The Rise and Fall of Intra-EMU Diversification
April 14, 2008
By Stephen Jen | London
Summary and Conclusions
Last week, we proposed the hypothesis that one of the key reasons why the EUR has been so strong in recent years is the rise in the financial ‘home bias’ in Euroland, in contrast to the opposite trend witnessed in the rest of the world (RoW). We follow up on this hypothesis in this note by highlighting two opposing forces that dictate the degree of financial ‘home bias’ in Euroland. On the one hand, Euroland’s financial ‘home bias’ should increase over time because of the enhanced liquidity and depth of the EUR capital markets. On the other hand, gradual economic and financial convergence within Euroland will eventually erode the benefits of intra-EMU diversification and force European institutional investors to allocate more assets outside the EMU. So far, the first force has dominated. But we expect the second force to eventually kick in and lead to a reduction in the EMU’s financial ‘home bias’. Our Hypothesis on Why the EUR Is So Strong Last week, we proposed a hypothesis that may help to explain why the EUR is so strong (see Why Is the EUR So Strong: a New Hypothesis, April 3, 2008). In that note, we argued that, in this age of financial and trade globalisation, most countries in the world have exhibited a declining trend of financial ‘home bias’ – which is the ratio of financial assets held in local currencies relative to those held in foreign currencies. In the case of the US, we observed that their real money accounts, which have around US$22 trillion in assets under management (AUM), have aggressively diversified out of USD assets since 2003. Japanese retail investors, similarly, have begun to reduce their financial ‘home bias’ since summer 2006. Retail investors in emerging Asia and Latam have followed the same trend. This makes sense: not only is the globalising world offering rewarding investment opportunities in various parts of the world, but the benefits of financial diversification have also become more obvious and realisable as improved information on different markets has helped investors to be more comfortable with holding exposure to assets of faraway countries. But in Euroland the trend has been exactly the opposite. Since 1999, the financial ‘home bias’ has risen drastically. These divergent trends in ‘home bias’, we argued, are a key force distorting the currency markets as the EUR is pushed deep into overvalued territory against most currencies. NB would cut interest rates quicker. Two Opposing Forces Dictating EMU’s ‘Home Bias’ The first of the two forces driving Euroland’s ‘home bias’: benefits to European institutional investors investing within the EMU arising purely from the enhanced liquidity and depth of the asset markets. Before 1999, how much a European institutional fund invested within other European countries should not have had a major impact on the benefits of doing so. However, after the introduction of the euro, the liquidity conditions of most assets in Europe improved exponentially. In this new environment, the higher the home bias, the greater the benefits that could be reaped. The second force dictating the ‘home bias’: the costs of not diversifying out of the EMU, which is a function of economic and financial convergence. We presume that the pace of economic and financial convergence probably accelerated with the introduction of the EMU, but at a pace that is slower relative to the growth in asset market liquidity. If our presumption is correct, then the costs of not diversifying out of the EMU should have risen at a faster pace after the introduction of the euro in 1999, relative to before 1999. Also, this cost of not diversifying should rise with the degree of home bias, i.e., as the economies converge, it is costlier to run a high home bias. The ‘equilibrium’ level of home bias should have risen since the introduction of the euro, particularly if the improvement in the liquidity of the EUR asset markets materialised at a faster pace than the economic and financial convergence within the EMU member countries. Over time, however, it is likely that there will be more economic convergence as the pace of liquidity improvement of the EMU capital markets decelerates. In turn, what this means is that we ought to have witnessed a surge in the financial ‘home bias’ within the EMU in the early years of the introduction of the euro, followed by a decline in the home bias as the initial boost to market liquidity decelerates and EMU economies become more in sync. EMU Capital Markets Have Deepened Significantly The liquidity of Europe’s bond market since 1999 has shown dramatic improvement. While liquidity was stagnant in the first four years of the EMU’s life, as of 2003, the depth of the EUR bond market grew significantly. Other measures of the liquidity of the bills market and money market tell a similar story. EMU Financial Markets Have