Finding a Balance - Where We Are, What's Next?
November 30, 2009
By
Daniele Antonucci | London
Summary and Conclusions
Spain has so far weathered the global economic downturn better than most of its European neighbours. We argue that this trend is unlikely to continue. We reach six main conclusions:
• First, the construction sector is still unlikely to stabilise any time soon. With house prices overvalued by as much as 30% on some metrics, we don't expect a return to positive growth rates in construction investment until end-2011.
• Second, although the job shakeout will be sharper but shorter in Spain than in the rest of the euro area, we think that a revival in consumer spending next year is too much to hope for. With wage growth set to slow further, private consumption will lack support.
• Third, private sector deleveraging will continue for quite some time. The pass-through of lower official and market interest rates to mortgage and corporate loan rates might provide some relief, but it is unlikely to prevent a period of belt-tightening altogether.
• Fourth, credit will continue to remain a scarce resource over the next two years. With still considerable uncertainty over potential losses, banks may remain reluctant to lend, even if the government ensures that they are well capitalised.
• Fifth, with a ballooning budget deficit and long-term sustainability problems in its public finances, Spain looks set to be one of the first countries in the euro area to scale back its stimulus measures. Tax hikes are on the agenda as early as next year.
• Sixth, Spain's adjustment is happening at a fast pace. With GDP contracting less than employment, labour productivity growth has accelerated. If sustained, these gains will lower Spain's unit labour costs and trigger an export-led recovery further down the line.
The main takeaway for investors is that, with its economy still heavily imbalanced, Spain has to endure a structural adjustment. While most of its European neighbours have been affected by the same cyclical headwinds - from the commodity-driven inflation shock last year to the economic fallout of the financial turmoil this year - they do not have to simultaneously address imbalances of the same scale. Spain looks set to be one of the last economies in the euro area to emerge from recession. In our view, it will contract outright in 2010 too - unlike the other major European countries - and expand far slower than the euro area as a whole in 2011.
Where We Are - Rebalancing on Five Fronts
Courtesy of a credit-fuelled housing boom-turned-bust and high private sector debt, it had been widely expected that the fall in economic output in Spain would be far greater than in Germany, France or Italy. After all, these countries feature reassuringly high household saving ratios, dull or not too overstretched housing markets and comparatively low private sector debt. However, these expectations have been shattered. Admittedly, GDP has declined by a hefty 4.5% in Spain from its peak in 1Q08. However, at 5.1% the peak-to-trough contraction in the euro area as a whole has been more pronounced.
A closer look at the facts, however, reveals that Spain has suffered much more than most of its European neighbours. Despite a sizeable fiscal stimulus, private consumption in Spain has fallen four times faster than in the euro area; the contraction in construction investment has been sharper; and exports have plummeted by as much as in the other major euro area countries. The plunge in GDP has been more contained in Spain for one simple reason: it all comes down to a much steeper fall in imports. Net trade has contributed positively to GDP growth in Spain since the start of the downturn, while it has contributed negatively in the euro area.
The medium-term economic outlook remains challenging. While Spain has to deal with multiple structural adjustments - ranging from the aftermath of the housing bubble to most-needed deleveraging in the private sector - the other major countries in the euro area do not have to address imbalances of the same magnitude or on so many fronts at the same time.
Five aspects are relevant to gauge where we are in this structural adjustment process and what the next steps are likely to be: the construction sector; the labour market; private sector deleveraging; constraints to the supply of credit; and the public finances. Let's examine each of these factors in turn.
1. The Construction Sector - Stabilisation Still Far Off
Spain's housing market bubble has started to deflate and construction investment - the main driver of the Spanish success story over the past few years - is now contracting sharply. However, with a fairly small correction in prices so far, the adjustment process in the housing market is only just beginning, we think. At this stage, we don't expect a return to positive growth rates in construction investment throughout the forecast horizon (end-2011).
Indeed, the housing downturn in Spain is lagging far behind that of other hotspots. Valuation measures, such as the house price-to-income and house price-to-rent ratios, suggest that house prices in Spain would need to fall by a lot more than in the US and the UK to return to their ‘fair value'. For example, Spanish house prices would need to decline by 58% from their peak between 2006 and 2007 to bring the price-to-income ratio in line with its long-term average (or by about 30% from where they are now). Similarly, the price-to-rent ratio points to an overstretched market in Spain.
