Asia ex-Japan
Implications of EU Debt Concerns for Asia ex Japan
May 11, 2010

By Chetan Ahya | Singapore & Sumeet Kariwala | India

Summary

The recent developments in Greece and Europe have been a pointed reminder about structural issues related to too much debt in some of the developed world economies.  The manifestation of this persistent structural challenge in the recent debt market developments has increased the downside risks to our bullish view on AXJ's growth cycle and reduced upside risk to our inflation outlook. Indeed, as of now all leading indicators and current data points indicate a very strong trend in domestic and external demand. Our current base case forecast assumes GDP growth of 9.0% in 2010 and 7.8% in 2011.

However, the key risk now emanates from the potential emergence of round II of severe stress in the European and global financial system, funding shortages and downside risks to global growth.  Of course, the decision by policy makers in the EU to start an emergency stabilization fund for EMU should help to buy more time to implement the serious structural changes needed to improve the underlying fiscal health. Even if the downside risks do materialize, we believe that AXJ economies will emerge resilient again even in this round of global growth uncertainties.

Signposts to Watch

The €110 billion emergency lending facility from the EU and IMF has not been enough to calm the markets, as reflected in yields on government securities. Effects are beginning to spread beyond Greece and the EU to other markets. Over the last four days, the troubled eurozone countries saw their G-sec yield spreads over Germany move much wider again. A greater concern now is the widening in government debt spreads in Spain and Italy. On Friday (May 7), the closing Spanish 2-year bond spread over Germany widened by 121bp to 236bp, while for Italy, it widened by 100bp to 185bp over the last four days. In Greece, it widened by 827bp to 1,773bp, Portugal by 267bp to 552bp, and Ireland by 200bp to 403bp during the same period. Moreover, the euro continues to depreciate further. Sovereign debt risks are now becoming visible to the broader financial system. London inter-bank offer rate (LIBOR) - Overnight Index Swap Rate (OIS) spreads, a measure of perceived credit risk in the inter-bank market, has widened to 19bp from 12bp three days ago. It will be critical to watch whether conditions could develop similar to those in 2007-08, eventually weighing on the global liquidity conditions affecting global growth. Currently, our global team is forecasting strong global GDP growth of 4.6% in 2010 and some moderation to 4.0% in 2011.

When and What Can Policymakers Do?

After the market closed on Friday, eurozone leaders decided to put together an emergency fund for EMU countries. There are three elements to the new fund: First, opening up the EU balance-of-payments facility to euro area countries and increasing its ceiling from €60 billion to €110 billion. Second, a European stabilization fund amounting to €440 billion. Third, an additional IMF tranche for euro area countries of up to €250 billion (see Europe Economics: Fast-Track to Fiscal Union? by Elga Bartsch and Daniele Antonucci, May 10, 2010).

Our Chief Economist for Europe, Elga Bartsch, believes that by putting additional safeguards in place for the euro area financial system, governments finally appear to be rising to the severe challenges coming from sovereign debt. But, like the measures taken before - for the benefit of Greece - a stabilization fund is just buying time for distressed borrowers. The fiscal policy action taken in these countries during this ‘extra time' is essential. If yet another rescue mechanism isn't followed by aggressive austerity measures, the problem would just continue to fester - and could eventually manifest itself elsewhere. What is the end game? Co-Head of our Global Economics team, Joachim Fels, argues that a sovereign crisis ends in default or inflation, or both. He thinks the latter is the more likely outcome, through massive further monetary easing.

Implications for AxJ Economies: Two-Step Framework

First Stage Impact

Hopefully, the measures announced on Sunday will help calm the markets for some time. However, if sovereign credit problems continue to deepen, in the first stage, we believe investors will remain focused on the external balance sheet linkages more than the trade linkages, which we think will emerge as an issue later. If the risk-aversion trend continues, the market is likely be concerned about external balance sheet linkages, including FX reserves to short-term external debt ratio, current account balance, dependence on capital inflows, exposure of the banking system to wholesale funding, and commercial banks' holding of European sovereign bonds. Even in 2008, markets remained in the grip of similar issues until the financial system in the US stabilized and global risk appetite improved. Last time, the three countries that suffered the most in the region in the first stage were Korea, India and Indonesia. The region was separated into two groups: (a) Korea, Indonesia and India and (b) China, Taiwan and ASEAN ex-Indonesia. We believe that an almost similar distinction will be operative in the region this time as well, if the risk-aversion were to be sustained.

Our economics team has been positive on the fundamentals and growth outlook for Korea, India and Indonesia. However, certain idiosyncratic factors in these three economies make them more exposed to such global conditions then others.

•           Both Korea and Indonesia have their current account balance in a much better position currently compared with the period when the credit crisis in the US emerged in 2008. Even so, both the countries still have relatively less comfortable FX reserves to short-term ratios.

•           Korean banks also have significant dependence on wholesale funding.

•           Indonesia also tends to suffer from added pressure as foreign investors cut risks by selling its local debt paper. Foreigners own about 24% of the outstanding SBI (Sertifikat Bank Indonesia) paper, which works out to about US$8 billion.

•           While India has a reasonably high ratio of FX reserves to short-term external debt, it runs a higher current account deficit of US$31.5 billion (2.5% of GDP) as of December 2009 and has a high dependence on capital inflows. Over the last 12 months, India would have received capital inflows of US$60 as per our estimates. We believe that foreign capital inflows also play an important role in kick-starting private corporate capex in India. Hence, any sustained reversal in capital inflows would hurt the investment trend.

However, the downside risks appear to be low for these three countries compared with 2008, as domestic bank credit growth rates are already in a low range, though recovering. This will limit the shock to the domestic financial system.

Final Impact

As we learned from the 2008-09 experience, unless the global financial markets stay risk-averse for a long period, the final impact on AXJ GDP will depend on the eventual downside to global growth, the trade exposure of various AXJ countries, and the ability of policymakers to generate counter-cyclical policy support. Based on these parameters, we would rank the countries in the region in the following three groups:

Group I (Less Impact): China, India Indonesia

Traditionally net exports have been a significant contributor to China's growth, compared with that of India and Indonesia. Still, China has the best macro balance sheet in the region, as reflected in its large FX reserves balance, high current account surplus, low fiscal deficit and low public debt, as well its ratio of external debt to GDP.  We also see China as best positioned in the region to initiate counter-cyclical policy measures.

Indonesia and India should be less affected from the downside in global growth due to their relatively balanced economic model with a large contribution from domestic demand to GDP growth. However, it will be important to have stabilization in global capital markets soon, particularly for India, to ensure that the growth momentum is not affected sharply because of a reversal in capital inflows.

Group II (Moderate Impact)

Korea has emerged strongly from the adverse impact of the 2008 credit crisis. While its dependence on external demand is high, the adverse impact on its exports tends to be softened by its large exposure to China. Korea has indeed managed to increase its market share in global goods exports even in 2009. Moreover, Korea also adequate fiscal policy room to defend against the downside from global growth.

Group III (Most Exposed): Taiwan and ASEAN Excluding Indonesia 

These countries have very high dependence on global growth and exports. We believe that Singapore, Taiwan and Malaysia would be affected more than Thailand, which has a relatively lower export orientation, even though Thailand would also lack the political environment to initiate strong counter-cyclical fiscal policy measures.

What Will Asian Policymakers Do?

The region's policymakers have already been slow in reversing monetary and fiscal stimulus. We believe that the first step would be to take a pause in current moves to reverse the strong monetary and fiscal policy measures announced in 2008 and early 2009. So far, the only meaningful reversal in policy support has been on the liquidity measures. AXJ's GDP-weighted policy rates have moved up only to 4.57% from the low of 4.44%. Governments in the AxJ region had no major plan to reverse the fiscal stimulus in 2010. While we expect China's fiscal deficit to remain unchanged in 2010, AXJ ex-China is expected to improve marginally to 4.1% from 4.8% in 2009. Moreover, many countries have initiated measures to prevent speculation in property markets.

In the event of persistent risk-aversion in the global financial markets and a weakening global growth environment, we believe that the buffer really exists in fiscal response. Almost all countries in the region except India have enough fiscal room on the basis of public debt to GDP. On the monetary policy front, potential risks in the growth landscape will make it harder for AXJ central banks to lift rates.

Downside Risks to Our Growth Estimates

We expect AXJ GDP growth to accelerate to 9.0% in 2010 from 5.9% in 2009. AXJ's industrial production showed a sharper decline and a quicker recovery to the trendline growth rate of 9% than it did during the Asian Financial Crisis and after the tech bubble burst. AXJ ex China's industrial production index has recovered quite close to the hypothetical trendline IP index, derived assuming that the IP growth rate during March 2003 to March 2008 had continued without any impact from the credit crisis.

However, the recovery in capex has been weak so far relative to the rebound in industrial production. We believe that capacity utilization levels should have recovered significantly in AXJ ex-China, particularly in India, Korea and Indonesia. Our current base case forecasts assume that a recovery in exports would ensure a further rise in capacity utilization, resulting in a strong pick-up in private corporate capex led by India, Korea and Indonesia. However, in the event of sustained risk-aversion in the global financial markets, we believe that the region's external demand and investment recovery will be at risk.

Bottom Line

Our global macro team believes that the measures announced by the EU leaders on Monday morning Hong Kong time should help calm the markets for now. As Elga Bartsch highlights, if yet another rescue mechanism isn't followed by aggressive austerity measures, the problem would just continue to fester - and could eventually manifest itself elsewhere. If policy actions are not enough to calm the markets, in the first stage (over the next few days) we believe that investor focus will be on the external balance sheet - FX reserves, short-term external debt, current account, dependence on capital inflows and commercial banks' holding of European sovereign bonds.

Second stage: when capital markets settle in response to policy actions, the downside risk from global growth and the ability of the region's policymakers to take counter-cyclical policy measures will be the critical considerations for arriving at the final impact on the GDP growth of various AXJ economies. 

The key will be the duration of this global risk-aversion cycle. If the global capital markets stabilize soon, we expect to see continued strong growth, with bigger risk of asset-price bubbles and inflationary pressures building up in the region. If not, we believe that  policymakers in Asia ex-Japan will need to start implementing the structural reforms required to accelerate domestic demand on a sustainable basis instead of attempting just a cyclical response from monetary and fiscal policy (see our thematic piece on the subject: Asia Pacific Economics: Can Domestic Demand Lift the Burden of Rebalancing? July 27, 2009).

