have been comfortably below those of the US, the UK and Japan.
The anatomy of a crisis: The chickens come home to roost
However, it is not so much the aggregate outcome, but the dispersion of outcomes, allied to the fact that individual countries cannot print their own currency, which poses the systemic threat the euro. Moreover, the countries in the most difficulty - the ‘PIGS’ – also have the most over-valued currencies as a result of their failure over the years to hold down wages and inflation in line with the core countries as their inflationary culture carried over into EMU. The tables have really and truly been turned now as northern Europe, led by Germany, enjoys strong growth and the periphery stagnate or contract. The chart below shows how unit labor costs have diverged since currencies were effectively fixed in 1997.
Unit labor costs in the ‘PIIGS’ France and Germany, 1997-2010
Source: European Commission Spring Forecast 2011
The adjustment task is especially daunting because the devaluation option has been closed off. Currency devaluations are almost always an indispensible part of the solution to sovereign debt crises because by boosting real growth and inflation simultaneously they increase the denominator in ‘debt-to-GDP’, fast-forwarding the adjustment to debt sustainability. With the devaluation option closed off the only other way to regain competitiveness is to deflate wages and prices, but that is very painful, particularly in highly regulated economies ridden with nominal rigidities; and it tends to depress nominal GDP and boost real interest rates into the bargain making debt sustainability all the more difficult to achieve. Aggressive fiscal tightening without currency adjustment might just push these economies into a death spiral.
The PIGS are in a desperate position, mainly of their own making. To add insult to injury the ECB, with its ideological blinkers on, is bent on pressing ahead with its rate hiking cycle. ECB rate hikes will expose the next weakest links in these highly leveraged peripheral economies and hasten the next phase of the crisis. Their only source of growth is exports, and the only reason their exports are growing is because their export markets have been buoyant. But export markets are already slowing leaving these economies vulnerable either to sliding back into - or deeper into - recession.
Now that the European authorities have conceded that a Greek restructuring is inevitable the question is whether Portugal, Ireland, and most importantly, Spain, and Italy can survive. The euro might survive Irish and Portuguese defaults/restructuring, because these two economies only amount to $330bn or 3.5% of euro-zone GDP (Greece accounts for 2.6%). Spain, however, is an altogether different proposition: at just over Euro1 billion, it accounts for 11.5% of euro-zone GDP and is double the size of the other three. Italy is an even bigger fish and at 16.5% of euro-zone GDP is triple the size.
The Portuguese economy is in desperate straits, and Portugal seems to be headed down the same path as Greece. Ireland is trying hard, but its economy is in a state of collapse and the budget is hopelessly off track. Spain and Italy are in better shape but are in danger of sliding back into recession. Spanish and Italian recessions could bring the euro-zone crisis to a dramatic conclusion because this would likely to be accompanied by a loss of access to bond markets and they are arguably ‘too big to save.’ See Appendix for a more detailed discussion of each case.
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Box: The ominous collapse in potential growth in Europe and the developed world
One little documented issue is how potential growth rates have deteriorated in the developed countries in general, and in Europe in particular, mainly for demographic reasons. In the euro-zone growth potential has slipped to just 1% according to latest OECD estimates. It is about 1 ½% in France and Germany but close to zero in the PIGS and Italy (see table below). The implications for medium term debt sustainability are alarming because if the ECB sticks to is inflation target this implies medium term nominal GDP growth of no better than 3%.
OECD estimates of growth potential in 2011 – selected countries
Country Growth potential
Australia 3.28
Austria 1.88
Belgium 1.18
Canada 1.86
Denmark 1.04
Finland 1.32
France 1.41
Germany 1.47
Greece 0.36
Ireland -0.32
Italy 0.24
Japan 1.21
Netherlands 1.11
Norway 2.37
Portugal 0.54
Spain 0.76
Sweden 2.06
Switzerland 1.84
UK 0.86
USA 1.92
Euro area 1.09
OECD total 1.58
Source: OECD
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Cultural divergence
Another issue that goes to the heart of the crisis and transcends notions of economic convergence is that of cultural divergence and political corruption. Perhaps the best reference point is Transparency International’s Corruption Perceptions Index. The two countries that stand out in the euro-zone are Italy and Greece. After cooking the books to secure entry into EMU, Italy’s surprising ability (until recently) to steer clear of trouble contrasts with its endemic level of political corruption. If it was discovered that the Italians have been misreporting their budget data, European financial markets would surely rupture given the size of the Italian economy.
