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Venezuela
A Hard Currency Tipping Point, Revisited August 03, 2010 By Daniel Volberg | New York The decision to tighten capital controls in May appears to have postponed Venezuela's day of reckoning. When rising capital outflows threatened to undermine Venezuela's economic model, policymakers moved aggressively, severely tightening capital controls in late May. The ability of the authorities to effectively limit capital outflows - which reached $18 billion (5.5% of GDP) last year - should, in theory, significantly boost Venezuela's balance of payments. However, we suspect that, given measurement issues and uncertainty around the value of Venezuela's oil exports, there is still a risk that Venezuela may be facing a dollar crunch. The oil export data is a matter of heated debate and there is a risk that oil export numbers as reported in the balance of payments may be inflated. Therefore, while the published balance of payments statistics are likely set for a significant boost in the quarters ahead, there is still a risk that Venezuela may be faced with a dollar crunch, despite the elevated oil prices. That raises the prospect that policymakers may eventually have to prioritize between essential imports and international obligations. In sum, it appears that Venezuela's debt burden may be becoming increasingly onerous. The Dollar Balance Venezuela's economic model is built on an excess supply of dollars. Given the policy heterodoxy - especially the lack of property rights, expropriations and rising participation of the state in the production and distribution process - the supply of goods has become increasingly dependent on imports, as domestic production has fallen. In turn, Venezuela's reliance on imports means that it must generate enough dollars to finance those imports. Indeed, we reiterate our view that the key metric for measuring Venezuela's economic viability is the dollar balance - the balance between dollar supply and demand. Dollar supply is largely a function of two elements: oil exports and external debt issuance. Meanwhile, dollar demand has historically been driven by three factors: import demand, debt service obligations and capital outflows. Given the new policy environment, we'd argue that the dollar balance needs a revision. We had estimated that, given recent trends in the drivers of dollar supply and demand, Venezuela's dollar balance for this year and next was likely to post a cumulative deficit of near $20 billion (see "Venezuela: A Hard Currency Tipping Point?" This Week in Latin America, March 30, 2010). However, an important component of that analysis was the large and rising private capital outflow. Given that in mid-June the authorities tightened exchange controls and effectively shut down private capital outflow, the dollar balance is due for an update. Demand for Dollars Given the tightening in capital account restrictions, imports of goods are likely to be the most important driver of dollar demand this year and next. With the parallel market that had financed the bulk of imports in recent quarters now defunct, imports are likely to be financed through government-sanctioned channels in the quarters ahead. The bulk of imports are likely to be financed through CADIVI - the government's currency agency. Based on the dollars provided in the first and second quarters of the year, we estimate that CADIVI will supply importers with near $30.3 billion this year. For next year, we expect CADIVI to boost dollar supply to near $35 billion as the economy continues to substitute domestic goods production by imports. In addition, a smaller portion of imports is likely to be financed via the SITME system - the central bank's new dollar bond trading system that replaced the parallel market. Given that the SITME system has been operating at near $30-40 million dollars per day since it was introduced in mid-June, we expect this system to supply importers with hard currency totaling near $5 billion this year and near $8 billion in 2011. In sum, we are revising our forecast for imports to $35.4 billion in 2010 (from $28.9 billion) and $42.6 billion in 2011 (from $30.1 billion). In addition to imports of goods, Venezuela is likely to continue to demand hard currency to run a significant net deficit in services trade. The balance of payments data show that last year net trade in services posted a deficit of $7.6 billion. And annualizing the 1Q10 results suggests that Venezuela may post a deficit in the trade in services of at least $6.1 billion this year. For 2011 we expect a net deficit of $7.6 billion, in line with the average of the past three years. Add to that a net deficit in international transfers of roughly $0.5 billion this year and next, and we find additional dollar demand of $6.6 billion in 2010 and $8.1 billion in 2011. How will these extra dollars be obtained outside of the official channels of CADIVI and SITME? We suspect that the bulk of services may be related to PDVSA expenses that the national oil company can pay for directly. Debt service obligations are likely to also be a driver of dollar demand. The consolidated public sector external debt stands at $58.2 billion, near 28% of GDP. This external debt implies debt service - capital plus interest - of $5.6 billion in 2010 and $8.4 billion in 2011. Those debt service obligations are an additional source of dollar demand. Finally, public sector capital outflows may require extra hard currency. While the authorities appear to have clamped down on private sector capital outflows, the public sector generated outflows of $7.1 billion in just 1Q10. Even assuming zero additional net outflows the rest of the year, this total would be significantly above the $3.8 billion average public sector capital outflows during the last three years. Thus, to be conservative we assume that this year's capital outflows will remain limited to the $7.1 billion dollar public sector and $3.3 billion private sector outflows observed during 1Q. In sum, we project total capital outflows of $10.4 billion this year; for 2011 we project public sector capital outflows declining to the $3.8 billion average of the past three years. In sum, overall dollar demand should still be substantial this year and next. Summing up our projection for imports, capital outflows and debt service obligations, we find that dollar demand may be near $58 billion in 2010 and near $63 billion in 2011. Dollar Supply The supply of dollars is likely to remain largely a function of oil exports. Oil exports in 1Q totaled $15.7 billion and accounted for 95% of total exports. Given the average 1Q price of the Venezuelan oil basket of near $70 per barrel, this implies an export volume of roughly 2.5 million barrels per day. Assuming that the volume remains stable and using the futures curve to project oil prices forward, we estimate that oil exports should total near $62.3 billion in 2010 and $65.6 billion in 2011. As an aside, the assumption on oil output stability may prove too generous: in recent years, independent estimates suggest that Venezuela's oil production and export volumes have been falling. The Balance Combining the dollar demand and supply it appears that the decision to tighten capital controls may have provided the authorities with a tight, but manageable dollar balance. With total dollar demand of $58 billion in 2010 and $63 billion in 2011 against a total dollar supply of $62 billion this year and $66 billion next year, the authorities should be able to produce a better balance of payments snapshot than what we had expected just a couple months back. Indeed, doing the math, we find that the dollar supply could exceed dollar demand by a cumulative $7.0 billion the next two years. Debt Issuance While the dollar balance could be in surplus this year and next, we still expect the authorities to continue to issue external debt. A key source of demand for debt issuance comes through the SITME system that the central bank introduced in June. The system is a dollar bond trading system and thus requires a constant supply of external bonds. The government has leaned heavily on the local commercial banks to supply the $30-40 million per day that the system has averaged since inception in mid-June. However, with total bank dollar bond positions now near $1.3 billion and bank foreign currency working capital needs near $1 billion, the system is at risk of running out of supply. Hence, we estimate that the authorities may issue a total of $6 billion in external debt to local market participants - largely commercial banks - to reload their ability to provide dollar bonds to the SITME system. And we suspect that the authorities may issue another $7 billion next year. Not As Good As It Seems? It appears that by tightening exchange controls the authorities have regained control of the situation, but we suspect that there is significant uncertainty regarding the true scale of the challenge facing Venezuela. The key issue at play is that, since 2004, PDVSA's international transactions are independent of central bank control. The result is that the balance of payments statistics published by the central bank largely reflect PDVSA's official statistics, rather than observed cross-border flows. There is significant risk that officially reported oil export proceeds may be inflated. PDVSA reported that last year's oil exports