Eurozone Debt and the Rise of DM Political Risk

8/6/2019 Eurozone Debt and the Rise of DM Political Risk

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26 May 2011

Thoughts from a Renaissance manEurozone debt and the rise of DM political risk

Charles Robertson+44 (207) [email protected]

As we are repeatedly asked about our views on the eurozone, we have compiled what we believe are the key graphs to look at.

Greeces public debt ratios are 33% worse than the next highest country, Italy, and appear to beunsustainable. This is not true of Portugal or Ireland, whose debt ratios, even by 2012, are on course to be below Italys, which hasmanaged a debt ratio of 120% for roughly 20 years (albeit helped out along the way by the 1992 devaluation).

As Greece would still run a budget deficit roughly equivalent to its education budget even if it wrote off100% of its debt, then we believe no default or restructuring can occur without the permission of the EU and IMF. Or rather, Greececan of course do what it likes, but no one will fund its residual primary deficit, so very painful cuts would still be required. The EUdoes not expect Greece to achieve a primary balance in 2011-2012.

Few trust Greece to deliver the austerity it needs to manage its debt burden, in part because previous

governments blew up a good fiscal position even when the economy was booming. Debt restructuring, with the imposition of losseson the ECB and others, is our base case for 2013 at the latest.

The major problem for others on the periphery of Europe is not sovereign debt but private sectordebt. The total debt burden is actually higher for Ireland, Portugal and Spain than for Greece. We struggle to see how any of thesecountries will improve living standards in the coming decade. The private sector debt boom which fuelled the good times of 1990-2008 is over, and finance, construction and retail are presumably dead in the water for years to come. Ireland might at least benefitfrom exports of goods and service (over 100% of GDP), but Portugal and Spain do not have this advantage. All face tax hikes,government spending cuts, less bank lending to fuel consumption or investment, and years of tough choices. Private sector debtdefaults will presumably be a theme for the coming years.

Voters are already rebelling against the austerity required, with the worst government defeat in Irish historyoccurring this year and the worst election result in thirty years for the incumbent Socialist party in Spain. Meanwhile, voters innorthern Europe are rebelling against the bail-outs for peripheral Europe and seem likely to resist any significant move towards a

federal Europe.

The obvious economic solution is for countries to leave the eurozone.Argentinas economy returned to stronggrowth after devaluation even though exports were just 10% of GDP (similar to Greece). Unfortunately, it would probably trigger abanking collapse as depositors fled to euro accounts in Germany, and could perhaps force the imposition of capital controls.Eurozone leaders will try to resist this, but they cannot prevent voters from choosing this option.

Therefore, it is now political risk which markets must watch, with elections in Portugal (2011), Spain(2012), Greece (2013), France (2012) and many others. European political risk might displace emerging market (EM)political risk as a major cause of market distress over the coming years.

In the meantime, we would not be surprised by an earlier Greek debt restructuring, even as we assume theEU will do what it can to push the problem into the future, in the hope that a weaker euro, falling commodity prices, surprisinglysuccessful productivity improvements in peripheral Europe or the arrival of magical leprechauns with pots of gold will rescue the

situation. Given the options, we believe investors are better off in EMs and future reports will concentrate on those opportunitiesinstead.

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26 May 2011 Thoughts from a Renaissance man Renaissance Capital

The debt problems in the eurozone are particularly acute for Greece. Its public debt

in 2011 of 158% of GDP will be nearly one-third higher than Italys public debt of

120% of GDP, and nearly double the average eurozone debt level of 88% of GDP.

Figure 1: Public debt-to-GDP ratios in the EU, 2009-2011

Source: Eurostat, EU Commission forecasts

Figure 2 shows that Italy has been able to sustain a debt level of 120% of GDP

since the early 1990s. This suggests Ireland (118% of GDP in 2012) and Portugal

(107% of GDP in 2012) could manage a burden this large. Note that while Belgium

survived a debt burden of 140% of GDP, this was sustainable thanks to a

devaluation in the 1980s and only rising interest rates associated with German

reunification delayed a quicker reduction in Belgian debt after this.

Figure 2: Public debt as % of GDP in high debt eurozone countries 1992-2012

Source: OECD 1992-2008, Eurostat 2009-2010, EU Commission forecasts 2011-2012

At the sovereign level, Greece looks to be in a unique position in Europe. From a

global perspective only Japan has a higher debt burden.