Partially Converged The equity markets within Euroland have converged in recent years, with rising cross-country correlations. For example, the correlation between the markets in France and Germany rose from 0.66 in the 1980s, to 0.83 in the 1990s, and 0.93 in the last decade. Similarly, such correlations have broadly risen across most European countries, and the trend has accelerated further since the introduction of the EMU. This implies that, all else equal, the benefits of diversification within the EMU are declining (or the benefits of diversifying out of the EMU are rising), as the EMU markets no longer offer uncorrelated returns. At some point, we think the positive liquidity effect, which argues for a higher financial ‘home bias’, will become saturated, and the negative diversification effect will lead to some decline in financial ‘home bias’. Bottom Line The balance of two conflicting forces dictates the financial ‘home bias’ within Euroland. On the one hand, improved liquidity and depth of the capital markets in Euroland encourage a higher home bias. However, over time, as economic and financial convergence within the EMU gradually takes place, the benefits of diversifying out of the EMU should rise. So far, the first force has dominated. However, we suspect that the latter force will become more important. Already, after rising for five years, the EMU’s financial home bias has remained flat for the past two years. We believe that it will eventually decline, in sync with the general trend we are witnessing in most parts of the rest of the world. Such a decline in European financial home bias will remove an important support for the EUR in recent years.
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New Elections, Shaky Foundations
April 14, 2008
By Vladimir Pillonca | London
Here We Go Again Barely two years after the previous elections, Italians will once again be voting, on April 13-14. The main coalitions are the new centre-left alliance, led by Walter Veltroni’s Partito Democratico (abbreviated PD), and Silvio Berlusconi’s centre-right alliance, the Popolo della Liberta’ (PdL). The Stated Objectives Look Similar Both sides’ electoral programmes are quite generic, and do not appear very different on the surface. Below are some of the key macro themes that feature in both coalitions’ electoral plans: i) Boosting Purchasing Power Both the centre-right and centre-left coalitions profess their intent to boost households’ purchasing power, by reducing taxes for lower-income households. This objective reflects the widespread perception that workers’ purchasing power is being eroded, and with real wage growth recently turning negative, this feeling is likely to become more acute going forward. Predictably, Walter Veltroni’s centre-left alliance (PD) tax policies have a somewhat more redistributive slant, but the over-riding theme is broadly similar. ii) Lower Tax Pressure Tax pressure has risen from an already high level (from 40.5% in 2005 to 43.3% of GDP in 2007). This increase reflects two factors: i) the previous government’s effective fight against widespread tax evasion; and 2) almost two years of above-trend growth (as tax receipts are strongly pro-cyclical). Having achieved higher tax compliance, some selective payback in the form of lower tax rates and selective tax credit for households and firms is now attainable, in our view. Indeed, given the sharp deceleration that the Italian economy is experiencing, some easing of tax pressure is almost inevitable. But the approach will necessarily have to be selective: the large debt burden limits the scope for aggressive and indiscriminate tax cuts or sizeable fiscal injections. iii) Improving Infrastructures The need to improve infrastructures, particularly in the South of Italy, is also acknowledged by both coalitions, with a special emphasis on improving and extending the high-speed rail network. iv) Liberalisations The centre-left proposes to implement the third leg of the Bersani package to further liberalise the services sector (previous sections of this package were already implemented by Prodi’s government), strengthening the role of anti-trust authorities. Berlusconi’s centre-right coalition also professes similar intents with regards to liberalisations (though little was achieved this front by the previous centre-right coalition). The PdL also mentions tax credits on investments, and proposes selling state assets as a way to reduce government debt. Higher Growth, More Innovation As we have argued elsewhere (Italy Banks and Economics: The Wrong Place to Hide, March 20, 2008), we believe that some restructuring has taken place among Italian firms, particularly among mid-corporates. This process is far from complete, but some exporters appear to have successfully moved towards higher-valued segments of product and services markets. Yet there is still a lot that can be done to enhance Italy’s ability to grow and