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UAE
Where Do We Stand on Debt Restructuring?
May 11, 2010

By Mohamed Jaber | Dubai

Recent news indicates that the restructuring terms being offered to Nakheel's trade creditors are better than expected, in our view: In an emailed announcement sent out on April 26, Nakheel reiterated that it intended to repay trade creditors in full: 40% in cash and 60% in the form of publicly tradeable securities. It also confirmed that these tradeable securities will carry a 10% annual return. However, the announcement did not indicate their potential maturity. Given where the debt of other Dubai Inc. entities is currently trading (e.g., the yield-to-maturity on Dubai Holding Commercial Operations 2017 bonds currently stands at around 12%), we attempt to estimate the potential discount on those tradeable securities, assuming different yields and maturities. We believe that these securities could be trading at discount of about 7-42% to par, depending on their maturity and post-issuance market yields. For the total debt owed to trade creditors, this would translate into a possible ‘haircut' ranging from 4% (bull case) to 25% (bear case). Under our base case scenario - which assumes an 8-year maturity and a 15% market yield on the tradeable notes - we estimate that the haircut on Nakheel's overall trade liabilities (including the 40% paid in cash) would be around 13%. This is significantly below our earlier projection of a 25-50% haircut on Dubai Inc.'s debt (ex-government).

This should be good news for Nakheel's debt holders: The relatively generous terms outlined above have not yet been put into effect, as they still require approval by the majority of trade creditors. However, with trade creditors being offered relatively accommodative terms and bond holders likely to be repaid in full, bank creditors may now also expect a favourable restructuring deal. As such, we believe that banks may be reluctant to accept offers of a 1-2% interest rate on their restructured debt that were reported in the media recently. It should be noted that Nakheel's ability to offer favourable terms to its creditors has been made possible by the injection into the company of US$8 billion in new funds from the Dubai government's Financial Support Facility (FSF).

We estimate that following the redemption of its bonds at maturity and the 40% cash payment to its trade creditors, Nakheel would still be left with about US$3.2 billion in new government money, which should help to support its liquidity and debt-servicing needs over the near term.

But what's good for Nakheel may not necessarily be good for Dubai: In the absence of any sizeable haircut, and given the government's significant financial intervention, we believe that Nakheel's debt burden has effectively been shifted ‘out' in time and ‘up' onto the sovereign level. Nakheel may have managed to deal with its imminent liability commitments, but it is far from clear at this stage if it will be able to continue to do so in the future. A potential pick-up in economic activity and a possible strengthening of the real estate market would indeed improve the odds of its success, but we think it is too early to tell whether this will be the case. In the meantime, the Dubai government will be directly impacted by the company's performance. Not only is the Dubai government the sole shareholder of Nakheel and its parent company, Dubai World, but it has also further increased its exposure to these entities by injecting into them US$9.2 billion and US$10.5 billion, respectively. Most of these funds were provided for by the government's FSF, which itself has been fully funded through government borrowing from Abu Dhabi. In essence, the debt burden of Nakheel and Dubai World is not necessarily being reduced - it is rather being transformed from a corporate to a sovereign one. Good for the corporates, less so for the sovereign.

Can the Dubai government's finances shoulder additional debt? The Dubai government's gross debt (ex-GREs) currently stands at US$28.7 billion, or about 38% of GDP. However, some of Dubai's GREs, with disclosed debt of about US$21 billion, may be ‘too strategic to fail'. Should their debts be regarded as contingent liabilities on the government, Dubai's sovereign debt to GDP would rise to around 66%. Viewed in isolation, these figures are largely in line with regional averages. The IMF estimates that average government debt to GDP in oil-importing MENAAP countries was around 63% in 2009. However, although the government's direct debt exposure is not necessarily large, its economic size is relatively modest. This is because off-budget spending by Dubai's GREs has traditionally accounted for a significant share of public sector outlays. Dubai's budget expenditures to GDP stood at no more than 14% in 2009, compared to an estimated average of 28% for MENAAP oil importers. The government's smaller fiscal footprint has therefore increased the toll of debt servicing on its finances. We expect interest expense on the Dubai government's direct debt to account for about 17% of its fiscal spending in 2010. This figure rises to close to 29% if the government's contingent liabilities are also taken into consideration. Moreover, should we continue to see a shifting of risk from the corporate to the sovereign level, this debt service burden may continue to increase in the near term.

While further spending cuts may be difficult, the focus will likely turn to increasing fiscal revenues: The government has already shown its intention to tighten its fiscal stance; its announced 2010 budget was about 6% lower than in 2009. Capex was also reduced by about 11%. However, given the relatively small size of the budget, the marginal benefits of further spending cuts at the sovereign level may be small.

Instead, we would argue that greater attention may need to be paid to expand the revenue base. Currently, non-tax and customs revenues make up around 96% of revenues. With a few exceptions, corporate, income and consumption taxes are almost non-existent in Dubai. Increasing tax revenues - including through the introduction of VAT - may be an option. But the benefits of increasing the government's tax revenue base will need to be carefully weighed against the potential negative impact this may have on the emirate's competitive positioning within a generally tax-friendly region.

Greater attention may need to be paid to the consolidation of public sector finances: There are significant benefits to rationalising the expenditures of GREs and diverting some of their excess cash flows to the Dubai government. Indeed, this process may have already started with the introduction last December of a law requiring most of Dubai's GREs to transfer their surplus cash to the government and imposing tighter restrictions on their spending plans. It is notable that the government's share of GRE profits did not exceed US$0.5 billion in 2008. If the government continues to take on the debt of its GREs, its ability to consolidate public sector finances would be critical to easing investor concerns regarding the increasing level of risk being transferred to the sovereign. Should the government's measures fall short of investors' expectations, attention could again turn to the emirate of Abu Dhabi. The extent of potential financial support from the Abu Dhabi government continues to be the most significant unknown in the Dubai debt-restructuring equation. It is difficult to over-emphasise the need for greater transparency on this issue during these times of heightened global concerns regarding sovereign credit standing. 

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Turkey
Revising Up Growth Forecast and Changing Timing of Rate Call Stages of Contagion
May 11, 2010

By Tevfik Aksoy | London

Revising our real GDP growth forecast: The growth rate that started to gradually ease in late 2007 decelerated further in 2008 to post a mere 0.7%Y expansion after recording an average 6.8% annual growth during 2002-07. This followed the 2009 recession that resulted in a 4.7%Y real contraction in GDP. The initial consensus estimates that went as far as expecting a recession in the magnitude of 6-7%Y have been proved wrong for reasons that did not come as a surprise to us (our forecast was -5%Y). First, the banking sector, as opposed to many countries facing the global financial turbulence, had been in a very healthy condition, with no exposure to toxic assets or problematic consumer loans. Second, the retail consumer was not leveraged. Third, after some hesitancy, the government took some fiscal action by cutting taxes temporarily and allowing certain fiscal amnesties to keep the production and consumption mechanisms intact. The increased public spending helped lift growth in 2H09, which is likely to lose steam somewhat in 2010 with the ongoing efforts to curb the fiscal deficit.

Based on a combination of factors, ranging from the persistently low interest rates, rising consumer loan stock, improving business sentiment, production indicators as well as a partial revival in exports, we are revising our real GDP growth rate forecast to 5.0%Y for 2010 (from 4.0%Y previously), while lowering our 2011 forecast marginally to 4.0%Y. The main changes that pushed our forecast higher in terms of the individual components of growth were private consumption, which went from 2.5%Y to 3.6%Y, and exports, which went from 4.3%Y to 5.1%Y. On the other hand, we lowered investment expenditure growth slightly to 3.5%Y from 5%Y previously and raised imports growth to 9.5%Y from 7.2%Y, which limited the upside to growth.

Our revised real GDP forecast is now more optimistic than the consensus forecast of 4.6%. However, the consensus forecasts had been rising steadily over the past months and, in our view, following the release of the 1Q results (which we expect to post double-digit growth) the consensus numbers will be revised up further. With an annual growth rate forecast of 5% in 2010, Turkey comes second after Russia among the main members of the region based on our forecasts.

Industrial production up sharply, mostly on base effects: Starting with December 2009, industrial production had been gaining speed, mostly on the back of base effects, given the sharp downturn in production in early 2009. We expect the base effect-driven picture to remain in place for most of 1H10, but also looking at the seasonally adjusted data, we see a decisive improvement in production numbers. Whether this trend would continue throughout the year depends on the domestic demand conditions such as the availability and usage of credit but also the external demand as Turkey's main sectors that had been driving production are geared towards exports.

Capacity utilisation improving gradually but still far from suggesting a solid rise in investment demand: After a choppy start to 2010 and staying below 70% in 1Q10, capacity utilisation exceeded 72% in April. This is still very low in comparison to the 75+% levels of 2007 and 2008. Given the excess capacity in the manufacturing sector and the unlikely case of a sudden surge in demand, we expect investment spending to remain rather muted.

Consumer loan growth picking up gradually: At the start of 2010, one of the key risks against a healthy pick-up in growth had been the heavy borrowing requirement of the Turkish Treasury and the associated high debt rollover ratio. This was expected to crowd out the private sector and limit the availability of funds to be channeled to the consumer. While this turned out to be the case earlier in 1Q, there had been a fast recovery in both the supply of and the demand for loans such that the expansion in consumer loans reached 20%Y in April. One of the key indicators of current and future growth, namely housing loans, had been picking up decisively on a weekly basis since mid-2009 but has accelerated noticeably so far in 2010. The auto loans had been hit the hardest during the recession with a near 30%Y decline but have been recovering gradually since then. Still, with a growth rate of around -15%Y, this segment of consumer loans seems to have a long road ahead to suggest a pick-up in overall demand conditions, in our view.

With government bond yields near historical lows, the upside in profit potential in securities seems lower than in the past couple of years. Hence, the efforts to extend consumer or corporate loans as well securing a larger market share via aggressive pricing could provide more upside to loan growth in the months ahead. If that turns out to be the case, the gradual recovery in private consumption might continue even at an accelerated pace. As we discuss later in the note, the possible delay in the central bank policy rate hike could also provide significant room to manoeuvre for local banks in keeping both loan and deposit rates broadly stable.

Unemployment is still a major problem: The recovery in growth and the bounce from the trough of the worst point of the recession clearly helped unemployment decline from the peak level of 16.1%. However, this had been mostly based on the sharp rise in employment in the agricultural sector as well as temporary employment. Only in recent months had some noticeable pick-up in employment in the manufacturing sector been materialising. At any rate, we do not expect the ongoing recovery to be creating solid changes in employment, and we project the overall unemployment rate to be around 14% throughout the year. This is likely to be another factor limiting the pace of growth in domestic demand and hence real GDP.

