Will There Be Political Will?

GIC Tokyo

Manuel Balmaseda

CEMEX Chief Economist

Political will will determine the outcome

Eurozone debt problem manageable 1

Austerity fatigue vs. Bail-out fatigue 2

Quo vadis Europe 3

Political economy dominating economic policy

Debt dynamics dependent on external

factors 4

3

Europe does not have a larger debt problem than others

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

EMU US Japan

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

EMU US Japan

0

100

200

300

400

500

EMU US Japan

Fiscal Balance

Source: IMF

Current account balance

Debt by sectors

Public

Households

Corporate

4 Source: IMF, ECB

Despite the vulnerable fiscal situation yields

remain low in Japan and the US

Note: Size bubble: 10y yield average last 3 months. Fiscal Balance: average 2011-12.

Gross debt: 2012

JPUS

EZ

-15

-10

-5

0

5

0 50 100 150 200 250

Fisc

al B

alan

ce (

% G

DP

)

Government gross debt (% GDP)

Europe does not have a larger debt problem than others

5

Europe, the never-ending story?

Uncertainty as to whether Europeans want more Europe or not

(actions speak louder than words)

Current crisis, the necessary trigger to push forward the

European Project

The Euro zone is currently in an unstable equilibrium

Bail-out fatigue vs. Austerity fatigue

Enhanced integration

• Short-term easing

• Mid-term reforms

• Long-term integration

and redistribution

Implies loss of

sovereignty

Disintegration

Resort to traditional tools

(devaluation, strong

monetary support) to

alleviate the real effect

(unemployment) of the

needed adjustment. High

costs (default, banking

linkages, fear of floating)

Political game: playing with fire

7

A game of

chicken 1

Towards a

“new” Euro 2

Core Europe forces

other countries to

undertake the

necessary

adjustments and

reforms

Periphery countries

know that the break

up of the Euro

would be a

catastrophe for

everybody, including

the core

Will Spain and

Italy belong to the

“new” Euro?

Emerging crisis in mature(?) economies

• Unfinished project:

• Incomplete institutional framework

• Political dynamics will set the speed, scope and timing of

resolution

•Address linkages between sovereign debt and banking solvency

• From private exposure to private exposure, thanks to the ECB

• Need for a transfer union in the long run, only possible with

integration

• Four roads to debt reduction:

• Primary surplus: frontloaded fiscal policy

• Lower interest rates: markets penalizing, not rewarding, fiscal

discipline

• Economic growth/inflation: ECB action required, at least, in

the short term

• Restructuring/default

8

9

The European crisis is not a fiscal crisis, but a political crisis

0

2

4

6

8

10

SPA GER FRA UK IT US

0

1

2

3

4

5

6

SPA GER FRA UK IT US

0

10

20

30

40

50

60

SPA GER FRA UK IT US

Overall fiscal deficit (% of GDP) Fiscal tighteninng (% of potential GDP)

General government expenditure (% of GDP) Debt service (% of GDP)

Source: IMF, “Fiscal Monitor” Oct. 2012

-1

0

1

2

3

4

5

6

SP PT GR IT IR FR NL EA17 UK US DE

2012 2013

Beware of coordination, it can add up to your

troubles

Fiscal Multiplier Variants

-0.5

0

0.5

1

1.5

T+RP+NC T+NRP+C GI+RP+NC GI+RP+C GI+NRP+NC GI+NRP+C

Composition: T (Taxes Oriented) or GI (Gov expenditure/investment Oriented)

Risk Premium: RP (decrease in risk premium) or NRP (stable risk premium)

Coordination: C(Coordinated) or Non Coordinated (NC)

Source: Cemex Economics

BE

FI

FR

GER

GR

IRE

IT

JP

NLPT

SP

US

-15

-10

-5

0

5

0 50 100 150 200 250

Fisc

al B

alan

ce (

% G

DP

)

Government gross debt (% GDP)

11

Sudden stop of flows: Whose currency is the Euro?

Source: IMF, ECB

Despite the vulnerable fiscal situation yields

remain low in Japan and the US

Note: Size bubble: 10y yield average last 3 months. Fiscal Balance: average 2011-12.