were 2.7 million barrels per day. Of that total, exports to the Caribbean, Central America, Africa and South America totaled 0.7 million barrels per day. Exports to Europe, North America (principally the US) and Asia (mainly China) totaled 2.0 million barrels per day. The 0.7 million barrels per day of oil exports to the Caribbean and others may not be paid for in cash, but rather financed on credit with uncertain recovery value. In addition, the exports to Asia may not be made at market prices, but rather at a discount. Thus, assuming that PDVSA's export volume last year is a good proxy for the export volume this year and next, and applying the futures curve-derived price for the Venezuelan basket, we can estimate the portion of oil exports that is likely to generate hard currency. Using the official PDVSA numbers, we find that in 2010 oil export cash generation may be closer to $51 billion if we include exports to the US, Europe and Asia, or $43 billion if Asia is excluded. For 2011, a similar calculation means oil export proceeds of between $54 billion and $45 billion. Adjusting official statistics results in the dollar supply-demand balance tipping significantly into the red. After adjusting official figures to reflect the likely hard currency oil export proceeds, we find a significant shortfall in dollar supply relative to dollar demand. With total projected dollar demand of $58 billion in 2010 and $63 billion in 2011, we find that Venezuela may be faced with a cumulative shortfall of $16-33 billion over the next two years. And there appears to be a significant discrepancy between official and independent statistics regarding Venezuela's oil exports. OPEC reports that Venezuela's total production in the three months through June was 2.2 million barrels per day. There is some controversy regarding these estimates - the OPEC numbers could reflect exports rather than total production. Even assuming that OPEC numbers reflect exports rather than production and using the official data to isolate the share of exports that is likely exported for hard cash (roughly 60-73%), we find that oil export proceeds could reach only $34-41 billion this year and $36-43 billion next year. Thus, excluding dollar debt issuance, the effective dollar shortfall this year and next could reach a cumulative total of $37-$51 billion. Fears of Financial Strain A hard currency shortfall of up to $51 billion over the next two years would be a negative surprise for Venezuela watchers, in our view. Current market prices of Venezuelan bonds in the next two years imply a relatively limited risk of a problem. However, our work indicates that Venezuela's ability to pay might be strained if the dollar shortfall is near $51 billion over the next two years. Between the near $29 billion in international reserves the central bank held as of last week and near $11-13 billion in other hard currency assets, we calculate that Venezuela's public sector has a liquidity cushion of near $40-42 billion. With cumulative debt service costs of $13.9 billion this year and next, one can build a plausible case that the authorities may be faced with the prospect of having to choose to import goods and services or to honor debt service obligations within the next 18 months. Bottom Line We are not ready to make the call that Venezuela is facing an imminent financial dilemma. We are however concerned that, given the limited transparency in Venezuelan data, we cannot discount the risk that the $6.5 billion dollar surplus that the official balance of payments statistics are likely to show over the next two years could actually turn out to be a sizeable ($51 billion) deficit. And while Venezuela watchers appear to have grown more vigilant over the past few months, we suspect that it is still prudent to remain cautious, given the continued intensification in policy heterodoxy, potential for negative surprises due to the lack of transparency in the data, and rising event risk in the months ahead.
Greece
Does Greece Deserve More Credit? August 03, 2010 By Daniele Antonucci & Elga Bartsch | London Summary and Conclusions Staff teams from the European Commission, the ECB and IMF will be in Athens from July 26 to August 6 to conduct a more comprehensive review of economic developments and policy implementation, as called for under the Fund's Emergency Financing Mechanism. What will the teams find ahead of the next (conditional) loan disbursement in September? The first full assessment of Greece will paint the country in a favourable light, we think. In this report, we take stock of Greece's progress. We reach five main conclusions: • The budget numbers indicate that Greece is broadly on track to meet its fiscal consolidation targets this year, and possibly ahead. In 1H 2010, the budget deficit has narrowed by over 40%. • Transparency on the status of implementation of the individual fiscal measures has increased. It appears that Greece has complied with all the measures that had to be put in place by the end of 2Q. • On the structural reform front, the parliament passed the key pension reform bill at the beginning of July - beating the deadline of September 2010. The focus will now shift towards execution. • Greece appears to be mustering the political will to implement the next steps of the austerity programme - at least for now - given a solid parliamentary majority, a popular prime minister and contained social unrest. • Investors will need to see progress over a longer time span, and there is no guarantee that Greece will not restructure. But the disincentives to default are stronger than the incentives, we think. The upshot is that Greek sovereign risk appears more than adequately priced into both the bond and CDS markets, in our view. This is especially true for long-dated paper, which is still trading at a fairly heavy discount. Of course, uncertainty is still out there. But the risk/reward trade-off - at least at this stage - looks quite attractive to us. Is Greece Hitting its Fiscal Targets? Greece's efforts to regain market confidence and restore the viability of its funding model have to do with shrinking the budget deficit and reducing the debt burden, as well as with far-reaching structural reforms aimed at enhancing potential growth and limiting ageing-related spending over time. Although these are still early days, Greece's progress on both fronts looks tangible. The budget numbers - any improvement in sight? Despite initial market scepticism on Greece's ability to deliver on its fiscal adjustment plan, we can't help but notice that Greece's net borrowing needs declined considerably in 1H 2010 relative to the corresponding period of the previous year, with the deficit shrinking by 41.8%Y. And the improvement was truly remarkable regardless of whether the calculation is performed on a cash or fiscal basis. The central government's cash deficit fell to €11.45 billion in January-June 2010, from €19.68 billion in January-June 2009. The budget's primary deficit - which excludes debt-servicing costs - also narrowed to €5.47 billion from €12.42 billion. This is clearly a positive development, and puts Greece on track to reach its deficit-reduction targets for this year, or even slightly ahead. The scope for improvement was considerable - given the poor situation of Greece's public finances before the start of the fiscal consolidation process - so the hard part is still ahead of us. Whether this encouraging trend in the budget numbers will be sustainable remains to be seen. However, while we remain cautious, we find some comfort in these numbers. What measures have already been implemented? The fiscal adjustment plan - together with the accompanying structural reforms - has already gone through several phases, starting with the initial set of measures outlined in the context of Greece's stability programme presented at the beginning of the year and ending (at least for now) with the recent extra tightening in the context of the conditionality attached to the EMU governments/IMF loan. Phase #1: Greece's belt-tightening has started before its request for financial support to the other EMU governments and the IMF. The initial fiscal effort was not sufficient to achieve the deficit-reduction targets Greece had committed to in its latest stability programme (presented to the European Commission on January 15), but its subsequent implementation - along with additional measures - has been key, in our view, to cut the budget deficit by a significant amount in the first half of this year (see Europe Economics: Whither Greece? January 25, 2010). Phase #2: Following an emergency procedure, the Greek parliament approved a package of additional fiscal measures on March 5, amounting to about €4.8 billion (approximately 2% of GDP). Among the most significant revenue-raising measures (worth around €2.4 billion, or 1% of GDP), there was an increase in the VAT rate across the board (from 4.5%, 9% and 19% to 5%, 10% and 21% respectively), further rises in excise taxes (fuel, cigarettes and alcohol) and the introduction of new excise taxes (luxury goods and electricity). Among the most significant expenditure measures (worth around €2.4 billion, or 1% of GDP), there was a further reduction of public sector nominal wages and pensions. In particular, the extra payment that the Greeks generally receive in December as part of their salary was cut by 60%, various