Of course, the indications from these measures should be taken with a pinch of salt. We are not suggesting that house prices will decline by 58% in Spain. The actual peak-to-trough fall will of course depend on many circumstances, ranging from the effectiveness of the policy measures to demographic factors. However, taken at face value these metrics are consistent with a much deeper housing downturn in Spain than in any other euro area country, with the exception of Ireland.
Against this background, the adjustment in Spanish house prices is at an early stage, we think. Despite a remarkable housing bubble - probably bigger than in the US and UK, but smaller than in Ireland - Spanish house prices have fallen by just 9.1% from their peak in the first quarter of last year. This compares with a peak-to-trough fall of around 21% in the UK (Halifax, all houses), 24% in Ireland (permanent tsb/ESRI) and 31% in the US (S&P/Case-Shiller, national).
But why is the Spanish housing market adjusting so slowly? One explanation could be that, at least so far, the downward correction has primarily affected the volumes transacted rather than the prices of the transactions. In other words, sellers did not want to sell because they could not get an attractive price. But even if the first leg of the adjustment had to do mainly with a collapse in the volume of transactions, this does not mean that a collapse in prices will not follow. From this perspective, house prices are simply a lagging indicator, i.e., the second leg of the adjustment might well entail a more pronounced decline in house prices.
Our econometric analysis suggests that house prices are still overvalued, thus confirming the indications from the price-to-income and price-to-rent ratios. However, they may not be as overvalued as those metrics would imply. For example, while the house price-to-income ratio points to an overvaluation of around 33% in 2009, our model provides a ‘fair value' estimate based on a number of fundamentals - ranging from per capita income and number of households to interest rates - and points to a mismatch of around 10%. The actual decline in house prices might lie somewhere in between. Either way, the message is that the adjustment is less advanced in Spain than in other hotspots. Hence, there is still scope for considerable declines.
The slide in house prices - along with the prospect of further declines - has already triggered a downward correction in construction investment. However, the extent of this adjustment is not nearly enough, in our view. Despite a 21% drop from its peak in 4Q07, construction investment still accounts for around 14.3% of total economic output - one full percentage point above its long-term average. The equivalent figure for the euro area is 11.7%, which is roughly in line with its long-term average.
The upshot is that an additional 7% decline in Spanish construction investment would be required just to bring it, as a proportion of GDP, in line with the historical average. However, this decade's construction boom has pushed up the average, which may overstate the sustainable construction investment-to-GDP ratio. Indeed, the average from 1980 to mid-1998, i.e., before the housing bubble, is 12.1%. To bring the construction investment-to-GDP ratio in line with that level, the additional decline in Spanish construction investment would need to exceed 15%.
Furthermore, to eliminate the existing oversupply of homes, the construction investment-to-GDP ratio may need to undershoot its long-term average. The past five years witnessed the construction of more than three million new homes, but sales were far less dynamic, at just over 1.5 million. This means that about half of the newly built homes, or 5.6% of the housing stock, may sit unoccupied. If new home sales remained at the current level - and assuming that homebuilding stopped altogether - it would take about six years to clear the existing oversupply of homes.
In all, we believe that a further 10% fall in construction investment in 2010 alone is very much on the cards. This would reduce GDP by about 1.5% over the same period. However, the likelihood of a sharper fall is quite high. In our bear case scenario, we factored in a decline twice as large. In addition, we would not be surprised to see considerable weakness in the following year too; at this juncture, we don't expect construction investment to expand whatsoever until the end of 2011.
2. The Labour Market - Bulk of the Adjustment Behind Us
So a stabilisation in the construction sector still looks far off, even though a considerable adjustment has already taken place. As is well known, this adjustment has triggered a surge in unemployment, especially since early 2008. There is a stark difference between Spain and the euro area as a whole in this regard too.
Indeed, although Spain may not have slowed as rapidly as the euro area, the surge in unemployment has been faster. Since the beginning of 2007, the number of unemployed in Spain has risen by 2.3 million and accounted for two-thirds of the increase in total euro area unemployment over the same period. In Spain, the unemployment rate is currently at a staggering 19.3%, far higher than the euro area figure of 9.7%.