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Figure 3: Flow and stock of public debt as % of GDP

Source: Eurostat, national sources

The key difference between Greece and Japan is that Japanese household savings

of nearly 170% of GDP in cash and bonds are almost equal to the government debt

level. This means that not only can Japan finance its own debt but it can do so at

very low interest rates, allowing the fiscal burden to be managed (for now). In

Greece, the relative numbers are household savings of around 85% of GDP against

a debt level of nearly 160% of GDP. This huge gap means that Greece looks

particularly dependent on foreigners at the sovereign level.

Figure 4: Household savings data from 2008 (unless otherwise stated) as % of GDP and public debt in 2011as % of GDP

Source: Eurostat

Therefore, to get external support for a high level of government debt requires: 1) a

high level of domestic savings, or 2) a high level of external trust that the debt

burden is sustainable. Greece has neither.

The key problem for Greece is not actually the debt burden itself, although it is far

more expensive for Greece to manage than for Japan. After all, Greece was able to

sustain interest payments of 11% of GDP annually from 1992-1996 (although

Estonia

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inflation was higher then, so the real burden might not have felt so harsh), while in

2012, the EU Commission expects Greece to only be paying 7.4% of GDP.

Rather, the problem is that Greece might never get its budget deficit under control.

The EU Commission believes that Greece will still be running a budget deficit of

9.3% of GDP in 2012, so the debt burden will continue to mount. Greece needs to

run a budget deficit of 3% of GDP and have a growing economy to stabilise the debt

burden.

Figure 5: Budget balance as % of GDP, 2009-2012

Source: Eurostat 2009-2010, EU Commission forecasts 2011-2012

How can Greece grow? In expenditure terms, government consumption is ruled out.

In 2011, Greece will be spending 50% of GDP and it needs to cut spending, not

increase it. Higher taxes to reduce the budget deficit are likely to hurt private

consumption, and banks are going to be reluctant to lend. Net exports areunfortunately not going to help much either as exports account for a small share of

Greek GDP. Meanwhile, which companies will invest heavily in this environment?

Presumably very few. To cap it all, Greeces central bank (the ECB) is raising

interest rates. The EU Commission expects Greece to record only marginal growth

in 2012, after three years of GDP contraction. Argentinas record suggests three

years of contraction is as much as a population is prepared to take before politicians

give up.

Figure 6: No decent growth in these countries, GDP % change YoY, 2009-2012

Source: Eurostat 2009-10, EU Commission forecasts 2011-2012

Why are the EU Commission and the market so pessimistic on Greece? Is it

unrealistic to assume that Greece might push through harsh austerity?

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The IMF produced a research report in 2010 (clickhereto access Default in Todays

Advanced Economies: Unnecessary, Undesirable, and Unlikely) which showed that

many countries with high debt burdens were able to avoid default through the 1980s

and 1990s. What the authors failed to highlight is that nearly all these countries

devalued their currencies significantly to achieve the growth needed to improve their

budget picture. So, history is not an encouraging guide.

Nor is Greek fiscal history very encouraging. Leaving aside the often-quoted

comments that Greece has spent 100 of the past 200 years in default, we only need

to look back at the 2000s to make a call on the Greek appetite for austerity.

In the early 1990s, the Greek economy grew at just 1% annually, and the

governments primary surplus, its revenues minus its expenditure excluding interest

payments, was 1.6% of GDP.

Attracted by what would be a 6.3% of GDP annual saving in interest payments, and

helped by a currency devaluation in 1998, the government had political support to

increase the primary surplus by 1.9% of GDP annually to 3.5% over 1997-2001.

This would not have felt too painful as the growth rate trebled to 3.8% of GDP

annually, and as banks were lending large amounts to households and corporates.Today there is no such pot of gold at the end of the austerity rainbow.

Once Greece was in the eurozone and interest rates had fallen, the interest burden

was down to 4.8% of GDP over 2002-2006, and despite high growth of 4.2%

annually, the government spent so much it ran a 0.9% primary deficit. This is

remarkable to us. Despite everything working in its favour, and despite it being given

an extra 2.9% of GDP annually from saved interest payments, the government cut

taxes by 2% of GDP and increased non-interest spending from 37.4% of GDP to

40.0% of GDP. It worsened its fiscal position by 4-5% of GDP. It is little wonder that

now, when nothing is working in Greeces favour, few believe that Greece can

achieve a primary surplus.