wage supplements were reduced by 2% (on top of the 10% already announced), salaries of workers in public sector enterprises were cut by 7%, and all private and public sector pensions were frozen (all the increases already budgeted were cancelled). Phase #3: The Greek parliament passed the new tax bill on April 15. The law introduces reforms in five main areas of the Greek tax system: • Taxation of personal income: 1. introduction of a unified progressive tax scale, which treats all sources of income uniformly; 2. abolition of autonomous taxation and most tax exemptions on personal income; 3. determination of imputed minimum taxable income, based on the services, assets and estates owned or used by the taxpayer; 4. incentives for issuing and collecting transaction receipts in purchases of goods and services; 5. accounting-based determination of incomes, with documented receipts and expenses and invoices for goods and services for all self-employed persons; and 6. obligatory electronic submission of tax declarations as of 2011. • Taxation of capital and real estate: 1. taxes on real estate holdings, and transfers and contributions of real estate or shares of companies that hold or manage real estate assets; 2. taxes on donations of real estate and contributions in cash to non-profit legal persons governed by public law, legal persons governed by private law and other persons previously exempted; 3. higher taxes on real estate offshore companies, as well as abolition of all existing exemptions; 4. higher taxes on church real estate and introduction of taxes on church property income; and 5. repatriation of capital from abroad. • Taxation of business income: 1. separation of taxable profits into non-distributed and distributed profits - the taxation of non-distributed profits will gradually decrease from 25% to 20% by 2014, while distributed profits (i.e., dividends) will be taxed as personal income; 2. extension of VAT obligation to include various economic activities previously exempted; 3. self-auditing standards to increase voluntary compliance of small business; and 4. tax certificates for businesses issued by certified auditors that verify the accuracy of the tax liabilities of businesses and companies. • Tax administration measures: 1. execution of all payroll and business-to-business transactions via bank professional accounts (2011); 2. acceptance of invoices exceeding €3,000 among companies or between companies and the state only by electronic means (2011); cross-referencing data for income tax verification purposes; 3. obligation for every company, business or professional to issue receipts via certified cash registers; 4. creation of specialised tax professionals to audit high-income individuals, fight tax evasion and collect overdue tax liabilities; and 5. higher penalties for illicit trade. • Tax incentives: 1. three-year tax-exempt period for the establishment and operation of new businesses by individuals up to 35 years old; 2. tax incentives for employment retention, particularly for businesses with reduced turnover due to the economic crisis; 3. tax incentives for energy conservation, upgrading of buildings and reduced energy footprint of businesses; 4. increased deductions in taxable profits for businesses investing in research and technological innovations; and 5. targeted tax incentives to promote entrepreneurship, safeguard employment and enhance investment in research. Phase #4: The fiscal adjustment programme that Greece is pursuing within the context of the EMU governments/IMF loan includes cumulative fiscal consolidation measures (additional to those already adopted in March) amounting to 11% of GDP through 2013. From 2013, the debt/GDP ratio is projected to follow a downward trend. The programme revises the government's deficit target for 2010 to 8.1% of GDP, down from its 2009 level of 13.6%. Additional fiscal measures for 2010 of €5.8 billion - approximately 2.5% of GDP - were adopted by the parliament on May 6. In particular, the new belt-tightening measures include: • An additional €1.25 billion increase in tax revenues (0.6% of GDP), with a significant carryover for 2011, through a further increase in VAT rates from 21% to 23%, and from 10% to 11% - the second hike over the past few months - and in taxes on fuel, cigarettes and alcohol on top of those previously announced. • An additional €4.55 billion in expenditure cuts (1.9% of GDP) by means of: nominal wage cuts of 7% through a reduction of bonuses and allowances (total from all 2010 measures = -14%); nominal pension reduction of 9%; intermediate consumption cut; and public investment reduction. The structural reforms - progressively implemented Greece's adjustment plan goes far beyond fiscal tightening. Fixing a number of fiscal deficiencies is another key goal. On this front, parliament passed the all-important pension reform bill at the beginning of July. Among the various structural reforms that will need to be implemented, this is one of the most relevant, in our view. Indeed, the IMF estimates that, without reform, spending on pensions would exceed 24% of GDP in 2050 - a 12.5ppt increase from 2010. Such an increase would result from very generous benefits relative to wages - e.g., an average replacement rate of nearly 75% - which can often be received before age 60, and from a benefit structure offering little incentive for older workers to remain in the labour force. The pension reform could curtail spending on pensions over the next few decades by introducing a contributory pension to top up a non-contributory, means-tested, minimum pension. In particular, the reform will raise the retirement age to 65 (including women in the public sector), curtail early retirement, increase the number of contribution years and index the retirement age to life expectancy. According to the IMF, the reform is less successful in containing spending on pensions in the medium term. Indeed, after the initial drop in pension expenditure, due largely to the elimination of the Easter, summer and Christmas payments, spending is projected to increase by 3% of GDP between 2015 and 2035. Moreover, the effects of the reform can be greatly reduced if some of the key pillars are excluded, resulting in a bigger increase in spending on pensions. The upshot is that the focus will now shift from passing the law in parliament (which has happened already), to executing it. The challenge of implementing the measures outlined is significant and room for slippages remains high. The burden of proof remains on Greece to convince markets that progress on this front is concrete and sustainable, but we find Greece's effort an appreciably good start. On Track, Possibly Better Than Expected Fine on the fiscal and structural reform fronts... So the budget data suggest that Greece is on track to reach its deficit-reduction targets and start implementing the required structural reforms this year (or slightly ahead) (for full details on the various performance criteria and structural benchmarks for this year - and indicative targets for the subsequent years - see the Appendix in the full report). Naturally, the scope for improvement was substantial - given the poor state of the public finances before the start of the fiscal consolidation - so the difficult tasks are still ahead of us, in our view. Of course, whether this favourable trend in Greece's public finances will continue remains to be seen. However, while we remain cautious, we find some comfort in these numbers. Further, we expect revenue growth to accelerate somewhat in 2H 2010, courtesy of the second round of VAT and other indirect tax hikes - which kicked in only in July. If anything, this suggests that the budget deficit may continue to improve at a brisk pace, especially in the short term. The progress on the structural reform front - especially on pensions - is equally encouraging. Here too, these are still early days and we are well aware that there is a difference between passing a law in parliament and implement it in full. Nonetheless, it seems to us that - over this very short time span - Greece is delivering satisfactorily on its overall adjustment plan. ...but what about the banks? Liquidity conditions are still tight. Banks face difficulties, as market confidence has not yet been restored and spreads have not yet resumed their downward trend - at least not for a considerable period of time. The recently published bank stress tests indicate that banks' solvency buffers remain adequate, with some erosion. However, the quality of banks' loan portfolios declined throughout the economic downturn. According to the IMF's latest report on Greece (IMF Country Report No. 10/217), published in July, non-performing loans (NPLs) have increased from 7.7% of the total in December 2009 to 8.2% in March 2010. What's more, the system-wide capital adequacy ratio has declined from 13.2% to 12.9% over the same period (still well above the 8% regulatory minimum). Partial data available for April and May 2010 indicate further slippage, with some differentiation among banks. Although banks' pre-provision operating income has remained stable at elevated levels, the need for larger provisions against NPLs has driven the banking system as a whole into a loss - after including provisioning and taxes. Against this background, the Greek parliament has now passed the legislation for the Financial Stability