Europe sovereign risks and euro weakness a risk to growth: So far, the sovereign risks in Europe and the associated asset price weakness and deteriorating sentiment had minimal impact on Turkey. However, with the recent surge in risks, the sharp weakening in the euro and the lack of growth in eurozone economies suggest that Turkey's exports might face a serious slowdown in demand. Despite the commencement of the recovery in exports in 4Q09, the weakness of the recovery suggests that fragility still remains. Granted, the eurozone and other European economies take around a 57% share of Turkey's exports, so the lack of growth on the European front will likely have a material impact on Turkey's growth prospects. Hence, we consider this issue as one of the key risks looking forward.

Policy rate tightening to come but possibly with a delay: We have long argued that inflation would constitute a significant problem and had been calling for the need to hike as early as July. The announcement of the exit strategy by the CBT and the faster-than-expected implementation of liquidity draining operations in the market comforted us to some extent. Moreover, the CBT's gradual change in rhetoric from über-dovish to nearly neutral in recent weeks and the mentioning of the readiness to act when necessary gave us confidence that the inflation-targeting policy is still given priority. The second Inflation Report of 2010 had been published with the emphasis on inflation forecast revisions, assumptions affecting inflation and growth as well as the monetary policy outlook. The CBT revised up its year-end CPI forecast to 8.4% (from 6.9%) for 2010 and 5.4% for 2011. These compare well with our 8.1% and 5.4% forecasts. The CBT's most recent MPC meeting (April 13) and the announcement of the details of the roadmap for its exit strategy on April 14 already brought a vast amount of clarity to the policy rate outlook, in our view. The most specific change compared to the previous Inflation Report was the CBT's mentioning of a statement that included "commencement of measured hikes starting 4Q10" to be one of the main underlying assumptions behind the inflation forecasts. Following the release of the report we maintained our forecast that the CBT might still act as early as July, although we mentioned the rising risks of a delay into 4Q. The government's recent decision to allow meat imports should help lower food prices noticeably in the months ahead and in turn we expect inflation expectation to stabilise. More importantly, the ongoing jitters in global financial markets and rising risks to overall growth lead us to believe that any hikes would come later rather than sooner. Hence, we are revising the timing of our policy rate hike call to 4Q10 rather than July but we leave the 150bp tightening expectation for the year unchanged. In our view, it is almost certain that the CBT will be following the exit strategy in the coming months and it will avoid a direct policy rate hike for some time, in the absence of a serious shock to inflation.

Risks to our policy rate call: The CBT is using the reports and the post-MPC meeting summary comments to communicate its view with market participants and the public. So far it had been conveying the message that inflation would remain high and higher than the targeted rate until late 2010 but ease noticeably in 1Q11. The expectations poll shows that the CBT had not been too convincing as the credibility gap is large. Any negative surprise in inflation in the coming months might result in further widening of the credibility gap and might pressure the CBT to act.

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CEEMEA
Stages of Contagion
May 11, 2010

By Paolo Batori, Pasquale Diana, Daniele Antonucci, Chuan Lim, James Lord & Alina Slyusarchuk | London

Greece received a three-year EMU/IMF loan amounting to €110 billion. EMU countries will provide €80 billion in total and €30 billion in the first year (first disbursement ahead of redemption on May 19) - with an interest rate of around 5%. This fiscal package is likely to resolve the short-term liquidity issue, as Greece can avoid issuing bonds for about two years, but Greece will have to work very hard to solve its fiscal problems, which remain substantial, to reduce its long-term solvency risk appreciably.

Very strict conditionality: possible boomerang as investors have shown doubts on effective achievement. The loan is conditional upon further belt-tightening in Greece, which will have to put in place yet another fiscal austerity package amounting to about €30 billion over three years (about 12.5% of 2009 GDP) on top of the tightening already implemented. The tightening will amount to 9.5% of GDP this year alone (including previously announced measures and the portion of the newly announced measures for the first year). There will be strict monitoring of Greece's progress on the fiscal front, with Greece reporting to the European Commission and the IMF at least every quarter. The loan is conditional upon Greece staying on track in terms of deficit-reduction targets. The market reaction to the package (positive on the news, but further sell-off on the following days) has highlighted that investors have low conviction on the possibility of achieving those criteria.

Medium-term solvency challenge is set to remain in Greece. Assuming that Greece will honour the package conditions and forecasting GDP contractions of 5% and 3.5% in 2010 and 2011, respectively, we expect the debt/GDP ratio to increase from 125% to 140-150% in two years. Investors may not be willing to remain committed for so long, before having a notable inversion of the debt/GDP trajectory.

The ring-fencing of Greece may prove to be a challenging task. What is the possible backdrop for Southern Europe? The Southern European countries have experienced increasing volatility, and credit risk concerns are likely to linger, in our view. The scale of the macroeconomic challenges is greatest in Spain, while Italy looks to be in a more favourable position from a fundamental standpoint. Portugal seems mainly a contagion story at this stage, we think, as its economic and fiscal backdrop look more robust than Greece's. Moving from a static to a more dynamic analysis, we conclude that Spain is likely to be more challenged from unfavourable funding conditions, as its interest expenditure versus total revenue seems to be more sensitive to the growing stock of debt.

We noticed a complete shift of perception in the credit premia in Southern Europe: Caution is warranted. We have computed the 2- and 5-year bond yield differentials between the Southern European countries and German Bunds, analysed the 2s5s slopes of risk premia and compared them to the 5-year yield differential (5-year risk premia).

We assume that yield differentials are mainly driven by risk premia. Interestingly, we noticed an important shift in trading mode between the November 2008-March 2009 period and more recently: sovereign risk premia in 2s5s slopes have moved from bear-steepening to bear-flattening. In other words, investors have skewed the probability of liquidity tension to the left, as they now see debt sustainability to be more challenging in those countries.

CEE countries present better fundamentals than Southern European ones. We widen the macro comparison to beyond Greece, and look at Greece, Italy, Portugal and Spain (GIPS), comparing standard vulnerability indicators with their equivalent numbers in CEE (Czech Republic, Hungary, Poland, Romania and Bulgaria). Subsequently, we offer our view as to what would trigger contagion concern spreading to CEE, even if macro fundamentals may not warrant it.

The macro comparison (looks across current account deficit, fiscal metrics, external debt and credit) suggests that on most measures of vulnerability, CEE overall fares better than the Southern European area.

•           The fiscal position is well known by now: even Hungary, with its debt/GDP ratio approaching 80%, has a debt stock which is far smaller than Greece or Italy's among the GIPS. Moreover, its primary balance corrected sharply over the last few years, and is now roughly zero. By comparison, Greece's primary balance (i.e., before interest payments) was over -7% of GDP last year (Spain's was -9%, Portugal's was -5%).

•           The current account gaps, which were singled out as a key indicator of CEE vulnerability ahead of the crisis, have corrected dramatically in Emerging Europe as imports and dividend outflows dried up during the crisis. The correction has been so sharp that in Hungary the C/A deficit has actually turned into a small surplus. Of course, with a normalisation in credit and consumption likely to materialise in the months ahead, these gaps will likely expand again. But given how unlikely we think it is that credit will resume at its pre-crisis pace, the double-digit C/A gaps seen in CEE pre-crisis will probably not be seen again. By contrast, the external gaps in Greece and Portugal in particular among the GIPS still look high. That means they remain reliant on foreign capital to keep funding these gaps to a larger extent than CEE.

•           Looking at external debt (i.e., the liabilities to non-residents) gives another measure (a stock, rather than a flow) of external dependency. In particular, the short-term portion of external debt (up to one year) offers an indication of how exposed these countries are to capital flight, in case non-residents decide not to roll over the debt. Hungary and Bulgaria look quite vulnerable on external debt, at 140% and 111% of GDP, respectively. But three of the GIPS (Greece, Portugal and Spain) look even more vulnerable on that score.

•           Private sector leverage is much higher in the GIPS than in CEE. In a sense, this is not at all surprising, given that credit penetration should be higher in economies that are more developed, and that CEE remains under-banked (this is indeed the rationale for the aggressive expansion of Western European banks into Emerging Europe). At the same time, the fast rise in private sector credit in Spain and Portugal over recent years has left their private sectors saddled with debt, which will hamper the recovery. In CEE, the Bulgarian private sector also looks over-levered, given the income level. This is the result of heady credit growth in the pre-crisis period.

CEE countries have entered Stage 2 of the contagion process: Caution is warranted. Since the Greek debt-sustainability concerns took centre stage in December 2009, we have been projecting a full decoupling of CEE countries from Greece, as fundamentals looked much better and valuation more attractive in the former area. What next? The CEE region has entered Stage 2 of the contagion path (outperformance on the downside as opposed to divergence), in our view, as debt concerns have spread to Southern Europe and both positioning and valuation are much less compelling in CEE now. We expect CEE credit spreads to outperform the GIPS, if market dynamics remain unfavourable (our base case scenario), while GIPS spreads could tighten quicker, if market conditions were to improve. We believe that the risk/reward profile of long CEE credit risk has deteriorated further and do not see any attractive relative value trade between GIPS and CEE countries (i.e., buying protection in CEE versus selling protection in GIPS), as this strategy looks very much directional to us. Stage 2 of contagion warrants caution and we reiterate our cautious stance in both credit and rates. FX markets are likely to experience high volatility as well. We offer some hedges that we find attractive.

Conditions are not mature to foresee a re-coupling in CEE. Although we acknowledge that a combination of less compelling valuations and more challenging technicals will expose CEE to higher volatility (in fact we anticipated an EM correction for May), we do not foresee a re-coupling with GIPS yet. Fundamentals are stronger and CEE countries are set to outperform GIPS in a volatile environment as long as capital markets are functioning, in our view. We are monitoring the 1-year CCS basis swap in CEE countries to gauge the level of tension and do not currently see any worrisome conditions.

We believe that debt-sustainability concerns spreading to Core Europe (CE = Austria, Belgium, France and Germany) is necessary to kick off the re-coupling of CEE to GIPS (Stage 3). Given the strong correlation between Core European 5-year CDS spreads and the 1-year basis swap, we would expect a much more critical situation for CEE, if the Core European average CDS spreads were to increase towards and above 100bp (current value 65bp).

Hedges against a possible re-coupling. Although the current situation is unlikely to degenerate into a full re-coupling trend in the coming two weeks or so, we believe it is worth exploring some hedges against the tail risk. In the remainder of this document, we offer some strategies that we believe offer good hedging potential (in a negative environment) and limited potential loss (if concerns were to recede).

Buy a basket of equally weighted 5-year CDS in Bulgaria, Hungary and Romania versus the 5-year iTraxx CEEMEA SovX index. Hungary, Bulgaria and Romania are the CEE countries with the most challenging fundamentals within the CEE region. The stock of debt in Hungary and exposure to the Greek banking sector in the Balkans are the main possible drivers of uncertainty/contagion, in our view. We believe that long 5-year protection in a basket of Hungary, Bulgaria and Romania versus the iTraxx CEEMEA SovX index (current spread 20bp) presents a very attractive hedge against a deterioration of the current situation and a transition from Stage 2 to Stage 3.