Corruption Perceptions Index – selected countries
Country Ranking Index
Denmark 1= 9.3
Finland 4= 9.2
Sweden 4= 9.2
Netherlands 7 8.8
Switzerland 8 8.7
Ireland 14 8
Austria 15= 7.9
Germany 15= 7.9
Japan 17 7.8
UK 20 7.6
US 22 7.1
France 25 6.8
Spain 30= 6.1
Portugal 32 6
Poland 41 5.3
Hungary 50 4.7
South Africa 54 4.5
Turkey 56= 4.4
Italy 67 3.9
Brazil 69= 3.7
China 78= 3.5
Greece 78= 3.5
Source: Transparency International
Greece is the most corrupt country in the developed world, and this helps to explain what has happened over the last ten years. The raison d’etre for the Greek Socialist party Pasok is to reward its supporters with high paid jobs in the public sector financed with money borrowed mainly from abroad, a manifestly unsustainable and unethical business model. Managing to gain acceptance into EMU was a brilliant stroke because it allowed this scam to continue for many more years. By contrast Ireland ranks highly and this helps to explain why Dublin has gone to extreme lengths to stay on track with its adjustment program, even as the Irish economy continues to fall short of expectations. Implementation risks for Portugal and Spain are somewhere in the middle.
The road forward: are we about to enter Act V Scene V of a European tragedy?
Viewing the crisis through this prism not only explains why Greece was prepared to deceive its European partners in the first place, it also helps explain Greece’s low pain threshold and hence unwillingness, or inability, to stick with any protracted austerity. . Therefore, the latest twist to the crisis - the discovery in May that Greece has not been complying to the strict conditionality laid out in the 110bn euro May 2010 bailout package - should not really have come as big a surprise. The probability of Greece sticking the letter of the new austerity package is close to nil.
The fallout from this latest development has once again rudely exposed the woefully inadequate governance and institutional structures in the euro-zone, in particular the failure of the architects of EMU to put in place a crisis resolution mechanism. In July market pressure spread ominously to Spain and Italy, who would be too large to bail out given the current resources of the European Financial Stability Facility (EFSF), the institution hastily set up last May in the wake of the first stage of the European sovereign debt crisis.
Peering into the abyss the Greek parliament passed a confidence vote in the government and new austerity measures in mid-2011, which enabled the fifth tranche of the original bailout package to be disbursed (12bn euro, 9.7bn from the EU and 3.3bn from the IMF). This will keep Greece afloat until September, when the sixth tranche is due (8bn euro). The original 110 bn. euro package was supposed to extend until Q2 2013, amid the technical assumption that Greece could re-access the market from 2012 to the tune of 45bn by mid-2013. Clearly this is unrealistic so the “troika” (EU, ECB and IMF) are at the time of writing discussing a new package to extent until the end of 2014.
According to the European Commission, without new measures the Greek budget deficit this year would be little changed from last year’s 10.6% of GDP. In order to meet the original 2011 deficit target of 7.6% of GDP, an inordinate amount of fiscal tightening needs to be squeezed into the second half of this year (6% of GDP at an annualized rate), and this is against a backdrop of a very fluid and unstable political landscape, increasing civil disobedience and an economy which is in freefall (contracting by at least 4% at an annual rate). The chances of the Greek government being able to deliver look extremely bleak.
Greece’s new medium term fiscal strategy
Source: European Commission
Private sector participation in any debt restructuring, which Germany has insisted on, has emerged as a complicated and intractable issue, with unknown systemic consequences. Politically it is indefensible for private bondholders not to participate even if it is on a strictly ‘voluntary’ basis. The complication arises from the likelihood that any form of private sector involvement will be seen by the ratings agencies as a default. If the ratings agencies downgrade Greek debt to selective default (SD), this could create a major problem because the ECB has pledged that it will not accept such securities at its regular repo operations, and the Greek banking system is increasingly dependent on the ECB as deposit flight accelerates. There are many creative short-run solutions to these issues, which can be presented as a panacea, but in reality they will be little more than a short term palliative, and not cure Greece’s underlying insolvency problem.