compete in the global economy, besides supply-side reforms (such as those of the Bersani package), improving the state and quality of infrastructures, and reducing the enormous amount of red tape and the overwhelming degree of bureaucracy. Finally, both coalitions’ intention to speed up the judicial system are, in principle, sound measures. Raising the Speed Limit: About Time The centre-left alliance is slightly more explicit on the need to boost productivity growth and innovation, and this certainly remains a vulnerable area: we estimate Italian potential growth to be in the 1.1-1.4% range, much less than the 2-2.3% for the euro area as a whole. Indeed, it is no coincidence that Italy has experienced three technical recessions in the last five years (compared to none in the UK and one in France) and that economic growth has been just 1%Y on average in this period. No wonder that purchasing power has failed to strengthen for many workers. Hence, we find it mildly encouraging that both sides acknowledge the need to promote more spending and effort on R&D, both in the private and public sectors, as well as creating a more corporate-friendly environment. These measures are positive for productivity. Again, a lot can and needs to be done on this front. However, whether this professed aim results in concrete and effective productivity-enhancing policy actions being implemented remains to be seen. Public Finances: Some Differences The theme of keeping government spending in check is shared by both coalitions. Berlusconi’s PdL mentions privatising and selling public assets as a means to reduce government debt, albeit without giving any details on how this may be done. On the whole, Berlusconi’s coalition is more vocal on tax cuts and seems to place less emphasis of fiscal rigour. The centre-left coalition has the opportunity to build on the fiscally responsible reputation built by Prodi’s government(s), and cites the target to reduce the overall primary government spending — by 0.5% of GDP in the first year of government followed by 1% of GDP for each of the next two years. However, even the PD coalition is not explicit on the timing of bringing down the debt-to-GDP ratio down to “below 90%” of GDP, merely stating that this will be done “rapidly”. Bottom Line: Effective Implementation Will Be Key Notwithstanding the professed similarity in the electoral plans, both alliances’ ability to implement change and enact the much-needed reforms remain to be seen. Smaller parties and political fragmentation could once again dilute the incisiveness and depth of the economic reforms that Italy needs to prosper. A prolonged period of policy inaction is a very concrete risk for all investors, spanning from equity to fixed income. A protracted stalling of the reform process would be bad news for Italy’s medium-term growth, fiscal sustainability and corporate profitability. Italy’s deficit is likely to deteriorate After a virtuous two years under Padoa Schioppa’s leadership, the deficit fell to under 2% of GDP in 2007, thanks to a steep rise in the primary surplus, largely reflecting a major boost in tax revenues (see Italy Economics: As Good as it Gets, February 29, 2008). But with the economy set to slow and primary spending steadily rising, we continue to expect the budget deficit to edge towards 2.7% of GDP this year and 2.8% in 2009 — only decimals away from the Maastricht ceiling (see Italy Economics: The Hidden Risks of a Fiscal Overshoot, November 27, 2007, for a detailed analysis). In the meantime, the debt-to-GDP ratio should remain comfortably above 100% of GDP. The new government’s plans will of course influence our forecasts for Italy’s public finances, particularly for 2009 and 2010. The silver lining is that the eventual decline of tax pressure should help to underpin a recovery in 2H09. Risks of Policy Vacuum In short, beyond the question of how effectively the electoral plans will be carried out, a key open question remains that surrounding the electoral law. The current electoral law needs to be modified to afford a sizeable non-proportional premium to the winning coalition in the Upper House. This would introduce a more significant seat advantage to the winning coalition, sparing Italy from the high political turnover it has become accustomed to. But reaching an agreement on a new electoral law could prove time-consuming, and deeply divisive, even within the coalitions themselves (see also One Government Crisis, Three Scenarios, February 23, 2007). The ensuing negotiations could easily detract attention from economic policy-making at a particularly delicate juncture for the Italian economy, while the outlook for global growth is also darkening further. Finding a solution for a highly fragmented political system could delay the much-needed depth of reforms that Italy urgently needs. This is a risk that investors should consider seriously.
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