Pay HUF 2s5s10s butterfly to position for a market correction in May/June. The front end is already pricing in terminal rates at around 5%, which is in line with our economists' projection. Abundant liquidity locally should continue to help anchor the front end relatively to the longer end. There remains little pressure from the locals to sell their bond holdings (usually out to 3 years), as long as cash stays soft. On the other hand, foreign positioning is heaviest in the 5y+ sector. We therefore think that 5y is the best tenor to pay. The expensiveness of the 5y sector is evident in the 2s5s10s butterfly, which is now trading at the bottom of the recent range. This butterfly tends to move directionally with the 5-year sector, and therefore is a good hedge against a risk-off environment. Even if risk appetite comes back, we believe that the front end should outperform as the market starts pricing in more rate cuts this year.

In CEEMEA, there are a number of potential hedges that we think are attractive for investors looking to protect long outright EM FX positions.

We think that buying 1x1 USD/HUF or 1x1 USD/PLN 3m call spreads will provide good protection. If investors buy the USD calls with a low strike of spot + 5% and sell USD calls with a high strike of spot + 10%, the portfolios will be protected as USD/EMFX heads higher. While HUF and PLN tend to trade more against EUR, we think that EUR will suffer on the back of contagion and rising risk-aversion, so USD/EMFX is likely to perform better.

Finally, we think that buying EUR/BGN forwards are an attractive hedge too. We believe that the market will begin to price in a greater chance of a devaluation in Bulgaria as the crisis spreads. Bulgaria is particularly exposed to the problems in Greece. Greek banks account for a significant portion of the lending in the Bulgarian economy (40% of total) and the forward curve is likely to price in a higher probability of devaluation (we do not expect a de-peg) as the Greek economy contracts in line with the severe austerity measures ahead. The 12-month tenor, for example, is currently pricing in about 1.7% of devaluation. This would be the theoretical premium investors will pay if market conditions improved, as it is unlikely to see a revaluation in that horizon. Increasing market uncertainty could require a repricing of higher probability of de-peg, and this would push the 12-month forward higher (more devaluation).

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Euroland
Fast-Track to Fiscal Union?
May 11, 2010

By Elga Bartsch & Daniele Antonucci | London

What's new in fiscal policy? In an all night session, the Ecofin Council finalised the details for a much larger-than-expected financial stabilisation package of up to €750 billion. There are three elements to the new fund: First, opening up the EU balance-of-payments facility to euro area countries and increasing its ceiling from €60 billion to €110 billion. Second, a European stabilisation fund amounting to €440 billion. Third, an additional IMF tranche for euro area countries of up to €250 billion. The latter two would make an emergency lending programme like the one implemented for Greece a much faster decision by avoiding another lengthy ratification process in national parliaments. In exchange for receiving emergency funding, recipients need to agree to a rigorous austerity plan supervised by the IMF, the EC and, we would expect, the ECB.

What's new in monetary policy: The ECB has announced that it will intervene in public and private debt markets. The interventions will be sterilised and hence don't constitute quantitative easing. The amount and details are still to be determined by the ECB Council.  Furthermore, the ECB will switch its upcoming 3M tenders back to full allotment and reinstate a 6M tender, allowing banks again access to unlimited term funding. Finally, in conjunction with the Fed, the ECB has decided to reopen the USD swap lines, which allow European banks to obtain USD funding against EUR collateral. 

Our take on the measures: The stabilisation fund, which constitutes a first move towards a fiscal union, is larger than expected. If the emergency liquidity for the periphery is not complemented by aggressive austerity measures, the underlying solvency problems will continue to fester - and eventually spread to the core. The ECB's policy actions, by contrast, probably fall somewhat short of market expectations for a big 1Y LTRO and/or big bond buying scheme. With tonight's ECB decision to open the door to purchases of bonds, the bank is walking a fine line in terms of its perceived credibility.

Fast Forward Towards a Fiscal Union in Europe...

Like the ERM crisis in the early 1990s, spurred on political initiatives to bring about the long-planned monetary union in Europe, it seems that the sovereign debt crisis could be acting as a catalyst for an ever closer union of European countries.  The decisions taken this weekend first by European leaders and then by finance ministers mark a big leap towards a fiscal union in the euro area, we think.  Not only have countries agreed to stand in for each other to an unprecedented extent, they have also agreed to foregoing some of their fiscal sovereignty and submitting to rigorous fiscal consolidation programmes should they require financial assistance. At €750 billion in total, the stabilisation fund amounts to a sizeable 8% of euro area GDP (equivalent to 10% of general government debt). The size of the stabilisation fund is likely to go beyond the expectation of most market participants as far as the fiscal stabilisation mechanism is concerned.

...and Tighter Surveillance of Budget Positions

The stabilisation fund clearly represents a move towards a closer fiscal union and towards the joint issuance of government bonds via the European Community (at least for the proportion of the fund handled via the balance of payments facility). The key difference between the stabilisation fund and joint bond issuance lies in the conditionality.  But the surveillance mechanism will only be as good as its supervisors.  Hence it was important to get both the IMF and the ECB involved too. If the experience of the Stability and Growth Pact is anything to go by, there is reason for concern about the effectiveness of the peer review process within the Ecofin with the support of the European Commission. That said, the peer review process of the SGP might also be sharpened in the coming months, given the recent experience and the fact that there is domestic taxpayers' money on the line for emergency liquidity assistance.

ECB, Increasingly Politicised, Gives Some More Ground

As with the decision on the collateral eligible at its refinancing operations, where the ECB already changed its rules twice, it becomes clear that the ECB's decisions have become increasingly politicised in the course of the crisis. As the delineation of responsibilities between the common monetary policy run by the ECB and national fiscal policies run by individual governments got more and more blurry, the independence of the ECB started to be compromised. Tonight the ECB decided to take one step further and - in addition to reinstating some of the measures it had already taken during the height of the financial crisis (term funding and USD swap lines) - also open the door to outright purchases of government bonds. These purchases will be sterilised and as such do not constitute quantitative easing, i.e., an expansion of the ECB's balance sheet.  So far, the size of the intervention programme and the details about which debt instruments the ECB is going to buy are not known.  This is a decision still to be taken by the ECB Governing Council.  Apart from the sterilisation, we would guess that the covered bond buying programme of the ECB could be a blueprint and would expect the ECB to reveal in due course the amount of the purchases it is targeting and the timeframe over which it expects to conduct these purchases. In the highly successful covered bond programme, there were hardly any details given of which bonds the ECB aimed to buy. 

Contrary to the covered buying programme, the ECB might be shying away from buying bonds in the primary market.  It is clear that the ECB has decided to give up some of its composure this weekend and embark on an unprecedented course of buying debt instruments in order to reduce volatility in financial markets and funding pressures in parts of the banking system.

Two Tales of a Sovereign Debt Crisis

We have argued in the past that the sovereign debt crisis is likely to play out in two ways: as a credit story within the euro area because the ECB isn't allowed to monetise government debt and as an inflation story in the UK and US where the central bank can and does monetise government debt.  It now seems that the euro area could be in the worst of both worlds.  Like the emergency lending facilities that Europe has activated, also government bond buying by the central bank - whether it is pure credit easing (i.e., sterilised) or outright quantitative easing (i.e., unsterilised - often casually described as printing money) - involving the central bank in stabilising government bonds mainly buys the governments facing financial distress some extra time.  Contrary to earlier decisions taken by other central banks, this purchase programme is not meant to up the overall amount of liquidity or lending. In other words, it is not quantitative easing. Hence, there is no additional money meant to be printed (at least not through the purchase programme). As a result, the potential longer-term inflationary dangers should be more contained.  But it will remain to be seen whether the financial markets come to this conclusion too.

Funding Pressures in the Financial System

The sharp sell-off in some of the peripheral bond markets in recent weeks will likely have had some repercussions on the euro area banking system. Even where euro area banks have allocated their government bond holdings to their hold-to-maturity assets, they still face a daily mark-to-market for bonds that have been pledged to the ECB as collateral.  Hence, the sharp fall in some bond markets could have caused some stress on the funding side, rather than the asset side as such.  For the overall banking system this should not be a major issue, given the extent of overcollateralisation and the small share of government bonds in the overall collateral pool. But for individual institutions this might not be case.  To the extent that the policy initiatives announced cause bond markets to rally, they will also help to relieve the funding stress.

EU Balance-of-Payments Facility Extended to EMU States

The smaller part of the stabilisation fund is based on an extension of the existing balance of payments facility to euro area member states.  In addition, the facility is upped by €60 billion to a total of €110 billion.  The balance of payment facility has recently provided emergency funding to Hungary, Latvia and Romania. In these cases, the European Community (EC) came to the market to raise funds by issuing EC bonds that are backed by all EU member states and then lent the money on to the countries in question under a joint funding programme with the IMF.  Typically, the lending is conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having a AAA rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, the IMF and the government concerned agree on measures designed to overcome the country's difficulties.

Based on a Commission proposal, Ecofin approved the loans to Latvia, Hungary and Romania, usually at a five-year maturity. Subsequently, a Memorandum of Understanding is signed between the EU and the member state, setting out the conditions of the loan. Following signature of the Memorandum and the Loan Agreement, the first payment tranche is released. Countries that would like to use this facility would probably be prepared to make budget cuts similar to what the CEE countries did and what Greece is doing now.  Payments are usually made in instalments. Ahead of the disbursements of further tranches there is typically an assessment of the progress made with respect to the policy measures taken.  So far, about €15 billion out of the BoP facility has been allocated to Hungary, Romania and Latvia (with around €10 billion having been disbursed already).  Hence, there is at the moment about €100 billion of emergency lending available in the BoP facility.

A New SIV to Stabilise Euro Area Sovereigns

The significantly larger part of the stabilisation fund though will be provided by a newly created Special Purpose Vehicle (SPV) backed by pro rata national government guarantees of the euro area member states.  The SIV will have a maturity of three years and can have a volume of up to €440 billion.  The IMF will provide additional funding of at least half the European contribution (hence up to €220 billion).  The loans will be subject to strict conditionality and have similar terms and conditions as the usual IMF loans.  By setting up such a SPV, euro area governments want to avoid having to go through the lengthy legislative process that we saw in the approval of the aid for Greece.

Impact on the EMU Periphery

The impact of the stabilisation fund will likely be felt most acutely in the EMU periphery, for two reasons. First, these were the countries that experienced some funding stress, with bond yields rising fast and furiously. Second, these are the countries that would have to agree to aggressive austerity programmes - should they have to draw on the lending facilities of the fund. In what follows we are looking at the implications for Spain and Portugal in particular, and would encourage readers to take a look at our more in-depth reports on those two countries too.