Gross debt: 2012

0

400000

800000

1200000

1600000

2000000

2400000

2800000

3200000

May

-08

Au

g-0

8

No

v-0

8

Feb

-09

May

-09

Au

g-0

9

No

v-0

9

Feb

-10

May

-10

Au

g-1

0

No

v-1

0

Feb

-11

May

-11

Au

g-1

1

No

v-1

1

Feb

-12

May

-12

Au

g-1

2

No

v-1

2Securities

Lending to Credit Institutions

Total Claims

Gold and Other Assets

12

ECB has been quite active, even as official rhetoric has not

been as forthcoming until recently

ECB balance sheet (M€)

Lehman

ECB has compensated the

disruption of European money

markets … ECB announces

new liquidity

measures

… and it has allowed for a reduction

of Euro area exposure to periphery

countries: private borrowing is being

replaced by public sector flows

Source: IMF, Global Financial Stability Report, Oct

2012

13

Cross-border private capital is being repatriated from the

periphery back to the core

Germany continues being the main lender,

but now through public sector flows

-300

-200

-100

0

100

200

300

400

5002

00

0

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

Change in Bundesbanks´s claims

on the Eurosystem (TARGET)

Net capital flows

excluding TARGET

Current account

balance

Source: Bundesbank Source: IMF, Global Financial Stability Report, Oct

2012

Measures focused only on the short run are, by definition,

short-lived

Prevent sovereign default (mainly in Spain and

Italy)

Prevent banking defaults from being systemic

1

2

Sustainable fiscal accounts (does not imply

frontloaded consolidation) 3

Banking restructuring pre-”banking union” 4

• Short run: to avoid a liquidity crunch, financing

needs (spreads)

• Long run: integration and sustainable growth

• Downsizing

• Denationalization and competition

• Too big to fail implies externality risks

ECB buying

time

Need to act in

the short run

vs. “real”

moral hazard

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

No

v-1

0

Feb

-11

May

-11

Au

g-11

No

v-1

1

Feb

-12

May

-12

Au

g-12

No

v-1

2

15

ECB intervention buys time

Financing costs back to beginning of the

year levels

IT

SPA

FRA

GER

ECB

Source: Bloomberg

40

90

140

190

240

290

340

390

440

Nov

-07

May

-08

Nov

-08

May

-09

Nov

-09

May

-10

Nov

-10

May

-11

Nov

-11

May

-12

Nov

-12

Financial

Corporate

Sovereign

Risk perception reduced after ECB

announcement

ECB

Markit Itraxx Sovereign, Financial and Corporate Index

• Default risk

• Break-up risk (exchange rate risk)

Europe continues buying time strategy, long-term strategy?

Institutional reform/Fiscal reform

• Lender of last resort (ECB)

• Fiscal integration (European Treasury) and Eurobonds

Incentive mechanisms (fiscal, regulatory, etc.)

Banking Union

• Pan-European banking resolution

• European Deposit Insurance Institution

• Regulation and supervision

Structural reforms across Europe, predominantly in the

periphery (competitiveness) but not only

Dominance of domestic politics (German & Italian elections)

Diminishing returns to the “buying time” strategy

Sovereign as reference for corporates (not a leveled playing field)

Increasing social risk 16

Credibility can drive positive dynamics …

End of 1994 Recession

Central Bank independence + Fiscal

Consolidation plan

> Improved Fiscal Balance

Debt Yields Decrease

Higher GDP Growth

Deficit Reduction (primary)

Virtuous Credibility Cycle

(Euro Accession)

> Deficit Reduction (primary & interest)

Low FX rate volatility

Interest rates decrease Cre

dib

ilit

y G

ain

s

Implied Probability of EMU Accesion

0

10

20

30

40

50

60

70

80

90

100

Jun-96 Sep-96 Dec-96 Mar-97 Jun-97 Sep-97 Dec-97 Mar-98

Source: JPMorgan

France

Spain

Portugal

Italy

Credibility “matters” and can deliver

good results in the very short term

17

Markets sells Sovereign debt

Yields & Cost of Debt rise

Debt Interest payments Rise

Budget Positions Deteriorates

> Primary Budget adjustments

Lower GDP Growth

Debt “mark to Market” hits bank

balance sheets

Vicious Credibility Cycle

(Self-Fulfilling Debt Crisis)

Initial adjustments non credible + rating

worsens

Cre

dib

ilit

y W

ors

en

s

Government Debt under prolonged GDP slowdown,

Higher Interest rates & Contingent Liabilities Shock

(% GDP)

Alternative Scenario: 2% lower Growth + 200 bp increase in real interest

rates

+ increase in cost of Guarantees.

Source: IMF

… but it can also drive negative ones

18 18

18

Don’t despair, “el dorado” is at the end of the road

Thank you!