The ECB’s stance is diametrically opposed to Germany’s. It wants to see no restructuring at all, not just to protect its own balance sheet and avert any systemic risks. The ECB appears to be pushing its own political agenda to force a fiscal union (which it sees as key to saving the euro), because without rollovers the Greek debt will progressively become socialized; i.e., increasingly held in official hands. As the proportion of official held debt rises, and market held debt declines, and as (if) the primary budget deficit declines, the incentive for Greece to default unilaterally increases. The incentive for Greece to stay the course now is that a withdrawal of official funding would mean that government and external deficits would have to shrink to zero, which would imply a ‘wile coyote’ moment for the Greek economy (perhaps a 20-30% drop in GDP).
Patience with Greece was already wearing thin before the discovery of its brazen non-compliance with the terms of the original package. Given the euro-zone’s weak governance and institutional structures, and differing agendas of key political players, the chances of a major credit event would appear to be significant. Even if the Greek government chooses to comply with the new austerity measures it is extremely doubtful whether it will be able to impose Draconian fiscal cuts on an economy which is in state of near collapse.
At that point the decision will have to be made as to whether Greece will be able to receive permanent transfers or whether it should exit the monetary union. The risk of contagion is high because as discussed above the other peripheral economies are in dire straits too, especially the structurally enfeebled Portuguese economy which could be on the brink of collapse (see annex below). Deposit flight could accelerate the end game. Why would any rational individual or corporation hold a deposit in a Greek bank? Or an Irish or Portuguese bank deposit for that matter?
Although Argentina operated a currency board, rather than participated in a monetary union, it was only 9 ½ years ago that Argentine US-dollar denominated deposits were compulsorily converted into Argentine pesos at a rate of 1.4 to 1. Within a month the exchange rate had moved to 2 (pesos) to 1 (dollar) and within six months to above 3.5 to one, a devaluation of more than 70%. If Greece had to reintroduce the drachma, a similar decline would be likely because Greece’s fundamentals are considerably worse than Argentina’s were in 2001.
The most sustainable solution would be a move to full-fledged political union where control over fiscal policy is taken away from national governments and given to a supranational institution. The problem is that political union cannot be achieved over night and is unlikely to happen before the crisis escalates to the point where European policymakers have to choose between full-fledged political union and the splintering of the euro.
Arguably, the high water mark for Federalist ambitions was the signing of the Maastricht Treaty 19 years ago, and there is little appetite for a full-blown political union. Establishing a supranational economic government to oversee fiscal policies could take months or even years, and would be highly contentious. It would be difficult to get countries to agree on the correct model. The best and most realistic hope to solve the is to introduce pan-European ‘euro-bonds’ but this is bitterly opposed by the Germans because it would eliminate the incentive of the PIGS to press on with painful fiscal adjustment.
Source: JP Morgan
In the event of a credit event, particularly one triggered by deposit flight, the biggest risk would be to the European financial system. The likely solution would be a “Euro-TARP” where fiscal resources would be pooled to bail out the banks, perhaps of a similar order of magnitude as the US TARP in October 2008, which was $700bn (500bn euro). Quite possibly a Euro-TARP would be administered by the European Financial Stability Fund (EFSF)
Conclusion – big trouble ahead
Big trouble lies ahead. There are several possible catalysts for the mother of all crises:
- Full blown bank runs in Greece, which quick spread to the rest of the periphery
- Greece is unwilling or unable to comply with the new austerity measures
- The Portuguese economy and banking system implodes
- Spain and Italy go into recession
- Spain and Italy lose access to the bond market as contagion fears spread
The best solution for financial markets, though not for European taxpayers, would be the ECB’s preferred solution (see above), augmented by the introduction of pan-European euro-bonds. However, it is very unlikely that the Germans would allow the PIGs to be left off the hook so lightly without a permanent transfer of power over fiscal and wages policy to a supra-national institution. Moreover, given the low likelihood that the PIGS will continue to be able to comply with their brutal austerity programs, this is unlikely to be politically tenable as taxpayer liabilities mount. Most probably there will be a severe crisis within the next few months, which will shift the tectonic plates of the euro-zone, and speed the quest for economic government and ever closer union. Whether the euro will survive is now an open question.