How Much Fiscal Tightening for Spain and Portugal?

Both countries are not facing long-term solvency concerns, i.e., their debt trajectory - especially in the short term, say over the next few years - seems sustainable. Over the long haul, when age-related public spending (i.e., pensions and healthcare) kicks in, there are some sustainability issues in Spain - along with Greece, Ireland and, outside the euro area, the UK, among others. Our rough-and-ready calculations suggest that debt stabilisation in Spain is unlikely to be as challenging as in Greece.

For example, we illustrate what the change in the Spanish debt-to-GDP ratio will be for different combinations of primary balance and nominal GDP growth. The starting point is debt-to-GDP ratio of around 55% and average coupon on the debt of around 5%; the debt trajectory will deteriorate a lot less than in Greece (see Our First Assessment of Greece's Loan and Austerity Package, May 3, 2010).

We highlight Spain as an example simply because of its size (12% of euro area GDP). Similar calculations for Portugal show that this country too is better placed than Greece. Right now, Spain and Portugal are under the market spotlight, because of liquidity - not solvency - issues. In practice, these two risks are deeply intertwined. Even a solvent country might face a restructuring or a default if it is not able to refinance its debt. In the case of a ‘confidence crisis', any country might face refinancing risks that might morph into sustainability risks.

One way to reduce these risks is to step up fiscal consolidation. How much is needed? The European Commission's recommendations might be a useful starting point. Spain and Portugal might just comply with these recommendations if they deliver on their current fiscal consolidation programmes in full. But to restore confidence, the chances are that more will be needed. At this stage, both countries have hinted at more belt-tightening to come - although no details are available yet.

Impact of Fiscal Austerity on Growth in the EMU Periphery

We will have to see what the details of any fiscal adjustment programme are. But take Spain, for example. According to press reports, the Prime Minister might present further austerity measures before the parliament on Wednesday. There is virtually no indication at this stage on the nature of these measures. But the government might bring forward the Central Government Austerity plan, for example. Together with the Portuguese government it will present its additional measures before the Ecofin Council on May 18. Other measures might include restraining wage outlays for the public administration, or cutting transfers and subsidies. According to newswire reports on Reuters, there were very lively discussions at the Ecofin about this issue.

Danger of a Double-Dip in Spain

In this scenario, fiscal tightening will hit the economy harder than in our base case - in which we expect the Spanish economy to shrink by 0.7% this year and expand by 0.8% next year. Should we see much more aggressive fiscal tightening, our bear case, in which the economy continues to shrink not only this year (and at a substantial pace) but also the next, might start to look more likely. In addition to potential fiscal policy action, we are watching bank lending to the private sector and the housing market closely as potential sources of downside risks to our below-consensus base case. If these risks materialise, the Spanish economy might not only underperform the euro area in 2010-11, but could also contract outright for an unprecedented three years in a row. Our bear case forecast for GDP growth stands at -2% for 2010 and at -0.5% for 2011. Hence, even if Spanish GDP growth creeps back in positive territory in terms of sequential quarterly GDP growth rates in 1Q (as we expect), the chances are that it will double-dip further down the line.

Growth in Portugal Also Might Be Poor

Similarly, the chances are that Portugal's economic outlook might turn out to be more challenging than expected - courtesy of more fiscal retrenchment and a high exposure to Spain, which absorbs about one-quarter of Portugal's exports. Relative to our base case GDP growth forecasts of 0.5% this year and 1% next year, Portugal might contract by as much as 1% this year and 0.5% next year - in our bear case scenario. Looking further ahead, Portugal's potential growth rate has changed the least among the various euro area countries - even accounting for the economic fallout of the financial crisis. However, the challenge is that such growth rate was quite low - at around 1% - even before the crisis. All else being equal, this is one of the main difficulties in addressing the fiscal problems. Spain, conversely, has far outperformed the euro area average in the decade prior to the financial crisis. But with no clear substitute for the construction sector as the engine of growth, Spain's potential growth rate too will be lower in the five years ahead.

Italy, Instead, Is Likely to Hold up Ok

Perhaps surprisingly to some observers, Italy looks like a quasi-core country from a fiscal standpoint (see Inching into the Core, March 15, 2010). There are many reasons for this, but one key difference between Italy and the EMU peripherals (and also some core country, such as France) is that Italy has managed to maintain a primary budget surplus for most of the past decade. This means that Italy - unlike France - did not need to borrow in the market to cover its interest payments. Indeed, Italy's primary budget looks in a better shape than most EMU countries. Of course, the recession triggered a shortfall in revenues and an increase in spending - courtesy of the functioning of the so-called ‘automatic stabilisers' - in all European countries. In Italy, this resulted in a primary budget deficit last year. But this is likely to be a temporary deterioration: we expect a balanced primary budget in 2010 and a small surplus in 2011. In France, conversely, the primary balance dipped into negative territory in 2002, and has remained there ever since. The chances are that the primary deficit will stay well in the red in 2010-11, to the tune of 5.5% of GDP on average.

The upshot is that Italy has less work to do in terms of cutting its budget deficit than the ‘typical' EMU country. Indeed, bringing the deficit from around 5% of GDP this year to less than 3% in 2012 (as requested by the European Commission) implies a more limited fiscal consolidation than in the other peripherals. With a sizeable stabilisation fund in place now, the risks of the contagion spreading to Italy is likely reduced significantly.

How Far Does a €750 billion Stabilisation Fund Go?

Clearly, a €750 billion stabilisation fund could support peripheral bond markets for a while and provide some respite to, say, Spain, Portugal and Ireland combined, for the remainder of this year and beyond. In addition, the ECB stands as buyer of government bonds, if needed.

ECOFIN Statement

The Council adopted the following conclusions:

The Council and the Member States have decided today on a comprehensive package of measures to preserve financial stability in Europe, including a European Financial Stabilisation mechanism with a total volume of up to €500 billion.

In the wake of the crisis in Greece, the situation in financial markets is fragile and there was a risk of contagion which we needed to address. We have therefore taken the final steps of the support package for Greece, the establishment of a European stabilisation mechanism and a strong commitment to accelerated fiscal consolidation, where warranted.

First, following the successful conclusion of procedures in euro area Member States and the meeting of euro area Heads of State or Government, the way has been cleared for the implementation of the support package for Greece. The Commission has signed today, on behalf of the euro area Member States, the loan agreement with Greece and the first disbursement will proceed, as planned, before May 19. The Council strongly supports the ambitious and realistic consolidation and reform programme of the Greek government.

Second, the Council is strongly committed to ensure fiscal sustainability and enhanced economic growth in all Member States and therefore agrees that plans for fiscal consolidation and structural reforms will be accelerated, where warranted. We therefore welcome and strongly support the commitment of Portugal and Spain to take significant additional consolidation measures in 2010 and 2011 and present them to the May 18 ECOFIN Council. The adequacy of such measures will be assessed by the Commission in June in the context of the excessive deficit procedure. The Council also welcomes the commitment to announce by the May 18 ECOFIN Council structural reform measures aimed at enhancing growth performance and thus indirectly fiscal sustainability henceforth.

Third, we have decided to establish a European stabilisation mechanism. The mechanism is based on Art. 122.2 of the Treaty and an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. Art 122.2 of the Treaty foresees financial support for Member States in difficulties caused by exceptional circumstances beyond Member States' control. We are facing such exceptional circumstance today and the mechanism will stay in place as long as needed to safeguard financial stability.

A volume of up to €60 billion is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF. The mechanism will operate without prejudice to the existing facility providing medium term financial assistance for non euro area Member States' balance of payments.

In addition, euro area Member States stand ready to complement such resources through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating Member States in a coordinated manner and that will expire after three years, respecting their national constitutional requirements, up to a volume of €440 billion. The IMF will participate in financing arrangements and is expected to provide at least half as much as the EU contribution through its usual facilities in line with the recent European programmes.

At the same time, the EU will urgently start working on the necessary reforms to complement the existing framework to ensure fiscal sustainability in the euro area, notably based on the Commission Communication to be adopted on May 12, 2010. We underline the importance that we attach to strengthening fiscal discipline and establishing a permanent crisis resolution framework.

We underlined the need to make rapid progress on financial market regulation and supervision, in particular with regard to derivative markets and the role of rating agencies. Furthermore, we need to continue to work on other initiatives, such as the stability fee, which aim at ensuring that the financial sector shall in future bear its share of burden in case of a crisis, also exploring the possibility of a global transaction tax. We also agreed to speed up work on crisis management and resolution.

We also reiterate the support of the euro area Member States to the ECB in its action to ensure the stability to the euro area.

Statement of the ECB

ECB decides on measures to address severe tensions in financial markets

The Governing Council of the European Central Bank (ECB) decided on several measures to address the severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term. The measures will not affect the stance of monetary policy.

In view of the current exceptional circumstances prevailing in the market, the Governing Council decided:

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they "will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures" and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.

In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.

To adopt a fixed-rate tender procedure with full allotment in the regular 3-month longer-term refinancing operations (LTROs) to be allotted on May 26 and on June 30, 2010.

To conduct a 6-month LTRO with full allotment on May 12, 2010, at a rate which will be fixed at the average minimum bid rate of the main refinancing operations (MROs) over the life of this operation.

To reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on May 11, 2010.

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Euroland
A Euro Area Stabilisation Fund
May 11, 2010

By Elga Bartsch & Daniele Antonucci | London

A Stabilisation Fund for the Euro Area

We are waking up to good news for the markets this morning. Overnight, euro zone leaders have decided to put together an emergency stabilisation fund for EMU countries. The stabilisation fund will be finalised before the market opens on Monday. The heads of state or government have asked their finance ministers to get together for an extra Ecofin meeting on Sunday afternoon to hammer out the details. A press conference has been scheduled for around 5:00pm London time on Sunday, but the timing of this briefing could obviously still change.

Ecofin Council to Finalise Fund Details on Sunday

At this stage, we don't know much about the details of the stabilisation fund. But, in general, we believe that this is an important move that could help stabilise the euro area periphery as well as the banking sector and the money markets, which all started to show signs of stress towards the end of the week. Risky assets would likely also respond positively. We are less convinced, however, that it will be seen as positive for the euro or for Bunds. Here we would not rule out a negative market response. Much of the market reaction, of course, will depend on the details of the announcement on Sunday and whether these will convince market participants. The size of the fund will likely be one important headline to look out for.