Figure 7: How Greece blew its primary surplus: GDP % change YoY and key budget data as % of GDP

Source: EU Commission

Greece can only afford to default with permission from the EU/IMF

This primary deficit position is extremely important. It means that, even if Greece

wrote off all its debt, the government still could not cover its expenditure. Last year,

excluding interest payments its deficit was 5% of GDP even closing down all

education (roughly 4% of GDP) would not have covered the gap. To close theforecast primary deficit of 2% of GDP in 2012 would still require half of the Greek

education budget to be removed.

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http://www.imf.org/external/pubs/ft/spn/2010/spn1012.pdfhttp://www.imf.org/external/pubs/ft/spn/2010/spn1012.pdfhttp://www.imf.org/external/pubs/ft/spn/2010/spn1012.pdfhttp://www.imf.org/external/pubs/ft/spn/2010/spn1012.pdf


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But even the most aggressive forecasts do not assume a total write-off of Greek

debt, so Greece still needs to borrow considerably more than 2-3% of GDP in 2011-

2012, and as the markets will not fund Greece, that makes it dependent on the

eurozone and IMF. Debt restructuring can only take place with their consent.

So, the question is when does Europe want to accept a Greek default? Media noise

out of Germany suggests they might be prepared to accept this in 2011 under a

different name, such as restructuring or re-profiling; but the ECB is opposed, arguing

that restructured bonds will not be acceptable collateral for the ECB, so it would stop

providing liquidity to Greek banks which would then go bust. It is not clear to us what

solution the ECB sees for Greeces problems, but, in the end, we assume the ECB

will have to change its tune as it did in 2010 when it decided to accept sub-

investment grade debt as collateral

We would not be surprised by a restructuring this year, and expect a default no later

than 2013, which happens to be an election year.

Greek default contagion to other sovereigns.

The charts above show that Greece is a unique case. No other country matches its

high level of public debt or the low coverage of this debt by household savings.

Irelands fiscal mess is similar to Greeces, but its growth is better, while Portugals

GDP performance will be nearly as weak as Greeces, but its debt-to-GDP ratio

looks better. The EU may be prepared to deal with the consequences of Greek

default, but we think it will not see the same justification for default by Ireland or

Portugal.

Of course, Greeces unique public sector debt problem did not stop Ireland and

Portugal both having to turn to the EU and IMF for support, and Spain may follow

later this year. A key signal of market distress is evidently the yield of Spanish debtover German bunds. But just because these countries borrow from the IMF and EU

does not necessarily mean they will also have to restructure their public debt.

But what about the private sector? This is where the real problem lies for peripheral

Europe, except, surprisingly, for Greece. Private sector debt is around 200% of

GDP in Ireland, Spain and Portugal, against 114% in Greece or 125% in Italy. Note

that we include two data series here for internal bank lending and eurozone-wide

bank lending to each country. We will use the former series in the subsequent charts

as it gives us more history.

Figure 8: Private sector (household and corporate) debt as % of GDP in 2010

Source: IMF, CEIC

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If we add the private sector (internal only) and public sector debt levels together, we

get quite a different picture.

Figure 9: Private sector (non-bank) and government debt as % of GDP in 2010

Source: Eurostat, IMF, CEIC

Now it is Ireland, Portugal and Spain that look in a worse position than Greece. The

default story is hitting Greece now because it is one single borrower that is having a

severe refinancing problem. But the debt burden is greater for the others.

If we do not believe that Greece can grow out of its problems, should we be more

optimistic about the others? The short answer is no. All four of the peripheral

countries boomed from the early 1990s on the back of a private debt explosion, from

an unweighted average of 60% of GDP in 1992 to 102% in 2001 and 185% by 2010.The resultant rise of the financial and construction sectors, as well as the retail

sector, is now presumably over.

Figure 10: Private sector (household and corporate) debt as % of GDP (LHS) and GDP % changeYoY since 1992 (RHS)

Source: IMF, CEIC, EcoWin, EU Commission

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We should therefore assume a long drawn-out period of many years where sluggish

growth becomes the norm and debt burdens rise, a little like Italy in a best-case

scenario. Wages need to fall relative to Germany, while unemployment has already

increased, which will make existing debt harder to afford. Rising ECB interest rates

will add to the actual cost of existing debt in Spain, most mortgages are variable.

Governments will have to follow austerity policies. Investment will be sluggish.