Fund (FSF). This should ensure that this facility becomes operational fairly soon. The FSF will be endowed with €10 billion to be disbursed in equal installments in September and December. The board will be composed of seven members, five of which will be nominated by the governor of the Bank of Greece and then appointed by the latter and the finance minister. The remaining two members will be the deputy governor of the Bank of Greece and the secretary general of the Ministry of Finance. The FSF will be independent and autonomous. Internal auditing functions will be established to ensure good governance. The FSF will provide monthly balance sheets and annual audited financial statements to the Greek parliament, Ministry of Finance, Bank of Greece, as well as the teams of the European Commission, ECB and IMF working on Greece. The modalities of capital injection will vary depending on various circumstances. Broadly speaking, one of the main mechanisms for capital injection is through preference shares, which would be converted into common shares if targets identified under the restructuring plan are breached or if the capital ratios are not complied with. The upshot is that, on this front too, Greece seems to have a plan in place to deal with banks' liquidity pressures and some solvency erosion. In the unlikely case that earlier financing were needed, this could be bridged by using T-bill placements or by drawing down cash balances. An IMF stress test update is planned for September to incorporate the latest developments on potential capital injection needs. So Far, so Good - What Are the Risks? Is the political will there? Although it appears that Greece is delivering on its adjustment plan, many continue to doubt that Greece could muster the political will over time. While the Greek government and parliament have not given us much reason to doubt their resolve, one main concern seems to be that strikes, street protests and social unrest more broadly will ultimately result in a ‘fiscal reform fatigue', which could lead to a delay - or even a rethinking - of the belt-tightening plan. This is a key risk. Greece has to deal with a significant credibility gap, which goes over and beyond its current public finance difficulties. Indeed, despite strong domestic growth and favourable funding conditions, Greece's fiscal position has deteriorated considerably since its entry into the euro area. That's why markets still appear reluctant to view the recent positive developments - at an admittedly early stage - in a more positive light. But developments on the political front are so far as encouraging as those on the economic front: • Parliamentary majority appears solid: The government is supported by a robust majority in parliament. For example, the pension reform bill in early July passed with 159 votes in favour out of 300, i.e., it got the full vote of the socialist party (157 MPs) and two extra votes. Moreover, Greece has a unicameral parliamentary system, i.e., there is no upper house that could eventually slow down the approval of the various policy measures. And the president cannot decide to hold a referendum on a particular bill, as was the case in Iceland. • Social unrest seems fairly contained: The government is coping well with protests - especially given the severity of the fiscal tightening. For example, a 20-day confrontation with the Greek farmers back in January did not result in any concession. And the six or seven general strikes that took place this year did not see the participation of huge crowds in several cases. This is not to say that accidents cannot happen. There is still a latent risk of social unrest - as the May episodes remind us. However, the overall situation appears fairly benign to date. • Prime Minister Papandreou remains popular: Despite the tough fiscal consolidation plan - and the deepening of the recession - various opinion polls suggest that the prime minister (who seems to understand that this is a historic opportunity to modernise the country and mentioned publicly that he is not necessarily seeking re-election in 2013, if this means a softer fiscal stance or less ambitious structural reforms) still enjoys broad support. And there seems to be a decent support for the austerity programme - though not for all the individual measures. • Tax-collection mechanism looks improved: Anecdotal evidence indicates that the fiscal administration - which needs to continue to improve, and by a substantial margin, by the government's own admission - is becoming more effective. There is no guarantee that this will continue, or that the situation will progress at the brisk pace observed over the past couple of months. However, while we remain cautious and acknowledge that room for slippages remains high, we think that the focus on tax evasion, for example, will continue to bear fruits. The upshot is that, up to now, not only has Greece met the demands of the euro area governments and the IMF; it has also done so in the context of no major social or political accident. And socialist - such as Greece's - or centre-left governments often find it easier than their conservative or centre-right counterparts to engineer a significant fiscal turnaround by negotiating with the trade unions. Fiscal Sustainability - A Few Scenarios So Greece appears to be delivering on its adjustment plan. But what about the medium term? While investors don't seem very concerned about the short term - as shown by their take-up in the recent T-bill auctions - their main worry relates to Greece's debt burden, which many deem to be unsustainable. After all, the purpose of the adjustment is to stabilise the debt/GDP ratio at less than 150% of GDP in 2012-13. Where to from there? Several factors could potentially have a significant impact on the Greek debt trajectory (see the sensitivity analysis in the recent IMF report on Greece's request for a stand-by arrangement, May 5, 2010): lower growth, greater deflation, higher interest rates and contingent liabilities from state-owned enterprises and the banking system. The main conclusion of the sensitivity analysis is that adverse shocks of reasonable magnitude would still be consistent with a turnaround in the debt dynamics (though the timing might differ from the base case). However, the combined impact of the various adverse shocks would render the dynamics clearly unsustainable. These simulation exercises, while helpful to contextualise the main risks surrounding the base case, have a rather mechanistic nature and disregard the key role of expectations. There is an aspect of ‘self-fulfilling prophecy' in these scenario analyses. For example, assuming higher financing costs would require additional fiscal austerity to meet the fiscal targets. In turn, this could cast doubts on Greece's ability or willingness to deliver on its adjustment plan, thus justifying the assumption of wider bond yield spreads. However, this argument is somewhat circular, we think. For example, assuming that markets feel progressively encouraged by Greece's fiscal progress, the resulting confidence boost might well lead to lower financing costs. In turn, this might translate into a more favourable debt trajectory over time, thus justifying the assumption of narrower bond yield spreads. So, while it makes sense to assume a conservative base case, the long-term debt trajectory depends on factors that cannot necessarily be modelled in these projections. This is not to say that the next phase of fiscal consolidation will be easy. Indeed, we think that the economic contraction in Ireland - where real GDP has so far declined by around 10% from the peak - could be a reasonable template for Greece (where GDP has so far declined by about 4%). A couple of years of tough domestic adjustment to restore some of the lost ground in terms of competitiveness are inevitable. But further down the line, if Greece continues to deliver on its fiscal targets, it is possible to imagine a not too far-fetched scenario where the structural reforms and the resulting crowding in of the private sector start paying off. These higher growth dividends, along with a potential upward revision - admittedly difficult to quantify - in the level of GDP (courtesy of the uncovering of the underground economy) might help reduce the debt burden. Should this happen within a reasonable timeframe, sentiment might improve and risk premia subside - as was the case for other high-debt euro area countries with a sounder fiscal policy (e.g., Italy and Belgium). Is the Unthinkable so Unthinkable? The scenario above is just one of the many possible futures. Of course, should Greece fail to deliver on its adjustment plan because, say, a protracted recession weighs more than expected on tax revenues or political instability leads to a U-turn in fiscal policy, then a debt restructuring might well happen. The evidence, however, seems fairly encouraging on this front - at least so far. It is perhaps more interesting to consider another scenario, which is increasingly becoming the consensus view. In this version of the story, Greece takes the deliberate decision to restructure all or a part of its debt when it manages to bring its primary budget balance (i.e., the overall budget balance excluding interest expenses) back in surplus. This will happen - at best - in 2012, we think. This scenario rests on the key consideration that, as