All Eyes on Any ECB Policy Action Backing the Fund

In addition, any accompanying action by the ECB will likely be key for calming financial markets. There was unconfirmed market chatter on Friday that the ECB was about to launch a €600 billion facility over the weekend. The market chatter about this facility was contradictory, in the sense that some were talking a one-year lending facility (i.e., a new LTRO which could replace the €442 billion rolling off on July 1), while others were claiming that the ECB was about to embark on an outright purchase programme for government bonds. The latter version was also reported this morning by a German TV station, ARD. Alas, we will have to wait until Sunday evening or even Monday morning to see what the deal really is.

Could Be Modelled on Hungarian/Latvian Rescue Fund

As stated earlier, there are no more official details on the stabilisation fund yet - apart from the statement below. Press reports suggest though that the stabilisation fund would have a similar structure to the rescue packages for Hungary and Latvia. In these cases, the European Community (EC) came to the market to raise funds by issuing EC bonds that are backed by all EU member states and then lend the money on to the countries in question under a joint funding programme with the IMF. These lending programmes were managed under the EU's balance-of-payments facility, which so far has been explicitly dedicated to help countries that aren't in the euro. Changing this provision would require a Council decision and the support of non-EMU members. This BoP facility was doubled to a total €50 billion during the financial crisis and about €15 billion has been allocated to Hungary, Romania and Latvia (with €10.2 billion actually disbursed already).

How Did the Hungarian/Latvian Programmes Work?

Under the BoP facility, the EC raises money in the capital market to fund the lending programme. Typically, the lending is conditional on the country delivering on a number of policy areas, notably tough budget cuts. Having an AAA borrowing rating, the EC can effectively pass its lower borrowing costs on to member states. In exchange, the EU, the IMF and the government concerned agree on measures designed to overcome the country's difficulties. This would probably be similar to what has just happened with Greece. The key difference would be that the fund would be readily available without having to go through the same lengthy approval mechanism again for another country. In addition, it seems that thus far there are no talks on possible IMF involvement in the euro area stabilisation fund.

Based on a Commission proposal, Ecofin approved the loans to Latvia, Hungary and Romania, usually at a five-year maturity. Subsequently, a Memorandum of Understanding is signed between the EU and the member state, setting out the conditions of the loan. Following signature of the Memorandum and the Loan Agreement, the first payment tranche is released. So far, Hungary (€6.5 billion), Latvia (€3.1 billion) and Romania (€5 billion) were granted assistance. Payments are usually made in installments. Ahead of the disbursements of further tranches there is typically an assessment of the progress made with respect to the policy measures taken. In the case of the CEE countries, this assessment was made by both the IMF and the European Commission. In the case of the euro area, it probably would just be the European Commission providing an assessment and the Ecofin Council taking the decision.

Some Important Differences

We had discussed the option of replicating these programmes for Greece in our first report on Greece (see Whither Greece? January 25, 2010, page 14). There is no indication of the amount that the EC could be mandated to raise yet, but if it really was modelled on the CEE cases, it would mean that also countries outside the euro area would guarantee the bonds issued by the European Community. We would deem such broad support from EMU-outs unlikely - especially in the UK, after the election. So it probably will just be the euro area countries who will back the fund and who seem to be moving towards more of a fiscal union in response to the crisis. In exchange, the fiscal discipline enshrined in the peer-review process under the Stability and Growth Pact will likely be tightened too. These changes and their compatibility with the European Treaty could potentially be challenged in the German Constitutional Court. That said, just this morning the Court threw out the case brought yesterday against the Greek rescue package.  

More of the Same ECB Liquidity or Something New?

In light of the decision taken and the details to follow on Sunday, we would also be watching out for supporting policy actions from the ECB - such as bringing back the fixed-rate full allotment long-term refinancing operations (LTRO) under which banks can borrow unlimited amounts of liquidity. Given that the details of the stabilisation fund will only be finalised on Sunday, we would doubt that the ECB will make an announcement before the market opens on Monday. We cannot remember the ECB ever having made market-relevant announcements over the weekend.

Reuters is reporting that the bonds issued by the new stabilisation fund will have an explicit guarantee of all member states and an implicit guarantee of the ECB. At this stage, it is not clear to us what this implicit guarantee of the ECB could imply. We had argued on Thursday after the ECB Press Conference that, for the moment, bond buying did not seem to be on the ECB's agenda (see ECB Watch: Calm in the Eye of the Storm, May 6, 2010).

Bottom line: Euro area governments finally appear to be rising to the challenge of the sovereign debt crisis and willing to put into place additional safeguards for the euro area financial system. Like the measures taken before - for the benefit for Greece - the stabilisation fund simply buys time for distressed borrowers.

In addition to the credibility of the rescue mechanism, the fiscal policy action taken in these countries during this ‘extra time' is absolutely essential. If yet another rescue mechanism isn't followed by aggressive austerity measures, the problem just festers - and could eventually spread even wider.

Statement of the Heads of State or Government of the Euro Area  

1. Implementation of the Support Package for Greece

In February and in March, we committed to take determined and coordinated action to safeguard financial stability in the euro area as a whole.

Following the request by the Greek government on April 23 and the agreement reached by the Eurogroup on May 2, we will provide Greece with €80 billion euos in a joint package with the IMF of €110 billion. Greece will receive a first disbursement in the coming days, before May 19.     

The programme adopted by the Greek government is ambitious and realistic. It addresses the grave fiscal imbalances, will make the economy more competitive, and will create the basis for stronger and more sustainable growth and job creation.     

The Greek Prime Minister has reiterated the total commitment of the Greek government to the full implementation of these vital reforms.     

The decisions we are taking reflect the principles of responsibility and solidarity, enshrined in the Lisbon Treaty, which are at the core of the monetary union.

2. Response to the Current Crisis

In the current crisis, we reaffirm our commitment to ensure the stability, unity and integrity of the euro area. All the institutions of the euro area (Council, Commission, ECB) as well as all euro area Member States agree to use the full range of means available to ensure the stability of the euro area.

Today, we agreed on the following:

- First, consolidation of public finances is a priority for all of us and we will take all measures needed to meet our fiscal targets this year and in the years ahead in line with excessive deficit procedures. Each one of us is ready, depending on the situation of his country, to take the necessary measures to accelerate consolidation and to ensure the sustainability of public finances. The situation will be reviewed by the Ecofin Council on the basis of a Commission assessment by the end of June at the latest. We have asked the Commission and the Council to strictly enforce the recommendations addressed to Member States under the Stability and Growth Pact.     

- Second, we fully support the ECB in its action to ensure the stability of the euro area.

- Third, taking into account the exceptional circumstances, the Commission will propose a European stabilization mechanism to preserve financial stability in Europe. It will be submitted for decision to an extraordinary ECOFIN meeting that the Spanish presidency will convene this Sunday May 9.

3. Strengthening Economic Governance

We have decided to strengthen the governance of the euro area. In the context of the Task Force headed by the President of the European Council, we are prepared to: 

- broaden and strengthen economic surveillance and policy coordination in the euro area, including by paying close attention to debt levels and competitiveness developments;

-reinforce the rules and procedures for surveillance of euro area Member States, including through a strengthening of the Stability and Growth Pact and more effective sanctions;

- create a robust framework for crisis management, respecting the principle of Member States' own budgetary responsibility.  The President of the European Council decided to accelerate the work of the Task Force.  The Commission will present its proposals next week on May 12.

4. Regulation of the Financial Markets and the Fight against Speculation

Finally, we agreed that the current market turmoil highlights the need to make rapid progress on financial markets regulation and supervision. Increasing transparency and supervision in derivatives markets and dealing with the role of rating agencies are among the key priorities for the EU. We also agreed on intensifying the work on crisis management and resolution in the financial sector and on a fair and substantial contribution of the financial sector to the costs of crises. The work on assessing whether more steps are necessary in view of recent speculation against sovereign debtors should be sped up. The President of the European Council therefore intends to discuss these issues at the June European Council, on the basis, where needed, of Commission proposals.

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United States
Review and Preview
May 11, 2010

By Ted Wieseman | New York

The deepening crisis in Europe and worsening spillovers across markets drove a big flight-to-safety rally in Treasuries over the past week.  Strong economic data were ignored as the severe widening in peripheral European debt spreads and sharp decline in the euro sent shockwaves across markets, with risk markets, especially corporate credit, plunging, volatility in rates and stocks soaring, commodity prices selling off sharply with an additional negative impact from rising investor concerns about the impact of China's increased efforts to slow its property markets.  The major new development during the past week's run of European turmoil was the relative severity of the widening in the yield spreads over Germany by much bigger and thus systemically important Spain and Italy.  There was some mild relief Friday, but for the week the 2-year Spanish and Italian debt spreads over German Bunds both more than doubled, to near 236bp and 185bp, respectively.  Though not quite as severe in relative terms and not as systemically frightening, the absolute moves were still much bigger and Friday's closes were new wides for Portugal (+245bp to 551bp) and Ireland (+183bp to 403bp).  Greek spreads also surged to new wides, but Greek yields are already at levels where the market - probably appropriately - is already priced for a reasonable likelihood of a debt restructuring.  Probably the most worrisome spillover into US markets from the EMU crisis was the major pressure through the week on 3-month Libor and short-dated eurodollar futures, which contributed to a huge further widening in front-end swap spreads, as European banks led a rise in liquidity demand that put big upward pressure on Euribor and near-term Euribor futures that has spread globally, with the Bank of Japan seeking to ease pressure in Tokyo markets with a big liquidity injection.  Inflation expectations in the TIPS market were crushed by the weakness in commodity prices and rising concerns about the global growth outlook, so there was a meaningful dovish repricing of Fed policy in futures markets at the same time eurodollar futures were seeing big losses, resulting in a further major widening in forward Libor/OIS spreads - a painful reminder of how the financial crisis first manifested itself in 2007 when soaring dollar demand led by European banks caused an, at the time, unprecedented blowout in Libor over expected fed funds.  The key question of course now is whether this contagion intensifies as it did in 2007 and a seizing up of global liquidity and a major increase in risk-aversion leads to broad weakness in the global economy, or whether the situation ends up more like 1997-98 when there were at times major spillovers from the crisis in Asia and then Russia into US markets but ultimately not enough to derail growth.  Indeed, the downward pressure on long-term rates, inflation expectations and commodity prices and the easier Fed policy in response to market turmoil ultimately resulted in the 1997-98 turmoil being stimulative for the US economy, which soared in late 1998 and 1999.  We will certainly be closely monitoring the extent of ongoing spillovers of this episode, but our base case at this point is that the growth impact stays mostly confined to Europe and that upside risks to the US outlook are becoming increasingly apparent after the past week's strong employment and ISM reports indicated that the acceleration in the economy in March has extended into 2Q.  Certainly the Treasury market is likely to remain well supported as long as the crisis in Europe continues - and we think it could for some time - and the collapse in inflation expectations that the European turmoil has caused should allow Fed tightening to be delayed longer than we were previously expecting even if growth upside continues to come through. 