Less well known, perhaps, is that a key reason for this particularly sharp rise in unemployment in Spain relative to its European neighbours is that a higher proportion of Spanish workers are employed on temporary contracts and can therefore be laid off relatively easily. Indeed, about one-quarter of Spanish workers have a temporary contract in Spain, against a euro area average of about 15%.
The structural characteristics of the Spanish labour market may mean that the job shakeout will be sharper but shorter than in the rest of the euro area. However, although this tentatively suggests that the bulk of the adjustment is already behind us, risks remain skewed to the downside on two fronts:
• First, the job shakeout has not affected Spanish workers employed on permanent contracts, who are harder to remove from firms' payrolls, to a significant extent - at least so far. While permanent employment is currently down by just 1.7%Y, the fall in temporary employment is much greater, at 18.2%Y. This suggests that the adjustment is not yet complete. During the recession in early 1990s, when permanent workers accounted for a similar share of total workers, permanent employment fell by more than 10% over a period of almost five years. In the current recession, the decline in permanent employment has been very small - at least so far - in the order of 2.5%.
• Second, Spanish workers who still have a job have so far continued to receive decent pay rises. But this is unlikely to continue for two reasons. For a start, wage indexation remains common in Spain; with prices now falling, wage growth will slow considerably next year. What's more, wages tend to respond to unemployment with a long lag and are only now beginning to react to the slump in the labour market. The upshot is that - even in the unlikely scenario of a swift improvement in the labour market - the job shakeout that has already taken place will negatively affect wage growth next year. At this stage, we would not exclude a broad stagnation in wages sometime in 2010.
In all, we think that these dynamics will play a key role next year. We believe that labour income will continue to contract in 2010, thus exerting downward pressure on private consumption growth: we expect a retrenchment in consumer spending of around 1.3% from a year earlier.
3. Private Sector Deleveraging - Not Quite There Yet
Another aspect of the adjustment process in Spain is related to the deleveraging of both households and firms. The credit-fuelled housing boom has resulted in a highly indebted private sector in Spain, where the sum of household and corporate debt amounts to 189% of GDP, much higher than the 146% euro area average. Private sector debt is particularly low in Germany and Italy, by European standards.
The high level of private sector debt in Spain was not a problem as long as it coincided with rising asset prices because the level of net debt did not rise as much as the level of gross debt. However, the housing market downturn reduced the ability to carry a high debt load. Moreover, with likely further falls in house prices, private sector deleveraging is set to continue for some time.
Of course, the falls in official and market interest rates will reduce the amount of money that households and firms need to put aside to service their debt. To the extent that the pass-through of lower official and market interest rates to mortgage and corporate loan rates is meaningful, this will provide some relief to a highly indebted private sector. But the offset is likely to be small and will probably just smooth over a longer period - or just delay - a much-needed deleveraging.
In our view, these dynamics may cushion a further period of belt-tightening in the short term, but they are unlikely to prevent it altogether. What's more, Spain's higher sensitivity to short-term interest rates will be a negative factor when they resume their upward trend. Indeed, variable-rate loans in Spain make up about 90% of total mortgages, compared with an average of 50% in the euro area.
4. Credit Constraints and the Economy - Feedback Effects
Unsurprisingly, given the severity of the current recession, annual lending growth to the private sector has been slowing for quite some time. But the situation has deteriorated even further in recent months: the stock of total lending to the private sector has now entered negative territory. What are the drivers behind the slowdown in bank lending and will this trend continue? The key issue here is the distinction between supply-side and demand-side factors.
An important demand-side factor is the housing market. Clearly, the slowdown in house prices is at least in part responsible for the slowdown in mortgage lending. Similarly, surveys of households' intentions to purchase a car and purchase or renovate a home suggest that demand-side factors have played a role in the slowdown in mortgage loans and consumer credit.
All else being equal, it is obvious that demand for bank loans decelerates during recessions. But, naturally, the negative impact of demand-side factors on bank lending tends to wane once the economy starts recovering. However, the current credit crunch is the result of supply-side factors too. The question here is how the constraints on the supply of credit will develop over the next few quarters and to what extent they will affect lending to the broader economy.
The Bank of Spain's bank lending survey indicates that the supply of credit is currently constrained. This survey shows that credit standards tightened further in 3Q. Encouragingly, the percentage of banks reporting tighter credit standards for corporate loans was small (just 5%, down from 20% in the previous quarter). However, this still means that banks have become even more reluctant to lend to firms, although the pace of tightening has slowed.