Countries like Spain, where household debt is very high, will look enviously at the

US and UK as they inflate away their debt.

Figure 11: Household cash and bond savings minus household debt as % of GDP

Source: Eurostat, Japanese central bank, Federal Reserve, BIS

Figure 12: The unemployment rate in Spain has returned to 1993-1994 levels, but without the prospect of aprivate sector debt boom to reduce it

Source: CEIC

As with Greece, there may be a reliance on exports to boost growth, but a strong

euro will hamper this. Only Ireland has a particularly open economy which will

benefit from higher external demand. We would not be surprised by increased trade

tension with China which Beijing may try to ameliorate by buying eurozone bonds

(including Spains).

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Inflation should be politicallypopular in these countries

Deflation should be politicallypopular in these countries

The Spanish should want to inflatetheir debt away - like the US or UK

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Figure 13: Exports of goods and services as % of GDP (balance of payments data)

Source:CEIC

The stress will show up in elections. Voters will reject incumbent governments thatare unable to deliver even modest improvements in l iving standards in the coming

years. Ireland has already seen the previously dominant Fianna Fail suffer the worst

election defeat of a sitting government since independence in 1921. In Spain, the

ruling Socialist party suffered the worst defeat in 30 years at the local elections in

May 2011, and are expected to lose the March 2012 elections. Portugals

forthcoming elections are now expected to show a defeat of the ruling Socialist

party, and in Greece the Socialist party is set to lose the elections due in 2013 if

the party can even remain united until that point.

Incoming governments will not fare well either. They too will be forced to continue

with austerity policies, while the ECB hikes rates and perhaps the euro strengthens.

Within five-to-ten years, voters may be rejecting both major parties in all four

peripheral countries. In Spain, the recently established 15 May movement (15-M) is

already doing just that. As politics gets ever tougher, peripheral Europe will be

looking for another solution.

Figure 14: Key poll and election figures

Opinion poll Election results

March 2011 Finland 2007 2011

Marine Le Pen (National Front) 23 True Finns 4 19Nicolas Sarkozy (incumbent) 21

Martine Aubrey (Socialist) 21 Ireland 2007 2011

Fine Gael 27 36Fianna Fail (incumbent) 42 17

Labour 10 19

Portugal 2009 2011Socialist 37 ?Social Democrats 29 ?

Spain - local elections 2007 2011

Socialists 35 28People's Party 36 38

Source: Wikipedia, Google

Towards a federal Europe?

An obvious solution is for the eurozone to offer far greater fiscal support to the

periphery nations. We see two key obstacles to this.

First, when the Germans agreed to sacrifice their beloved Deutschmark in the 1990s

in return for French acceptance of reunification, Germany expected the rest of

Europe to accept the new euro as a sort of gold standard. When Germans have

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faced competitive problems, they have accepted real wage cuts relative to the rest

of Europe to regain competitiveness. As there was no bail-out clause in the

Maastricht Treaty, they believed the rest of Europe would also have to accept this

model. Germany and others with a similar model find the idea of bail-outs very hard

to stomach.

Second, even if political leaders in Germany and other countries wanted to give

more money to peripheral Europe, an ever-increasing number of their voters do not

agree. The True Finns, who object to the current bailouts, saw their support surge

from 4% in the 2007 Finnish elections to 19% in 2011. We can assume that many

others were sympathetic to the party but were not prepared to back such untested

politicians. In France, Marine Le Pen might make the run-offs of the French

presidential election in 2012 (but few believe she can win), and she has gone still

further, suggesting France should leave the eurozone so it can devalue and protect

its industry. In Germany, the liberal Free Democrats have been reportedly

considering a shift towards euro-scepticism in a bid to improve their standing in the

polls. In Slovakia, there was great reluctance to even support the first package for

Greece in 2010, which is understandable as the Slovaks are poorer than the

Greeks.

While peripheral European voters will increasingly vote against the austerity policies

demanded by the north, northern European voters look increasingly likely to vote

against policies offering more support for the south.

Why not leave the eurozone?

The most logical solution for those countries looking for an export boost, additional

jobs, a budget revenue boost and a return to GDP growth is, evidently, to leave the

eurozone. Time and time again in EMs, when excess debt was built up, devaluation

proved to be the right (political) answer; however, many arguments were madeagainst this solution. Even in Argentina, where exports of goods were just 10% of

GDP in 2000-2001, devaluation did work. After an 11% GDP fall in 2002, Argentina

recorded average growth of 8.8% over 2003-2007.