long as the primary budget balance is in deficit, the incentive to restructure is not really there. In these circumstances, cutting the debt will not really solve the problem because, with the government now unable to fund the primary budget deficit, the savings required to balance the books will be substantial anyway. However, when the primary budget is back in surplus (or when the savings to make ends meet are lower than the interest rate expenses), Greece might be tempted to restructure - according to this line of reasoning - especially if it becomes too evident that the future pace of expansion of the economy is too low to sustain the debt-servicing costs (not our central scenario). What's more, a country would choose to default on its domestic debt, instead of enduring a painful domestic adjustment, if the cost of the latter exceeds the cost of the former. The cost of a sizeable fiscal retrenchment might be deflation, which affects the whole population. Conversely, the cost of defaulting on government debt affects the existing debt holders (and the future borrowing costs). But if a large share of government debt is held by foreigners (about two-thirds in the case of Greece), a default might seem more palatable, as the cost on the domestic population would be smaller. Both arguments are too simplistic, we think. We are not saying that the outlook cannot play out along these lines. Rather, we think that the incentives to avoid a restructuring are quite compelling too. In essence, this hypothetical scenario seems more realistic for an emerging market - where, at times, there really is the physical impossibility to get the foreign currency to make a payment, for example. But most of the debt is in domestic currency in Greece. True, ‘printing money' is not an option for an individual euro area member. However, the restructuring option - should it happen at all - would be weighed against four hurdles: • EMU countries most exposed: We estimate that (non-Greek) euro area banks account for about three-quarters of the outstanding foreign bank holdings of Greek government bonds (see Contagion, Exposure and the Policy Response, July 2, 2010). More broadly, euro area banks account for about one-third of foreign claims on EMU peripheral assets. In a sense, this suggests that there is a strong incentive for the euro area as a whole to avoid a restructuring or a default. Ultimately, it all comes down to a fine balance between transfers from the fiscally sound EMU members to those requiring a belt-tightening under strict conditionality. This is not to say that the EMU framework, in its present form, does not have room for improvement. Rather, it is an observation that defaulting on Greece's lenders of last resort (including the ECB) does have considerable political costs. Put differently, refusing to comply with the demands of much bigger neighbours does not come very easy. True, there is a probability attached to any scenario and a unilateral restructuring could still happen, but such an institutional set-up does strengthen Greece's resolve to comply, we think. • The domestic costs of debt restructuring: Greek bank holdings of Greek government bonds amount to no less than €60 billion (see Bank Stress Tests: Transparency & Spanish Stresses Help, but Missed Opportunities, July 25, 2010). And, including the domestic sector as a whole (e.g., households, other credit institutions, insurance companies, mutual and pension funds), the overall figure could easily exceed €100 billion. Is there an incentive to default on the domestic holders of government bonds? Not really, in our view. Let's assume, for example, a 50% haircut on the debt held by residents. The annual savings, in terms of reduced debt-servicing costs on this portion of the debt outstanding, could be less than 2ppt of GDP. Are these benefits big enough to justify a restructuring versus the costs (e.g., possible significant recapitalisation of the domestic banks, restricted access to the international bond market for several years, etc.)? On balance, we think that the former do not sufficiently outweigh the latter. • Sentiment playing a key role: There is no recent historical precedence for a default of an advanced country. However, the evidence suggests that, when the IMF loans were effective in helping to restore fiscal sustainability, it wasn't because of the size of the financial support package. Of course, the bigger the package the better - all else being equal. But in many cases the key factor was that private sector investors felt encouraged by the backstop, along with clear progress of the country undertaking the adjustment on the fiscal and structural reform fronts. In those episodes, the country complying with the IMF programme had considerably more respite and was able to continue to access financing, through the financial market, even after the end of the loan. This has not yet happened in Greece as, understandably, investors want to see progress over and above the initial encouraging results. From this perspective, a restructuring would not really boost sentiment. Conversely, it would undo the confidence-building that might eventually emerge. We believe that the Greek authorities will do their best to prevent such scenario from materialising. • Exiting the EU: One argument that is often mentioned on the ‘benefit' of a default is that, by reintroducing its own currency, Greece would be able to boost its exports by devaluing its exchange rate. In this case too, however, the benefits seem rather small. The fact is that Greece is a rather closed economy, with extra-EMU exports accounting for just 10% of GDP. What's more, leaving the euro area is not something that can happen overnight or behind the scenes, because the infrastructure to ‘print money' will have to be rebuilt, i.e., the ‘printing press' needs time to start working at capacity, new staff might need to be hired and trained, etc. Financial market participants and economic agents more broadly (from non-financial corporations to households) would know about this. The chances are that the reaction will be quite disordered. Given that there are no restrictions in the euro area, capital outflows might well happen - on the back of the uncertainty on the fate of the domestic banking system. To stop these outflows, Greece will have to reinstate capital controls, i.e., it will have to exit the Common Market and leave the EU - not just the euro area - thus reinventing its institutional architecture of the past 25 years. This is possible, but we deem the associated costs to be very high. Conclusions There is no guarantee that Greece will not default. This could even happen within the three-year period of the loan that the EMU countries and the IMF have agreed upon. There may be a fiscal slippage along the way or a refusal to tighten further, both resulting in no further disbursements. Or there might still be some kind of voluntary restructuring further down the line, or even some form of debt rescheduling within the arrangements of the EMU governments/IMF loan. Other risks are less talked about, such as the impact of a less favourable tax regime on companies and high-income or skilled individuals, which might drive financial and human capital away. Yet Greece appears to be delivering on its adjustment plan. These are still early days and we remain cautious, but the recent evidence is encouraging, in our view. Investors will need to see progress over a longer time span. But we don't see any compelling reason for an imminent reversal of the recent trend. Meanwhile, the disincentives to default are stronger than the incentives, we think. Uncertainty is still out there, but the sovereign risk/reward trade-off looks attractive, in our view.
Europe
A View from 2020: The Eurozone Break-Up of 2013 August 03, 2010 By Charles Goodhart | London Viewed from 2020, events over the past three years and events over the coming years may still be debated. Charles Goodhart, emeritus consultant of Morgan Stanley, looks back in his old age at the difficult events of 2009-13. Looking back now with the benefit of hindsight, the European collapse of 2013 appears from the vantage point of 2020 to have had a certain grim inevitability. Yet at the time, and in the years leading up to this debacle, it was far from clear what the future would hold, and many protagonists, especially in the policymaking arena, continued to contend that all would turn out alright, especially if their own policy proposals were followed. Although much was made at the time of the failure of Greece to get its public finances under control, even before 2008, many of the countries with construction booms, e.g., Ireland and Spain, had been running public sector surpluses. It was not so obvious in 2007/8 that these countries would be in any future difficulty. Yet such booms, and imbalances, cannot go on forever. It should have been clear that, once the housing/finance boom (as marked in the UK as anywhere else) was punctured, it would not be easy for the countries involved to grow their output and exports sufficiently to pay off their external/internal debts without distress. The Build-Up to Collapse Cause of the Break-Up: Two Chief Policy Failures The collapse was mainly caused by two key failures among European leaders. The first was the assumption that the unbalanced pattern of intra-European growth that had persisted from 1999 until 2008 could, and would, last indefinitely. The second was that these leaders could not agree on an over-arching vision for the longer-term future of the eurozone. 