How the constraints to the supply of credit will develop is inherently linked to the outlook for the banking sector. This is particularly uncertain at this juncture because of the feedback effects emanating from the real economy. In turn, credit developments will affect economic activity. In particular, the high level of private sector debt and likely further falls in house prices suggest that Spain looks set to be hit particularly hard by rising ‘plain vanilla' domestic loan defaults.
The good news is that the Spanish authorities are fighting hard to prevent a full-scale credit crunch. For example, the government has created a Bank Restructuring Fund in June, with €9 billion, including direct government financing of €6.75 billion and €2.25 billion from the deposit insurance funds. The fund would support possible restructuring of the financial sector. The size of the fund could be increased up to €99 billion through further legislative action and debt issuance. Up to now, the amount of capital injected by Spain into its financial sector has been zero.
However, even assuming that credit conditions will not tighten further, a meaningful easing may still be out of reach for quite some time. The government plan did not put a floor under banks' potential future losses; so their eventual size remains uncertain. Furthermore, banks accepting government funding will need to restructure. The upshot is that banks may remain reluctant to lend, even if the government ensures that they are well capitalised.
5. Public Finances - Fiscal Tightening on its Way
In 2007, Spain exhibited a budget surplus of 1.9% of GDP and a debt-to-GDP ratio of 36.1%, around 30 percentage points below the euro area average. In 2009, the budget deficit is likely to exceed 11% of GDP and the debt-to-GDP ratio should increase to around 55%. Without a credible strategy to ensure fiscal sustainability, the ballooning budget deficit and rising debt will increase investors' concerns on solvency risk. Government bond yield spreads are likely to come under upward pressure and yield curves might steepen. In Spain, government support has taken three forms:
• First, as virtually all advanced European economies, Spain has made capital available to banks (no take-up so far), guaranteed financial sector liabilities, purchased illiquid assets from financial institutions and extended direct loans. The upfront government financing amounts to 4.6% of GDP, according to IMF calculations (see The State of Public Finances Cross-Country Fiscal Monitor, November 2009). Although this is higher than in Germany, France and Italy, it is not atypical in Western Europe, where upfront government financing ranges from 1.1% of GDP in Switzerland to 20% in the UK.
• Second, Spain has implemented several fiscal stimulus programmes. Although this is no different from the rest of Europe, the scale of these programmes has been remarkable in Spain. This year, for example, the fiscal stimulus in Spain will likely turn out to be the largest - relative to the size of its economy - in the euro area, amounting to almost 2.5% of GDP (see the European Commission's Economic Crises in Europe: Causes, Consequences and Responses, September 7, 2009). Next year, the stimulus will likely be in line with the euro area average, at around 0.75pp of GDP.
• Third, there is one aspect relating to the fiscal costs of the crisis that has not received enough attention, we think: the effect that a weaker economy will still have on lowering tax receipts and boosting government spending even without any changes to existing programmes. The estimated effect of the so-called ‘automatic stabilisers' - which are quite large - will increase significantly relative to the pre-crisis situation even next year. Overall, Spain's fiscal position will be severely affected by the turmoil throughout the forecast horizon (end-2011); both budget deficit and public debt forecasts, in our view, have upside risks.
What's more, ageing-related expenditure might contribute to an increase in the debt-to-GDP ratio in the long term. Recent European Commission simulations (see the Sustainability Report, October 23, 2009) show that, on unchanged policies, by 2060 the debt-to-GDP ratio would be 766.6% in Spain, far higher than in Germany (318.9%), France (431.3%) and Italy (205.9%). The Commission's assessment shows that the long-term sustainability risk to Spain's public finances is high - together with Ireland, Greece and the Netherlands. Conversely, the long-term sustainability risk to the German, French and Italian public finances is medium.
Naturally, these simulations are highly uncertain. It is unlikely that bond markets will keep financing government debts amounting to a multiple of the GDP of the respective countries - or that governments will maintain their policies unchanged in the presence of ever-increasing debts. Still, two main takeaways remain valid:
• First, Spain needs deep structural reforms to bring potentially exploding public finances under control. This has become even more urgent because the recession might have damaged the pace at which the economy might sustainably expand, thus making Spain's ability to carry a high debt load more limited. These dynamics are complex and difficult to quantify with any degree of precision (for a general framework that is applied to Italy, but could be used for many countries, see Assessing the Damage, October 26, 2009). Still, we believe that the risk is material for the Spanish economy.