Annex one: Who’s next? A guided tour of the other troubled peripheral economies
Exports are the only bright spot for the PIGS (apart from Greece)
Source: Bloomberg (exports of goods and services national accounts definitions)
The only bright spot for the PIGS is in their export performance and domestic demand has contracted and export markets have been buoyant. However as growth slows in Europe, export performance is likely to weaken, leaving these economies even more exposed as fiscal tightening bites.
1. Portugal – the next Greece?
The Portuguese economy suffers from deeply rooted structural problems and chronic imbalances, and this is reflected in its terrible growth performance even in the EMU boom years. Public and external deficits have risen sharply since Portugal joined the single currency, as the government ramped up spending on health and welfare and as lower interest rates encouraged a decline in private savings. The government debt- to-GDP ratio doubled to 95% in the decade to 2010. Relatively high wage growth and chronically weak productivity has seen Portuguese competiveness deteriorate and the current account deficit was still 10% of GDP in 2010, little changed from the previous five year period. Portugal also has the highest negative net international investment positions at over 100% of GDP.
Portuguese banks have one of the highest loan to deposit ratios in the euro area (about 140%), while private sector gross debt to GDP at 260% is also one of the highest. The only savings grace is that Portugal did not really experience a real estate bubble in recent years and – so far – the Portuguese banking system has not experienced any significant deposit flight – unlike Greece’s and Ireland’s.
Portugal’s highly leveraged economy
Source: IMF
The corporate sector has liabilities amounting to 140% of GDP, one of the highest in the EU, and 80% of these mature within one year. Considering that Portuguese companies rely on banks for over 50% of their funding the corporate sector is highly vulnerable to bank inevitable deleveraging. Household debt is also very high at 96% of GDP (130% of disposable income), and 90% of mortgage debt is at variable rates. According to the IMF, as in other countries, the legal and institutional framework for addressing non-financial sector distress is woefully inadequate.
The Portuguese economy is blighted by deep-rooted structural deficiencies, including widespread product market regulations (e.g., impediments to competition) and chronic labor market rigidities (employment protection, limited wage bargaining flexibility, high unemployment benefits and severance pay and low skill levels). The economy entered a double dip recession in late 2010 after putting off much needed fiscal adjustment, the level of GDP is now just over 1% above the Q1 2009 low following the GFC
Portugal has agreed an ambitious adjustment program with a 78bn euro bailout package (52bn from the EU and 26bn from the IMF), which combines aggressive fiscal adjustment with wide ranging structural and banking reforms to bring down the budget deficit to 3% of GDP by 2013 and stabilize the debt to GDP ratio at 115%. The IMF is looking for domestic demand to contract by 10% over the next three years and GDP to decline by 4%. This year alone (June-December) the Portuguese are being asked to enact measures worth 5.7% of annual GDP, or 9.8% of seven month’s GDP. The likelihood of this being achieved is close to zero.
Portugal’s daunting adjustment program
Source: IMF
The challenge is so daunting and the risk so high that in all likelihood Portugal will not be able to stay the course. In the first decade of the 21st century the Portuguese economy only expanded by 5%, or 0.5% a year. Even in the decade before the GFC the economy only grew on average by 1.4%. Rising unemployment could undermine social support for the program, while large scale corporate bankruptcies could sharply increase non-performing loans piling additional liquidity and solvency pressures on banks. If the economy turns out weaker than expected this would undermine public debt dynamics.
2. Ireland – weak economy may require a second bailout
Ireland is a different very kettle of fish to Greece and Portugal, having run a responsible fiscal policy in the first decade of EMU. Ireland’s downfall was a reckless property lending boom, which saw bank assets rise to over 1000% of GDP and which led to a major banking collapse when credit markets froze and house prices cratered. At the peak of the boom the loan to deposit ratio reached 138%, one of the highest in the euro-zone. Even though banks have been de-levering the LDR has since risen to 168% as bank deposits have fled. Following recent laudably rigorous stress tests the Irish government is pumping an additional 24bn euro into its banks, on top of the 46bn previously.