For the week, benchmark Treasury yields plunged 15-25bp, with the front end lagging.  The 2-year yield fell 15bp to 0.82%, 3-year 19bp to 1.30%, 5-year 25bp to 2.17%, 7-year 24bp to 2.87%, 10-year 24bp to 3.43% and 30-year 24bp to 4.28%.  T-bills barely budged at first but finally joined the flight-to-quality bid on Thursday, with the 4-week bill's yield down 6bp on the week to 0.07% and 3-month 3bp to 0.13%.  With the dollar index surging over 3% and pressuring commodity prices on top of general global growth worries that were also added to by concerns about the impact of China's latest tightening moves, TIPS far underperformed, and inflation breakevens plunged.  Even with disruptions from the disaster in the Gulf of Mexico, June oil plunged 13% on the week, while industrial metals prices were down about 6%.  While the dollar surged to $1.271 from $1.329 against the euro and saw big rises against other European currencies, the Canadian and Australian dollars, and major emerging market currencies, it substantially lagged the yen, falling to 91.2 from 93.9, which added to global liquidity concerns, given the yen's perceived role as a funding currency.  The 5-year TIPS yield dipped 1bp to 0.39%, the 10-year was unchanged at 1.27% and the 30-year yield fell 6bp to 1.81%.  As a result, the benchmark 10-year inflation breakeven plunged 24bp to 2.16%, 5-year 24bp to 1.78%, and 5-year/5-year forward 24bp to 2.53%, after having pushed up to the high end of the historical range at 2.83% as recently as April 29. 

There was major upward pressure through the week in Libor and short-dated eurodollar rates and spreads over expected fed funds as a jump in liquidity demand that seemed to have been led by European banks ended up having a bigger impact on dollar than euro funding markets.  This dynamic brought back bad memories of the initial outbreak of the global financial crisis in August 2007, when European funding pressures also led to a severe widening in Libor/OIS spreads.  3-month Libor surged 8bp on the week to 0.428%, sharply accelerating what had been a gradual rise since the end of February after the SFP bills program began to be ramped back up and excess reserves to come down somewhat.  This boosted the spot 3-month Libor/OIS spread a bit less, to 18bp from 11bp, as some much milder upward pressure on overnight rates caused the expected average fed funds rate over the next three months to rise to 0.245% from 0.2325%.  This spread is priced to blow out much further in coming weeks and months.  The June 2010 eurodollar futures contract plunged 18bp to 0.65%, Sep 10 14bp to 0.75%, and Dec 10 7bp to 0.895% - against a decent scaling back of Fed tightening expectations this year as the Jan 11 fed funds contract gained 6.5bp to 0.435%.  As a result, the forward Libor/OIS spread to June surged to 38bp, September to 40bp and December to 42bp.  There was also significant pressure during the week on 3-month Euribor spot and near-term futures and spreads over the expected European overnight rate but less so than in US rates, which was puzzling.  In 2007, when the problem assets were dollar-denominated, there was a major rise in European banks' demand for dollars.  But it is unclear why the spillover from the weakness in euro-denominated government bonds is showing up more severely in dollar than euro interbank rates.  There is a rising expectation in the market that the ECB will follow the Bank of Japan and move to try to address the euro funding strains in the coming days with stepped up repo operations, which may provide some explanation.  We don't expect any domestically focused moves by the Fed, given the greatly improved economic backdrop, the still enormous amount of excess reserves in the US banking system, and the, to this point, muted moves in Libor rates and spreads relative to 2007-08.  It is possible at some point that the Fed could revive the FX swap lines with the ECB so that the ECB could provide dollar liquidity to European banks, but we're probably some way from that at this point.  The weakness in short-dated eurodollar futures and the big widening in forward Libor/OIS spreads helped drive a major widening in short-dated swap spreads and further flattening of the swaps curve.  Even after a decent pullback Friday, the benchmark 2-year swap spread widened 12.25bp on the week to 35.75bp, while the 10-year spread rose 4.75bp to 4.75bp, and the 30-year spread rose 3bp to -20.75bp.  So, the swaps rate curve flattened significantly more on top of the already big Treasury yield curve flattening. 

A notable positive market trend during the week was how solidly the agency MBS market performed during a big rise in interest rate volatility, which could help provide a material positive offset going forward for the US economic outlook to the negative economic fallout from Europe.  Normalized 3-month X 10-year swaption volatility rose to 120bp from 99bp, up from the low since late 2007 of 90bp hit in mid-March.  Mortgages lagged Treasuries and swaps with this volatility increase but not much, only about a third of a point versus Treasuries and a few ticks versus the widening in swap spreads for Fannie 4.5% MBS, as there was a decent tightening in mortgage Libor OAS spreads.  Current coupon mortgage yields fell below 4.25%, near their lows for the year, which should lower average 30-year mortgage rates down towards 4.875% after holding near 5% for most of this year.  

Risk markets were crushed broadly and volatility also soared.  The S&P 500 fell 6.4% to move slightly into the red for the year.  Big losses were seen across all major stock market sectors but with energy, materials, industrials and consumer discretionary stocks doing worst with losses near 8%.  The rise in equity market volatility was a lot larger than in rates, with the VIX spiking up to 41.5% from 22%, a high since the market lows in March 2009 after having been at lows since mid-2007 under 16% on April 20 before the latest wave of European turmoil began.  Investment grade credit performed horribly on Thursday, the worst day of the past week, but managed a partial rebound Friday as stocks kept sinking.  On the week there was still a severe 30bp widening in the IG CDX index to 122bp, 40bp wider than the recent April 20 tight and 37bp wider for the year.  Early in the week high yield credit was holding up very well along with subprime and lower-rated CMBS, as these areas were briefly seeing a lot more relative support from the positive US economic outlook, but these areas turned down very hard later in the week to join the broad weakness.  The high yield CDX index ultimately fell about in line with stocks for the week with a 6-point (or 6% since it closed near par on April 30) drop, which was about a 145bp widening in spread terms to near 640bp.  This brief resilience followed by a crash later in the week was also seen in the ABX and sub-AAA CMBX markets, with the AAA ABX index ending down 7% for the week, junior AAA CMBX 10% and AA CMBX 7%.  For a while the muni bond MCDX market was holding in much better than it did during the February Euroland weakness, but spillover intensified greatly mid-week before a bit of Friday improvement.  In late trading Friday, the 5-year MCDX index was about 35bp wider on the week near 165bp, back not too far from the worst close of the year of 180bp during the worst of the early February Greece spread widening. 

Non-farm payrolls surged 290,000 in April even though temporary hiring for the census remained sluggish at +66,000, and there were significant upward revisions to March (+230,000 versus +162,000) and February (+39,000 versus -14,000).  Job gains were broad-based, with good upside in business services (+80,000), construction (+14,000), manufacturing (+44,000), retail (+12,000), healthcare (+26,000) and leisure (+45,000).  Other details of the report were also strong.  The unemployment rate rose to 9.9% from 9.7%, but only because of a surge in the labor force (+805,000) that exceeded a big gain in the household survey's jobs measure (+550,000).  The average workweek rose a tick to 34.1, a high in over a year, which combined with the upside in payrolls boosted total hours worked by 0.4%.  Manufacturing hours jumped 0.8%, pointing to another very strong industrial production report.  Even with average earnings flat (the one disappointment of note in the report), the 0.4% aggregate hours gain boosted aggregate wages 0.5%.  Inflation should be soft in April because gasoline prices didn't see the seasonally typical increase, so should lead to particularly strong income growth in real terms. 

In addition to the surprisingly strong jobs report, both ISM surveys posted robust results in April, though the manufacturing sector continues to lead the recovery.  The composite manufacturing ISM index rose to a lofty 60.4 in April from 59.6 in March, a high since 2004.  Underlying details were even stronger, with the key orders (65.7 versus 61.5), production (66.9 versus 61.1) and employment (58.5 versus 55.1) posting good gains to unusually high levels, with a partial offset from a drop in the inventories gauge (49.4 versus 55.3).  The customers' inventories index also plunged to a near-record low of 33.0, and restocking going forward should provide support to further manufacturing growth.  The factory expansion continued to be very broadly based, with 17 of 18 sectors reporting expansion in both April and March.  Meanwhile, the composite non-manufacturing ISM index held steady at a four-year high of 55.4 in April after the 5-point surge seen in March and February.  Growth outside of manufacturing also remained broadly based, with 14 of 18 sectors expanding in April, the same as in March.  The business activity index rose to 60.3 from 60.0, a high since 2006, while orders pulled back 4 points but to a still-strong level of 58.3.  The employment index remained weaker, dipping marginally to 49.5.  The industry breakdown for employment was more favorable, however, with nine sectors reporting increased hiring and six further job cuts. 

On the softer side of the early April data run were initial indications for consumer spending.  Motor vehicle sales pulled back to an 11.2 million unit annual rate after surging to 11.8 million in March from 10.3 million in April.  And chain store sales results for April were somewhat softer than expected.  The full March/April period was quite strong, but it appears more spending was pulled into March by the early Easter and weather impacts.  Incorporating these results, we now see real consumer spending holding flat in April.  The starting point for 2Q was so strong thanks to +0.5% gains in real PCE in March and February, that even with an April pause, 2Q consumption would remain on pace for a gain near +3.25% on top of the 3.6% rise in 1Q. 

The economic calendar is pretty light in the coming week, with retail sales on Friday the most notable release, which is just as well since clearly investors are not focusing on US economic developments at this point.  While markets deal with the ongoing turmoil in Europe and try to gauge the spillover into other regions, the Treasury market will need to take down the quarterly refunding auctions.  This will be a bit less challenging, as the accelerating economy has translated to a big positive reversal in underlying tax revenue growth since March (though April non-withheld payments were soft) and allowed the Treasury to make a somewhat faster start to coupon size reductions than we were expecting.  The 3-year auction on Tuesday was lowered by $2 billion to $38 billion and 10-year on Wednesday $1 billion to $24 billion, but the 30-year on Thursday was held at $16 billion.  Economic data releases out in the coming week include the trade balance and Treasury budget Wednesday and retail sales and industrial production Friday:

* We look for a modest narrowing in the trade gap in March to $39.0 billion on a 1.3% gain in exports and 0.7% rise in imports.  Imports should be restrained by a pullback in services, which were boosted in February by Olympics broadcast royalty payments.  Port data also point to a flat reading for non-energy good imports, but higher prices should significantly boost petroleum products.  On the export side, higher prices should also provide a boost to industrial materials and food, and the shipments figures point to further upside in capital goods.  Note that our forecast is several billion dollars narrower than the BEA assumed in the advance 1Q GDP report. 