• Second, Spain doesn't really have a choice: some fiscal tightening will have to be implemented. Indeed, the government has indicated that it has already done all it can to boost the economy; a number of measures to start reining in the fiscal stimulus have been announced and some of them already feature in the 2010 budget. In other words, the Spanish government looks set to be one of the first in the euro area to scale back its stimulus measures next year. Conversely, fiscal tightening will have to wait until 2011 in most other euro area countries (with Ireland possibly the only exception), especially in those with more leeway on the fiscal front.
Of course, part of the tightening will be passive. For example, the special €400 tax rebate - which was introduced in 2008 for all taxpayers as a measure to boost consumption - will be eliminated in 2010. This should generate an extra €5.7 billion in revenues. But active tightening will play a role too. For example, the standard value-added tax (VAT) rate will be raised by two percentage points to 18%; and the reduced rate applied to new house purchases, transport services and hotel and catering services will be raised from 7% to 8% (the super-reduced rate applied to basic food, books and medicines will remain unchanged at 4%). These changes will become effective from July 2010 and should generate an extra €5.2 billion in revenues in 2010 and €10.3 billion in 2011. What's more, savings income (dividend income, interest, capital gains, etc.) will no longer be taxed at the flat rate of 18%. From next year, the rate will go up to 19% for the first €6,000, and then to 21% on savings income over and above that amount.
What's Next - Three Scenarios and a Silver Lining
Spain is in the midst of a structural adjustment, as shown in the previous section. Of course, how long it will last and to what extent the economy will be affected remains to be seen. The adjustment could be short and abrupt, for example, or protracted and mild.
Either way, until this adjustment has run its full course, Spain is unlikely to outperform the rest of the euro area - at least from an economic growth standpoint. In this section, we present three scenarios - base, bull and bear cases - for the next couple of years:
Base case - further contraction in 2010 followed by sub-par recovery. The slowdown continues over the next few quarters, but the economy starts expanding again - albeit at a moderate pace - in the second half of next year, courtesy of the lagged effects of the policy stimulus and a more export-friendly environment. Fiscal policy turns slightly restrictive and domestic demand stays weak. In this scenario (to which we assign a 45% probability), GDP growth remains in negative territory in 2010, to the tune of -0.7% (consensus = -0.5%), but the economy manages to grow by 0.8% in 2011 - lower than the far-from-impressive 1.2% expected expansion for the euro are as a whole.
Bull case - return to subdued but positive growth next year with further acceleration in 2011. The lagged effects of the policy stimulus turn out to be greater than currently envisaged and partly offset the impact of the announced fiscal tightening. House prices fall at a slower pace relative to the baseline and construction investment falls by a smaller margin. Foreign demand for Spanish goods and services picks up more strongly as early as the beginning of next year. In this scenario (to which we assign a 20% probability), GDP growth comes back into positive territory - but barely so - in 2010, and accelerates to about 1.5% in 2011.
Bear case - GDP shrinks for three years in a row. Credit conditions remain restrictive for longer than expected and the announced fiscal tightening hits the economy hard. This triggers a sharper fall in house prices, and a more momentous correction in construction investment. In turn, Spain's public finances come under pressure and the capital flows that have been financing the sizeable current account deficit vanish. This sets off a further downward correction in asset prices. In this scenario (to which we assign a 35% probability), the Spanish economy contracts outright not only this year and the next, but also in 2011.
Of course, other plausible scenarios could be constructed by slight alterations to the above-mentioned assumptions; and different subjective probabilities could be assigned to the same scenarios. Bearing these caveats in mind, the main takeaway from our scenarios is that we believe that risks to the Spanish economy remain skewed to the downside. In other words, we think that the likelihood of our bear case playing out is relatively close to that of the base case. What's more, the upside is likely to be limited even in the bull case, especially over the next six months.
Regaining Competitiveness?