1. Assuming debt-fuelled growth could persist: Imbalances that were a natural result of the construction of the eurozone were allowed to persist far too long. • Low interest rates = construction boom: The entry of the southern European and peripheral countries, such as Ireland, into the eurozone (and the prospective entry of Eastern European economies) had led to a housing and construction boom in those countries as nominal interest rates fell sharply; at the same time interest rates converged to a euro area ‘norm' in the build up to the euro's launch. • Accelerated by bank lending: Accelerating the boom, housing and construction sectors were enthusiastically financed by banks (and their shadows) both within and outside their own country. • Result = Private indebtedness and a loss of competitiveness... The result in these countries was a massive increase in private sector indebtedness, largely matched by increasing capital inflows (from banks in Germany, France, etc.), and by the same token a large current account deficit. The construction boom of 1999-2007 in the peripheral European countries had been partly responsible for unit labour costs rising faster there than in Germany; indeed, this was part of the adjustment process in response to the boom. • ...leading to almost insoluble problems when the boom turned to bust... By the time the boom broke in 2007/8, several eurozone economies had seen major losses in competitiveness over that boom. If a recovery in competitiveness was to be the chosen route to salvation, then this required wage/price declines (relative to Germany), i.e., internal devaluation, of eye-popping intensity. Some succeeded (Latvia - not a eurozone member, but pegged to the euro); some made a good attempt (Ireland); but in others it was beyond the capacity of the body politic. The shift of national indebtedness from the private to the public sectors in 2008-10 deferred, but did not resolve, this issue. • ...and a weakened banking system: As economies had become over-indebted during the preceding boom, their banks were in particular difficulties. These banks held claims on local property, now fallen in value, and with liabilities (e.g., via the interbank market) to banks elsewhere in Europe. 2. The lack of a unified vision The second main policy failure was that the European political leaders could not agree on an over-arching vision for the longer-term future of the eurozone, for the ultimate end-game. One set of leaders continued to hanker for a more centralised, federal Europe with a shift of fiscal competences to a central budget, and enhanced political unification. A second set of leaders felt that the eurozone, and to a lesser extent also the single market, should comprise a narrower grouping of nation states with similar economies, and between whom labour and capital could flow very freely. Group 1: Stick together at all costs: For this group, even the weakest member of the eurozone (Greece) had to be propped up, kept intact. Restructuring their debt, even if done in an orderly way, if that was feasible, would be a disaster and unthinkable. Entry into the euro system should be a one-way street with no exit. But in return for continuing (fiscal) support, all the member nation states should increasingly lose their independence to set their own fiscal policies, becoming more like US states in this respect. Given the difficulties that the periphery would have in regaining growth and competitiveness, that vision of the European end-game implied (fiscal) transfers from the stronger members of the eurozone of an unlimited and potentially unbounded (both in time and amount) extent. Group 2: No ‘transfer union': Many countries, notably Germany and the Netherlands inside the eurozone, and the UK outside, were not prepared to sign up for such a ‘transfer union'. They had a different vision of the longer-term development of the eurozone. Their end-game was that the eurozone should be a narrower grouping of nation states with similar economies, and between whom labour and capital could flow very freely, more akin to the optimal currency area of theory, rather than the more inclusive eurozone of 1999-2012. In their view, fiscal transfers were a wasted subsidy to bad behaviour and replete with ‘moral hazard'. If other countries could not match up to the German example, they should be encouraged to restructure, not prevented. As countries' economic conditions changed, they should have (and utilise) the option of leaving, and possibly then subsequently rejoining, the eurozone. The eurozone should be a voluntary union of similarly minded and similar-economic nation states, not a mélange of differing economies herded together within a nascent federal United States of Europe. The Consequences of Policy Failure... The main consequences of these policy failures was 1) an almost inevitable over-focus on austerity measures post-recession. 2) An open debate about the European ‘end-game' that caused the markets to become, and remain, unsettled. 1) Policymakers focused excessively on austerity: Given lost competitiveness and over-indebtedness, a major focus of economic policy should have been on the questions of how to enable these countries to meet their debts through enhanced competitiveness and growth. Instead, the focus was almost entirely on additional public sector austerity. This focus was largely forced upon the politicians by the developing Greek crisis of 2009-10, whereby a vicious spiral ensued. Market doubts about the ability of the Greek government to meet its debt commitments led to higher risk premia, which led to further doubts about solvency. And such worries about Greece soon led to contagious overspills into the risk premia of other over-indebted eurozone countries. 2) Open political disagreement and so unsettled markets: Once the European crisis began to unfold, in 2010, the incompatibility of these differing visions began to cause difficulties. At each stage in the crisis, the federalists would insist that some way of helping Greece, or Spain, or Portugal must be found, and that such help would soon be on its way. But in each case, such help meant putting cash on the table, and in almost every instance those opposed to a ‘transfer union' would then express doubts about whether they could/would/should put up the money. The backing and filling, the internal debate about the European end-game among the political elite was a major factor causing markets to become, and to remain, unsettled. When the crisis did reach a local climax in spring 2010, there were hopes that the combined IMF/EU support for Greece, and the wider and bigger European Stabilisation Fund, could assuage market fears. But both of these were perceived as temporary financing measures, not a means of resolving or removing the underlying problem of over-indebtedness in these countries. Moreover, there were valid concerns that such temporary measures would not give sufficient time for readjustment in the peripheral countries, and would not be extended should there still seem to be a continuing need for that. Response to the Crisis: Shooting the Messenger? There were several measures employed to counter the crisis. One of the most important was the weight political leaders put on attempting to limit the capacity of the markets to destabilize the eurozone. The Lehman collapse in September 2008 punctured the European housing/construction boom. A combination of automatic fiscal stabilisers and Keynesian stimuli led to sharply increasing fiscal deficits and rising debt ratios. Whereas in October 2008 most fiscal authorities could credibly support their own banking systems, by mid-2010 in many countries the fiscal system and the banks were struggling. The worse the fiscal position, the more threatened was the solvency of the banking system, and vice versa. But there was also an element of self-fulfilling amplification via market pressures. Such pressures raised risk premia and interest rates and hence made sustainability harder to maintain. Many political leaders convinced themselves, though few others, that the crisis was largely the result of market over-reaction, and of failure by the credit ratings agencies to give due weight to the determination and to the reforms of the European political leaders. The need was, therefore, felt to be to limit the capacity of markets to destabilise the eurozone. Step 1: CDS restrictions The first step was taken in May 2010, when Germany took measures to prevent the use of ‘naked' CDS in its own country, though there was no apparent evidence that the CDS market had had any significant effect on European sovereign bond markets, or their risk premia. Although the EC encouraged the adoption of similar measures elsewhere in the EU throughout the summer of 2010, bond markets did not recover, except temporarily in July to October, and risk premia remained elevated. Step 2: The formation of the ERA Credit ratings agencies (CRAs) followed the market down, and a slow but steady drumbeat of ratings downgrades for the eurozone peripherals continued throughout 2010. But each such downgrade triggered off some further sales. European politicians believed that the CRAs were being willfully blind to their major reforms and restorative