* We expect the Treasury to report a $56 billion April budget deficit, $35 billion wider than in the same month a year ago due mainly to a surprising fall-off in April 15 tax payments.  Based on the Daily Treasury Statement, April non-withheld taxes were down $25 billion (or 18%) versus a year ago.  In contrast, we had been expecting a small increase based on the anticipation that capital gains realizations would level out following the very steep drop-off seen in 2008.  The swing in non-withheld taxes along with continued upside in payments for unemployment benefits and other social insurance programs should more than offset some further acceleration in withheld taxes.  So the message from the revenue side of the budget is that the impact of the recent pick-up in economic activity is starting to flow through but that backward-looking factors (such as 2009 capital gains realizations) are even weaker than anticipated.  We recently updated our budget outlook and now look for a deficit of $1.25 trillion (or 8.5% of GDP) in F2010 - a bit narrower than our prior forecast.

* We look for a flat reading for April retail sales overall and ex autos based on the softer results for auto and chain store sales and a modest price-related drop at gas stations. 

* The employment report pointed to a very sharp jump in factory output during the month of April.  Indeed, even after factoring in another weather-related dip in the utility component, it looks like overall IP will be up nearly 1%.  And the key manufacturing category is expected to post a 1.2% gain, which would represent the sharpest jump since the cash-for-clunkers-related surge in activity seen last summer.  Manufacturing ex motor vehicles is also expected to be up 1.2% - one of the sharpest jumps seen during the past decade.  By industry, the strongest performers in April are expected to include: metals, machinery, textiles, paper, printing and petroleum.  Finally, the utilization rate is expected to jump to its highest reading since November 2008.

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United States
Budget and Financing Update - A Few Bright Spots in a Dark Tunnel
May 11, 2010

By David Greenlaw | New York

We are updating our US budget forecast and financing outlook to incorporate recent developments, including TARP repayments, slower-than-anticipated stimulus spend-out, and a pick-up in withheld income and employment taxes. These positive developments have been partially offset by surprising weakness in April non-withheld payments.  The bottom line is that we now look for a budget deficit this fiscal year of $1.25 trillion (or 8.5% of GDP).  This estimate is $75 billion narrower than the $1.325 trillion forecast we published in late January.

A couple of months ago, withheld income and employment tax collections began to outpace our expectations, so we have modestly raised our estimates for the year as a whole. However, April non-withheld tax payments came in well below our estimate.  On a DTS (Daily Treasury Statement) basis, April non-withheld taxes were down $25 billion (or 18%) versus a year ago.  We had been expecting a small increase based on the anticipation that capital gains realizations would level out following the very steep drop-off seen in 2008.  Thus, the message from the revenue side of the budget seems to be that the impact of the recent pick-up in economic activity is starting to flow through, but that backward-looking factors (such as 2009 capital gains realizations) are even weaker than anticipated.  On the spending side, stimulus-related outlays appear to be tracking below official estimates.  Moreover, the Treasury reported a $114 billion reduction in TARP outlays for the month of March tied to a re-estimate of the losses that will ultimately be borne by that program.

The deficit is expected to decline gradually over the next few years as economic recovery takes hold, tax rates rise and stimulus-related spending slows. In 2011, our deficit estimate is $1.125 trillion (7.3% of GDP), and by 2012 we see the deficit at $975 billion (6.0% of GDP).  While the declining trajectory of these projections might seem somewhat encouraging, it should be noted that further progress beyond 2012 would be grudging at best under current policies.

But the long-run outlook looks bleak.  To assess the longer-run outlook, we took the CBO's baseline budget estimate for F2020 and adjusted it for the impact of expiring tax provisions.  This approach implies a $1.2 trillion budget deficit in F2020 - or 5.25% of GDP.  It's worth noting that the CBO's economic projections show a 5.0% unemployment rate in 2020.  So, even with the US economy at full employment ten years from now, the adjusted baseline budget deficit is still more than 5% of GDP.  Moreover, these estimates do not incorporate three negative risks to the deficit outlook that appear to be identifiable - but not quantifiable - at present. First, there appears to be a significant likelihood that promised offsets to the forthcoming increase in government healthcare spending may not materialize. Second, there is a risk that states and municipalities may require significant financial assistance beyond that contained in the 2009 economic stimulus legislation. Third, these estimates include only a modest amount of additional support for the GSEs - and do not build in any losses associated with the Federal Housing Administration's mortgage insurance program, despite considerable exposure to still weak real estate markets.

The picture beyond 2020 is even bleaker. Pressures associated with an aging population and healthcare inflation point to rising entitlement spending and a further intensification of the budget imbalance.  Specifically, long-run estimates published by the CBO show that combined spending on Social Security, Medicare and Medicaid is expected to jump by a little more than 4% of GDP between 2020 and 2035.  Factoring in the impact of higher debt service, the structural budget deficit could well reach (a Greece-like) 10% of GDP over this timeframe.  Clearly, the US continues to face severe budget pressures over both the short and long run even though the recent improvement in the economy has brightened things a bit.

Near-Term Outlook

We detailed our budget estimates for the next few years.  The following policy assumptions are used to derive our budget estimates:

•           An AMT patch is enacted every year.

•           Additional defense spending is authorized relative to the current budget, consistent with the supplemental appropriations for wars in Iraq and Afghanistan that have been enacted in recent years.

•           A sharp cutback in physician reimbursement payments under the Medicare program continues to be delayed (as has been the case every year since 2003).

•           The 2001 tax rate cuts are extended but only for those earning less than $250,000 (consistent with President Obama's campaign pledge and F2011 budget proposals). The tax cuts on interest and dividends adopted in 2003 expire after 2010 as scheduled.

•           The ‘Making Work Pay' tax credits are extended.

•           Extended unemployment benefits (and COBRA subsidy) continue through the end of 2010.

•           A freeze on non-defense discretionary spending is adopted in F2011 and F2012.

•           We do not include the small-business tax breaks or the bank liability tax proposals that are receiving consideration in Congress. There is still a good deal of uncertainty regarding the final outcome of these proposals, and the items appear to be too small to have any meaningful impact on the budget outlook.

Impact on the Public Debt

Our deficit estimates imply a sharp rise in government indebtedness.  We estimate that the ratio of debt held by the public to GDP will hit 67.6% by the end of 2012.  A back-of-envelope calculation using the CBO's long-run estimates (adjusted for expiring tax provisions) suggests that the debt/GDP ratio will hit 87% in 2020 - a level not seen since the post WW II period (1947).  In comparison, the public debt/GDP ratio was 36% when the financial crisis began in autumn 2007.  Meanwhile, the gross public debt - a measure which includes the liabilities to the Social Security and Medicare trust funds - would be well over 100% by the end of the decade. A study by Reinhart and Rogoff presented at the 2009 AEA meetings found that countries with gross debt/GDP ratios in excess of 90% tend to grow about one percentage point more slowly than other countries. Interestingly, this finding holds for both developed and emerging economies (see Growth in a Time of Debt, December 31, 2009).  Our analysis suggests that the US will easily exceed the Reinhart/Rogoff sovereign debt threshold by the end of this decade, absent policy action that addresses the deficit situation.

Impact on Treasury Financing

The adjustment to our budget forecast and the somewhat larger-than-expected cutback in the size of the May refunding auctions have led us to pare our expectations for coupon sizes going forward.  For some time, it has been clear that the Treasury was overborrowing and cutbacks in coupon offerings were in the pipeline.  For example, the current pace of coupon borrowing would imply a drastic shrinkage in the bill market over the next few years.  While cutbacks in coupon sizes lie ahead, there are a wide range of possible changes.

We consider three alternative financing scenarios.  Note that under each of the alternatives, gross coupon issuance amounts to $2.335 trillion in F2010.  This implies modest cuts in most coupon issues over the next few months.  The big question is where we go from there.

In the first scenario, the Treasury targets the bill share of the outstanding debt at 20%.  This is close to the historical average (adjusted for the impact of the Supplementary Financing Program in recent years).  Under this scenario, gross coupon issuance would need to be cut to a run rate of about $1.7 trillion and the average maturity of the outstanding debt would stand at 5.6 years by the end of 2012.

In the second scenario, the 20% bill target is the same, but the Treasury eliminates the 3-year note in order to try to achieve a somewhat longer average maturity.  Obviously, the overall amount of coupon issuance under this scenario would be the same as in the first (i.e., $1.7 trillion), but the average maturity of the debt would be slightly higher.

In the final scenario, the target is changed to something we believe to be more relevant in the current environment.  Instead of holding the size of the bill market at some proportion of the total Treasury market, we hold it near its historical size in relation to the overall economy.  In other words, we target the ratio of bills to GDP.  The long-run average ratio is a bit below 10%.  So, we created a financing scenario that holds the size of the bill market near $1.5 trillion over the next few years, as opposed to having it continue to grow rapidly in line with the expansion of the outstanding debt.  Such a shift helps to achieve a lengthening of the average maturity.

In autumn 2009, Treasury officials indicated that they were aiming to push the average maturity of the outstanding debt up to a range of 6-7 years (see remarks by Karthik Ramanathan, Acting Treasury Assistant Secretary for Financial Markets, at the CFA's 2009 Fixed Income Management Conference).  The average maturity dipped to about 4 years during the recession versus a more normal range of 5-5.5 years.  In our view, the intended extension of the maturity of the debt still represents a prudent strategy.  However, it will be impossible to achieve such an objective if there are significant cutbacks in the 10s or 30s.  Indeed, it is a bit of a stretch to even achieve the bottom end of the range within the next several years - especially under the first two scenarios which target a larger bill market.  Another factor to consider is the potential impact of draining operations conducted by the Federal Reserve.  As part of its exit strategy, the Fed will begin engaging in reverse RPs and term deposits at some point down the road.  Ultimately, the operations will take hundreds of billions of dollars away from the front end of the curve, and this situation could persist for several years.  Some shrinkage in the size of the bill market could help to alleviate the potential distortions across financing markets.  Thus, for a variety of reasons, we prefer the third financing scenario, which targets a smaller bill market.  We illustrate a rough assessment of the likely coupon sizes that will be achieved by early 2011 under this scenario.

Finally, it's important to recognize that borrowing needs remain extremely elevated by historical standards.  Indeed, although expected gross coupon issuance of $1.96 trillion in 2011 is down more than 15% versus 2010, it is higher than in 2009, far more than double any previous year, and little changed from our prior estimates.  As economic recovery takes hold in the US, credit demands will begin to emerge across the private sector.  Thus, we still believe that a significant supply/demand imbalance across fixed income markets will work to push real yields higher at some point in the future.

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