So Spain is still finding a balance. Regardless of which scenario eventually plays out, the key message is that we think the country is likely to expand slower than the euro area as a whole over the next couple of years - quite a change from the outperformance of the past decade. However, Spain's rebalancing act conceals a silver lining. The adjustment is happening at a faster pace than anticipated, courtesy of unexpected economic flexibility.
This is reflected in Spain's remarkable productivity gains, both relative to the previous 15 years - which witnessed a very poor productivity record - and compared to its European neighbours. In Spain, while the decline in GDP has not been as sharp as in Germany, France and Italy, employment has plummeted to a much greater extent. The upshot is that labour productivity growth has accelerated in Spain, in stark contrast to the slowdown registered elsewhere in the euro area.
These productivity gains, if sustained, will lower Spain's unit labour costs and boost export competitiveness. With domestic demand growth likely to be subdued even in our best case, this might prompt an export-led recovery and help the rebalancing of an economy that has been driven primarily by domestic factors during the boom years. Indeed, the widening of Spain's current account deficit seems to have matched the increase in construction investment.
The current account deficit has widened to an unsustainable level in recent years. In 2008, it stood at 9.5% of GDP and, in absolute terms, was second only to that of the US. But the rebalancing is now well underway and is taking place at a remarkably fast pace. In the second quarter of this year, Spain's current account stood at 4.4% of GDP, down from 8% in the previous quarter. Similarly, the trade deficit has narrowed considerably.
Of course, this has to do, first and foremost, with weak domestic demand. In other words, although the overall adjustment is welcome and definitely overdue, it is happening because imports have contracted sharply, while export growth has remained subdued - at least so far. If anything, this highlights the weakness of the Spanish economy. The hope is that an improved competitive position will boost exports, thus contributing to a healthy economic rebalancing.
Conclusions
In all, there are six main takeaways for financial markets:
• First, with its economy still heavily imbalanced on multiple fronts, Spain will go through a structural adjustment over the next couple of years. We believe that the country will contract outright in 2010 too, unlike the major European countries, and expand far slower that the euro area as a whole in 2011.
• Second, the construction sector is unlikely to stabilise any time soon. It might take up to six years to clear Spain's sizeable backlog of unsold homes; and house prices are overvalued by as much as 30% on some metrics. Accordingly, we don't expect a return to positive growth rates in construction investment until end-2011.
• Third, despite some improvement, private sector debt is still high relative to GDP. Hence, households and firms will both need to deleverage considerably. The pass-through of lower official and market interest rates to mortgage and corporate loan rates might provide some relief, but it is unlikely to prevent a period of belt-tightening altogether.
• Fourth, although the various policy measures put in place reduce the risk of a full-scale credit crunch, bank lending is likely to remain constrained for quite some time. With still considerable uncertainty over the extent and timing of potential losses, banks may remain reluctant to lend, even if the government ensures that they are well capitalised.
• Fifth, with a ballooning budget deficit and long-term sustainability problems in its public finances, Spain looks set to be one of the first countries in the euro area to scale back its stimulus measures. Unlike in Germany, France and Italy, tax hikes - in particular, a sizeable VAT rate increase - are on the agenda in Spain as early as next year.
• Sixth, Spain's adjustment is happening at a faster pace than anticipated. With GDP contracting less than employment, labour productivity growth has accelerated substantially. If sustained, these gains will lower Spain's unit labour costs, boost export competitiveness and trigger an export-led recovery further down the line.
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Q&A on Greece
November 30, 2009
By
Spyros Andreopoulos | London
Bottom line: In our view, Greece will not default, nor will it come close to default. In the short term, however, pressure on Greek assets may persist until the government produces a credible fiscal consolidation plan.
What's the fiscal situation? Serious, but not unmanageable. Debt/GDP should be in the region of 110% this year and around 120% next year. Arresting this trend will require substantial fiscal consolidation in the coming years. The newly elected government has so far not convinced the European Commission (EC), or financial markets, that it is willing to use its political capital to effect the necessary structural changes to get public finances, and the economy, back on track.
What needs to be done? The first priority is to get the budget deficit (12.7% this year according to EC estimates) under control. The EC - and ourselves - are concerned that the consolidation the government is planning in its 2010 budget may not be sustainable as the bulk of it stems from one-off, rather than permanent, factors. However, getting the budget deficit under control is unlikely to be enough to ensure fiscal sustainability. The high debt ratio and effects of adverse demographics impacting the economy from 2020 onwards mean that Greece needs to implement wide-ranging structural reforms (see From Athens to Dublin, November 2, 2009). The reforms should create jobs and the economic growth necessary to reduce the debt ratio over time.