Unlike Greece, Ireland has tried its best to meet its fiscal targets since accepting 85bn euro EU/IMF rescue package last November, but the problem is that contagion has pushed up long term government bond yields from 5% to 12%, and the domestic economy has been in freefall. In the first seven months of 2011 the budget deficit was 18.5bn euros, up from 10.2bn in the same period last year. Personal consumption has fallen by over 20% in the last three years, but is only back down to 2005 levels, while fixed capital investment is down by two-thirds from the peak.
Total non-financial debt to GDP in the euro area – Ireland is the highest (followed by Portugal)
Source: IMF
Household debt at 129% of GDP is the highest in the industrialized world, and ECB rate hikes will turn the screw even tighter on Irish households, and could trigger another leg down in house prices. Exports are the only bright spot but do not generate much revenue for the Irish Exchequer. The silver lining, and where Ireland contrasts starkly with the Club Med miscreants, is that Ireland has experienced modest deflation, and a sharp absolute and relative decline in unit labor costs, reflecting the fact that the Irish economy is more flexible than most other European economies. Combined with the collapse in domestic demand this has led to a sharp turnaround in Ireland’s current account balance from a deficit of 6% of GDP to broad balance.
However it is unlikely that Dublin will be able to start tapping funding markets in 2012 for a full return to market financing in 2013 as hoped. This now looks ambitious and Ireland may eventually need another bailout package estimated at 40bn euro to cover its funding needs to 2016.
3. Spain – the least ugly sister, but still pretty ugly
Spain is the least unhealthy of the PIGS, and has recently grown at nearly 1% thanks to a strong recovery in exports, while domestic demand is almost flat (rather than plummeting as it is in the other three). Spain’s current account deficit has also narrowed impressively from a peak of 10% of GDP in 2007 to 4% of GDP, while the government is conspicuously on track with its deficit cutting targets, whilst enacting long overdue product and labor market reforms. Moreover, its government debt to GDP ratio at 60% in 2010 is 25% points below the euro area average. Mainly for these reasons the markets have until very recently given Spain the benefit of the doubt, so Madrid can still access long term market funding.
However, as borrowing rates back up, markets are re-assessing amid major doubts. In the last three and a half years Spain’s unemployment rate has soared from a cycle low of 8% to 21% comfortably the highest in the EU. Although labor market reforms have now been introduced Spain still has one of the most highly regulated labor markets in the EU. While restrictions on hiring and firing have been relaxed much more needs to be done. In particular endemic wage indexation is not compatible with operating in a monetary union, particularly during periods of high unemployment and cost shocks (e.g., food and energy spikes). Spanish wage inflation remains above German wage inflation even though the German economy is booming and German unemployment is at a multi-decade low.
Spanish collective bargaining wage agreements have doubled this year on indexation
Source: Bank of Spain In addition, while Spain is meeting its general government deficit targets, this is only because of a significant outperformance at the Federal level. Regional government spending is still out of control and the IMF complains that the transparency of regional budgets leaves much to be desired. Moreover, while Spain’s debt to GDP ratio is relatively low, it is rising at a rapid rate because the economy is barely growing and the primary deficit was 7.3% of GDP in 2010. Recent PMI data showing the Spanish composite PMI slumping to a six month low of 49.2, suggests the economy may be losing what little momentum it had and sliding back into recession. If growth turns negative the debt to GDP ratio will continue to soar and rapidly converge to the euro area average.
The official Spanish house price index has fallen by less than 15% from its peak, which simply does not ring true given the huge overhang of properties. Another big leg down in house prices is a significant downside risk for the Spanish banking system and economy. Another is further ECB rate hikes because like Portugal, almost all the mortgage debt is floating rate. Finally, while the Spanish economy grew rapidly in the lead up to the GFC, this purely reflected the credit boom. According to OECD calculations Spain’s potential GDP growth is one of the lowest in the developed world at just ¾%.