The main difficulty is that it is likely to result in the bankruptcy of the banking system.

For anyone holding euros in Spain, it would make sense to shift those deposits to a

German bank in Germany, so we would see a run on the banking system. The

problem then is that European banks are so intertwined with Spanish banks, that the

global financial system would again be threatened. Capital account restrictions could

be imposed, but this would run counter to the European single market. Leaving the

eurozone would be more manageable if it was just Greece alone, but would be seen

as contagious.

So were stuck with the current mess?

Hence were stuck with the current mess. The most stable scenario is for Greece to

restructure its debt, by no later than 2013, and for Europe to accept the loss this will

entail for the ECB and other holders of Greek bonds. We should expect European

banks to raise capital against this forthcoming loss. We should assume the Greek

banking sector will be supported to prevent it being wiped out. Meanwhile, the

Portuguese and Spanish private sectors will suffer the pain of eurozone membership

for many years to come, while Ireland will hope to benefit from broader eurozone

growth. This seems to us to be the eurozones plan.


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The most positive scenario is a weakening of the euro and falling commodity prices,

with a rise in Iberian innovation, which would help produce better-than-expected

growth.

A more worrying scenario would be for Greece to leave the eurozone, which might

be right for Greece but would then lead to speculation that others could follow, with

destructive effects for banks around the region.

Impact on EMs

The current situation offers some advantages for EMs. The periodic return of risk

aversion helps reduce EM currency and commodity appreciation pressures, and

slows the rise in EM stock markets, helping to prevent bubbles. At the same time,

the stark contrast between the near bankruptcy of some developed markets and the

far better debt profiles of EMs only underline the relative attractions of EMs.

We, of course, have to fear the worst-case scenario of eurozone defaults spreading

to Spain, or multiple breakaways from the eurozone coinciding with banking

collapses in peripheral Europe. But unlike a typical EM crisis of the 1990s, it is hard

to see how markets can force this to happen now they have been removed from the

financing equation by the EU and IMF in Greece, Portugal and Ireland, which means

we will have to watch the political calendar in Europe.

Enough political shocks in peripheral Europe might result in unilateral withdrawal

from the euro. Political risk in Europe may therefore displace EM political risk as the

main threat to market stability over the coming years.

Figure 15: Key economic data, 2010

Ireland Portugal Spain Greece

GDP (EURbn) 154 173 1,063 230

Goods (EURbn) 84 37 191 16as % of GDP 54 21 18 7

Services (EURbn) 73 18 94 28as % of GDP 48 10 9 12

Exp GS as % of GDP 102 32 27 19

Debt as % of GDP 96.2 93 60.1 142.8Debt (EURbn) 148 160 639 329Budget balance as % of GDP -32.2* -9.1 -9.2 -10.5Budget balance (EURbn) -50* -16 -98 -24Outstanding value of bonds (EURbn) 89 108 465 255Note: *Budget was -12.2% and EUR19bn excluding the banks bail out

Source: Bloomberg, Eurostat, CEIC


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Descriptions of any company or issuer or their securities or the markets or developments mentioned in the Communication are not intended to be complete. The Communication should not beregarded by recipients as a substitute for the exercise of their own judgment as the Communication has no regard to the specific investment objectives, financial situation or particular needs ofany specific recipient. The material (whether or not it states any opinions) is for general information purposes only and does not take into account your personal circumstances or objectives andnothing in this material is or should be considered to be financial, investment or other advice on which reliance should be placed. Any reliance you place on such information is therefore strictlyat your own risk. The application of taxation laws depends on an investors individual circumstances and, accordingly, each investor should seek in dependent professional advice on taxationimplications before making any investment decision. The Communication has been compiled or arrived at based on information obtained from sources believed to be reliable and in good faith.Such information has not been independently verified, is provided on an as is basis and no representation or warranty, either expressed or implied, is provided in relation to the accuracy,completeness, reliability, merchantability or fitness for a particular purpose of such information, except with respect to information concerning Renaissance Capital, its subsidiaries and affiliates.All statements of opinion and all projections, forecasts, or statements relating to expectations regarding future events or the possible future performance of investments represent RenaissanceCapitals own assessment and interpretation of information available to them currently. Any information relating to past performance of an investment does not necessarily guarantee futureperformance.

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