What's the matter with Greek banks? The Greek central bank has warned Greek banks to prepare for a time when the ECB will be less generous in its liquidity provision. (On IMF numbers, Greek banks have been the recipients of 5.5% of total ECB liquidity provision.) From the available evidence, Greek banks at the very least don't seem to be in a worse state than the average of their European peers. According to our bank analysts, Greek banks are fundamentally sound. For example, their loan-to-deposit ratios are below the European average, and the deterioration in NPLs has been less pronounced than for, say, Spanish banks. We believe that Greek banks are getting hit because of public finance concerns. There is no reason to expect them to be the source of macro instability.
What about Greece's credit rating? Greece is currently still comfortably investment grade. It's rated A1 (outlook stable) by Moody's, A- (outlook stable) by S&P and A- (outlook negative) by Fitch. Even three downgrades by S&P or Fitch would still have Greek bonds at investment grade and therefore acceptable collateral with the ECB. Given recent developments in the fiscal balance (including revisions to deficit and GDP numbers), and given that the new government so far does not seem to be willing to act decisively, a downgrade (or change in outlook) would probably not be a huge surprise to the markets. That said, a downgrade could trigger a further rise in yields as many investors would no longer be able to hold Greek bonds due to internal risk-management reasons.
Will Greece default? For a country like Greece, becoming physically incapable to pay its creditors is very unlikely, in our view. A developed country government would almost always be able to raise sufficient funds to pay bondholders - through taxation, levies, etc. - provided that it is politically willing and able to do so. The current government was elected less than two months ago and has a comfortable majority in parliament. If pushed, we are convinced that the government would do whatever is necessary to avoid default.
Perhaps just as importantly, we believe that Greece will not be allowed to default since, at the current juncture, a Greek default would have systemic implications:
•· It would put pressure on other heavily indebted countries in the Euro-zone, and possibly beyond;
•· It would put pressure on the European banking system since many banks hold Greek bonds for their high yields.
This means Greece would be ‘prevailed upon' by the EU not to default (more below).
What if Greece faces a buyers' strike? Greece is planning to issue €55 billion next year. Yields may have to climb substantially for that to be absorbed, and the costs of servicing the debt, currently around 5% of GDP, would also climb. Even in that case, default is unlikely, in our view. Some perspective is useful. In 1994, the Greek government paid 12.7% of GDP in interest. In 1992, the implicit interest rate on the debt (interest payments divided by last year's debt) was 16.2% - with a much shorter maturity profile than is currently in place. Right now, Greek 10-year bonds yield 5.2%. All this goes to show that, with sufficient political will, even very high debt service costs can be met.
Can Greece be kicked out of the euro? No. There is no such provision in the Maastricht treaty. A country can, however, leave voluntarily.
Will Greece leave the euro? No, we don't believe so. Apart from it being unthinkable politically - an overwhelming majority of society and most mainstream political parties are in favour of the European project - it would be against Greece's best economic interest, whatever its intentions. Announcing that it will leave the euro could cause a bank run as well as a run on all Greek assets. The new Greek currency would likely depreciate heavily against the euro, making it more difficult for Greece (public and private sector) to repay debt.
Where do we go from here? Greece will very likely be put under ‘enhanced budgetary surveillance' by the EC in January, in our view. In practical terms, this means that the government would have to report every three months to Brussels what progress it has made in terms of reining in the budget deficit and implementing structural reforms. Our central case is that the government, not least because of this pressure, will gradually introduce tougher measures over time, beginning with January's Stability Programme Update - a submission intended to explain to the EC how the budget deficit will be brought down to 3% of GDP over the next years.
What's the worst-case scenario? As mentioned above, Greece will do everything to avoid a possible default, in our view; further, we think it would not be allowed to fail: before Greece comes into significant difficulty, the European Union would probably intervene by making funds available in the form of emergency loans. Finally, there is also the possibility that the EU would want to make an example of Greece by not intervening. In that case, we think the IMF would likely step in, probably with a standard Stand-By Arrangement.
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