measures. No more private rating agencies: On January, 2011 the European Commission announced the formation of the European Ratings Agency (ERA). Henceforth no European body, sovereign or corporate, could use, display or pay for any rating except that of the ERA. To mark its independence from politics the ERA was sited in Cologne, not Brussels or Strasbourg. ERA rated most EU sovereigns AAA... All EU sovereigns with the exception of Greece, Iceland and the UK were then rated AAA, with a special rating of AAA* for Germany and France. ...upon which market prices failed to rise... Much to the chagrin of both the EC and of the ERA, market prices failed to respond significantly to the (changes in the) ratings applied by the ERA. But this was taken by these same groups as yet another instance and indication of the inefficiency of such market prices. Ratings become ‘fundamental' values and ‘mark-to-fundamental' accounting followed: If market prices did not reflect fundamentals then what did? The answer, of course, was the ratings of the ERA. Given a rating of an asset by the ERA, another committee was established to transform that rating into a ‘fundamental value', often markedly different from the current market value. Pressure was then placed, increasingly through 2011 and 2012, on the IASB to shift from a ‘mark-to-market' accounting procedure to a ‘mark-to-fundamental' procedure. Banks incentivized to buy ‘cheap' government bonds: ‘Mark-to-fundamental' accounting had the consequence that it provided financial institutions with an incentive to buy and hold assets, such as Portuguese bonds, where market values were below ‘fundamental' values. Say such a bond traded at, say, 60, but its fundamental value was assessed as 100. Its purchase would generate an immediate profit, and addition to capital, of 40, with a similar disincentive for any sale. Likewise ‘mark-to-fundamentals' could dissuade purchases of assets whose market value exceeded its assessed fundamental value. Attempts to circumvent the market power of the ERA's ratings and assessed fundamental values by the use of various ‘artificial' derivatives were vigorously resisted and combated. The Dénouement The initial stage of the sovereign debt crisis had built up quickly, once realisation of the parlous state of Greek public finances interacted with an appreciation of the clash of political vision on the future of the eurozone. That clash of political vision, investors decided, not only could, but probably would, leave Greece on its own and virtually unable to pay its debts (at least in full and on time). Naturally the authorities sought to portray the plight of Greece as peculiar, even unique to Greece. While there was some truth in that, the deeper reality was that the crisis was one of over-indebtedness, with the debts distributed variously in the peripheral countries among their public sectors, banks, non-financial companies and households. The underlying problem was that the counterpart assets, castles in Spain, office blocks in Dublin, etc., were not such as quasi-automatically to generate repayment flows, for example in higher net exports. Indeed, much of the capital inflow had pushed up property prices, rather than new building, leaving the borrowers in net negative equity when the tide went out. After the event, this became obvious, but beforehand hardly anyone, whether borrower, lender, regulator, politician or economist saw the dangers. Early Stages of the Break-Up April 2010: Debt rollover and bank financing problems: The immediate and most pressing problem soon became one of financing the new and roll-over debt requirements of these peripheral countries. The snowball effect, whereby increasing risk margins led to higher interest rates, and higher interest rates made solvency ever more questionable, was taking hold. This vicious spiral was leading towards a collapse of some peripheral countries' bond markets, and a fiscal crisis. Moreover, many European banks held large amounts of such debt, and the bond price declines reinforced concerns about bank solvency, leading to problems for banks in refinancing themselves in wholesale markets. May 2010: IMF/EU rescue package: The first, and immediate, objective was to stop the snowball from gathering speed. This was done in two steps. First, after - what seemed to the markets interminable delays, largely - an IMF/EU ‘rescue package' of €110 billion was put together on 2 May 2010 for Greece. Second, in order to counter the overspill onto other countries, and other markets, a number of steps were taken over the weekend of May 9. These included the assemblage of a European Stabilisation Fund, amounting to € 440 billion, (which could be called upon by countries facing acute financial difficulties, but which would require severe IMF-style constraints on their fiscal independence if they did so); and also a, less than full-hearted, agreement by the ECB to buy some bonds of those countries where the markets had become ‘dysfunctional'. The impact on markets of such measures was reduced by the accounts of political tensions at the highest eurozone levels, and by the patent unhappiness with these developments in Germany, so risk margins and bond yields having initially retreated sharply, soon began edging back up again. But this mattered less now since a financing back-stop was now in place, if only temporarily. Such financing measures had bought time. Summer 2010: the calm before the storm: For a time a lull in the crisis did ensue. The publication of the stress tests on the largest European banks did not do as much to restore confidence, as the prior 2009 US precedent had done, but at least it did not make matters worse, and showed that the prospects for the bigger banks were controllable. Moreover, 2Q10 proved to be the peak of the recovery for most developed economies that year, so the arriving data from July till October for out-turns remained good. The onset of the holiday season was a welcome relief, and as policymakers departed to the beaches in July/August 2010, there was some hope that an awkward corner might have been turned. No Fundamental Solutions in Prospect No corner was turned in summer 2010, as equity and bond markets, and forward-looking surveys, indicated. The fall in output and quite dramatic rise in the debt ratio of the eurozone peripherals apparent in the early months of 2011 made the prospect of debt repayment seem increasingly improbable. Against that background it was hard to see how and why markets in such debt would ever recover on their own. Burden of indebtedness had simply shifted... The financing deals for Greece, and potentially for the other peripherals, simply shifted the indebtedness from weak holders to stronger creditors, such as the ECB and potentially the German taxpayer, without resolving the over-arching question of whether, and how, that debt might ever get paid back. ...with fading prospects of that debt being paid back: If one is excessively indebted, the first imperative is to stop running further huge current deficits. So, whether pressured from outside, by markets, or jumping voluntarily, the watchword for public finance in the developed world in 2010 was retrenchment. Almost all the peripherals, inside and outside the eurozone, and many of the major EU countries took strong measures to cut government expenditures and raise tax rates, simultaneously. The problem was that both the household sector, and indeed the banks, felt just as over-indebted and in need of deleveraging as governments. Companies, or at least large companies, were relatively flush with cash, but in the generally deflationary conditions of 2008-14, where was the incentive to invest? What is so odd, looking back on the debacle from the comfort of 2020, is why anyone should have thought that fiscal austerity on its own could have been a solution for the over-indebtedness of 2009/11. If one tries to read the literature of that time, it appears that the authorities put a lot of weight then on a, largely illusory, deus ex machina entitled ‘structural reform'. Whereas the measures actually proposed under this general heading, such as making it easier for employers to fire long-term employees, reducing workers' pensions and raising retirement ages, would have long-term benefits, it is less apparent why they should have been expected to raise growth in the immediate future. The exports of peripheral countries failed to pick up: So where was growth to come from, which might lessen the debt burden? The desideratum, of course, was that it should come from net exports, but net exports over the world as a whole must sum to zero. The decline in the euro and pound vis a vis the dollar, yen, yuan and Asian/commodity countries did provide some assistance to the Northern European states, such as Germany and UK, but even so this was partly offset by a fall in exports to the peripherals. Moreover, these latter countries depended quite heavily on tourism, and the political/social disturbances there, for example the general strikes in Greece and Spain, had the unfortunate side-effect of stunting the tourist trade during the main holiday season in 2010. But net exports grew as domestic demand shrank: Effectively, the only way to achieve consistency between surplus/deficits in the peripheral countries, and also, though to a much lesser extent, for the UK, was for a decline in real output/expenditures. This