4. Italy – growth (lack thereof) is its nemesis
Until quite recently Italy stayed out of trouble because it has consistently been running primary surpluses and did not employ countercyclical fiscal policy to anything like the same extent as most other euro area countries during the GFC. Between 2008 and 2009 Italy’s cyclically-adjusted primary surplus only moved 0.6% points from 2.0% to 1.4% of GDP. The average cyclically-adjusted primary balance stimulus was 2.0%, with 2.6% in France, 4.9% in Spain, 5.7% in Portugal, 4.3% in Greece and 3.9% in Ireland. Only Germany’s moved by less, by just 0.4% points.
Even though Italy has maintained budget discipline its debt to GDP ratio hasn’t fallen, and in EMU its primary surplus has been a lot lower than in the pre-EMU years when Italy had Latin-style interest rates. Unlike Belgium, which was similarly parsimonious in the first decade of EMU, Italy’s debt to GDP ratio never fell below 100%, and is now back up to 120% in the wake of the GFC.
Italy’s problem is growth; or lack thereof. In the last decade the Italian economy has only expanded at an average annualized rate of 7bp (0.07%). In the GFC the Italian economy contracted by 7%, and since the low point in mid-2009 GDP has only risen by 2%. At the heart of the problem is Italy’s structural loss of competitiveness. Not only has Italy allowed its costs to rise relative to most other EMU countries, it still produces a lot of modest valued-added goods, which compete against other emerging markets like Turkey with a much lower cost base. Italy’s global export market share has fallen precipitously over the last two decades (see chart below, blue line).
Italy’s composite PMI has declined to a 21 month low of 48.4, which suggests that like Spain there is a risk of sliding back into recession. With markets turning the spotlight on Italy as well as Spain the Italian government recently passed 50bn euro budget cuts to balance the budget by 2014. Unfortunately the cuts are conspicuously back loaded, and therefore lack credibility.
Italy’s problem: a chronic lack of competitiveness (and hence growth)
Source: IMF
Annex II: France is the weakest link of the AAA-rated euro economies
France is the weakest link of the six triple A-rated euro area economies. It is the most at risk from being downgraded, and if this happens to could be a dramatic game changer for the euro. As the charts below show, on government and external criteria France has by far the weakest fundamentals. Moreover France’s medium fiscal plans lack ambition and smack of complacency.
In the GFC France provided its economy with a fiscal boost equivalent to 2.6% of GDP, significantly more than the euro-zone average of 2.0. Moreover France is only proposing a modest pace of fiscal adjustment going forward, which will still leave the general government budget deficit at 5.3% of GDP in 2012 according to the European Commission, well above the euro area average of 3.5% and the more than triple the average of the other five AAA-rated countries (1.7%).
Since currencies were effectively fixed in 1997 France has lost competitiveness against its AAA counterparts and particularly against Germany, and this has been reflected in a swing in its current account balance from a surplus of 2% to a deficit of roughly 3%.
A French downgrade would be potentially catastrophic for the euro, because it would blow a hole in the European Financial Stability Facility lending capacity, and at a stroke critically undermine the credibility of the euro-zone’s hastily cobbled together bailout facility. This is because the EFSF’s effective lending capacity is based on the share of the AAA-countries, which is 255bn euro or 58% of the total 440bn euro. France’s share is 89.6bn euro or just over 20%.
The latest Greek package calls for loans of 109bn euro, which are likely to be split 70:30 with the IMF, implying a European contribution of about 76bn euro. This would be on top of the 18bn committed to Ireland and 52bn committed to Portugal for a total of 146bn. If the EFSF’s lending capacity is shrunk by roughly 90bn this would leave just 19bn for the EFSF’s expanded role.
The answer of course would be to expand the EFSF, perhaps say double it. The problem with this is that by increasing the AAA-rated countries’ contingent liabilities hasten a French downgrade. An attempt to expand the EFSF could hasten its demise and create a catastrophic crisis in the euro-zone.
Source: EFSF
Public spending as % of GDP
Source: IMF
General government deficit as % of GDP
Source: IMF
General government debt as % of GDP
Source: IMF
Current account balance as % of GDP
Source: IMF