reduced the level of private sector savings and surplus, raised the public sector deficit, and cut imports, thereby raising net exports. While this squared the circle between surpluses/deficits and incomes/expenditures, it made the debt overhang even worse. With GDP falling, tax revenues declining, and debt ratios rising even further, and fast, the over-indebtedness problem rapidly came to seem insurmountable. Although the European Ratings Agency maintained its sang-froid and AAA ratings, e.g., for Ireland, Portugal and Spain, the commercial CRAs did not. Re-instatement of QE in the UK... As an offset to the general shift towards fiscal austerity in 2010, apart from just a vague hope that something (new innovation, ‘structural reform', demand from China) would turn up, there was one available strategy, which was to use monetary easing to counteract fiscal deflation. With nominal interest rates already nearly at zero, that implied a return to greater use of credit and quantitative easing, thereby also driving down relative exchange rates, and putting further downwards pressure on real interest rates from higher expected future inflation. When the first disappointing estimate of GDP in the UK for 3Q appeared in October 2010, a heated debate ensued in the MPC there. On the one hand disappointing output growth, a fall in exports to Southern Europe, rising unemployment, especially as individuals were shifted from disability benefit to unemployment benefit, strikes and social disaffection in response to the expenditure cuts, and the prospect of continuing fiscal austerity, all served to press the argument for a vigorous re-start to QE. On the other hand, both inflation and inflation expectations remained above the desired level, with the prospect of the sharp rise in VAT yet to come; QE had not been a panacea before, and it was unclear whether QE and potential future inflation would be consistent with the mandate of achieving the two percent inflation for CPI, which was required of the MPC. The final decision to reinstate QE, and on a large scale, was finely balanced. ...but not in the eurozone... While the decision to go for further monetary easing was difficult in the UK, it was impossible to take this route in the eurozone. The country that benefited most from the decline in the value of the euro was Germany, and the rate of growth of Germany in 2H10 was better than in any other eurozone country. Although credit expansion and the broad monetary aggregates in the eurozone as a whole remained sluggish, the Germans, and several of their northern supporters, such as Austria and the Netherlands, could see no case for monetary expansion in the eurozone as a whole, simply in order to benefit the countries in difficulty in southern Europe. ...or the US: Similarly, in the US, there was insufficient consensus on the FOMC to enable further resort to CE or QE. The continued high level of the monetary base and concerns about future inflationary dangers and about the constitutional propriety of credit and/or quantitative easing, left the majority in doubt at the wisdom of pursuing QE further. This was in spite of the fact that the housing market continued to weaken quite sharply and unemployment remained depressingly high. And QE's prospects for success had anyway faded: There was a further problem in trying to use monetary expansion as a counterweight to fiscal austerity. This was that the weakness of the banks and the prospective introduction of tougher regulations, despite the welcome delays announced in July 2010, meant that the banks had no enthusiasm; indeed, they claimed little capacity, to expand their balance sheets. Thus QE, and CE, simply generated ever-larger cash balances for banks at their central banks, an outcome which unduly frightened those who saw future inflationary dangers from such a build-up of ‘excess' balances at the central nanks. This argument was eerily reminiscent of the Fed's concern with similar ‘excess' cash balances in 1937. Thus one major channel for expansion via monetary easing appeared to be largely blocked off. The Final Stages of the Crisis 5 August 2011 - German objection to EFSF extension: It was at this stage, on August 5, 2011, that the final stage of the crisis began. The trigger was an announcement by a senior official in the German Ministry of Finance that under no circumstances would Germany agree to any extension of the European Stabilisation Fund. During the subsequent press conference, the official said that, if the Southern European countries had failed to achieve a recovery through their own reforms that would enable them to stand on their own feet by 2013, then some other means with dealing with their debt would have to be found. This announcement was taken by all market participants as implying that some form of debt restructuring for several of these countries would, almost inevitably, take place in 2013; and, as one would expect, the effect of that on current bond prices was immediate. With yields going up, and bond markets in these countries effectively shutting, several of the affected countries, such as Portugal and Spain, immediately applied to draw on funding from the European Stabilisation Fund. This, of course, put further pressure on the need for support from the German taxpayer, and made the Germans, and their supporters, even more determined that the ESF should not be continued indefinitely. Debt restructuring came to seem inevitable: Such economic and market developments led virtually everyone, with the exception of a few super-optimists in the EC, to appreciate that the game was up, and that, at a minimum, some form of restructuring of the debt burden of such over-indebted countries would be necessary. Such pessimism was further reinforced by additional gloomy data on GDP from these countries for 2Q11 arriving in late-summer 2011. But how was this restructuring to be undertaken and where would the burden fall? In particular banks throughout the eurozone held large volumes of such debt, much of which was being used as collateral against borrowing from the ECB, and some of which was held directly via bond purchases of the ECB. February 2012: First debt restructuring negotiations: The first proposal was to restructure the outstanding debt of the peripheral countries involved into zero coupon long-dated nominal bonds with a final bullet repayment. These bonds' present value in July 2011 would be equal to the nominal outstanding value of existing debt, i.e., that there would be no reduction in nominal debt, but that the resulting cash flows would be pushed out into the far future. With no default, the European Ratings Agency (ERA) would continue to give such debt an AAA rating, and, under the mark-to-fundamental procedure, earlier described, banks could continue to hold these at face value on their books. While this seemed in principle a neat way of handling the problem, the calculated nominal end value of the debt that would have to be ultimately repaid was so enormous that the whole exercise was perceived as pure artifice. 2012: Growing discontent across Europe: Meanwhile, the peripheral nations themselves were becoming increasingly unhappy at the prospect of interminable negative growth, decay and austerity. There was a need to break away from this appalling set of constraints. Fortunately, there was no extremist political ‘ism', as there had been with communism and fascism in the 1930s waiting in the wings. Nevertheless, the electorates in all these countries were becoming increasingly unhappy and demanding some way out of the economic waste-land that appeared to be stretching ahead of them. Where was hope to come from? January 2013: Madrid ‘Accord': The Prime Minister of Spain called a ‘secret' meeting of Prime Ministers from other Mediterranean countries. They discussed what additional possible measures could be undertaken, while in each case being consistent with continued membership of the eurozone. Unfortunately, the media reached the conclusion that the meeting was being held to consider a joint exit from the euro. While this was not true in fact, formal denials were not believed, especially since earlier denials that the meeting was taking place at all were soon shown to be false. 12 January 2013 retail banking crisis: Once that (unfounded) rumour hit the tabloids, a major bank run on the banks in Greece, Portugal and Spain started almost immediately, with queues of depositors trying to switch their funds into banks in Germany or France. For a few hours the ECB sought to withstand the flood of recycling the flow out of the Mediterranean countries back to the banks there. But this involved taking on ever more risky assets as collateral for these loans, exposing the ECB itself to increasing risk of loss. At this point the ECB urgently notified all member governments of the eurozone that it could not continue to recycle the flood of transfers without being formally indemnified against loss by the joint and several guarantee of all member governments, and that it needed a positive answer before markets reopened the next morning. In such circumstances the potential extent of commitment that such an indemnification might involve was not quantifiable. Several governments, despite much soul-searching at overnight meetings, therefore felt unable to give such a commitment on behalf of their taxpayers. 17 January 2013: Grey Wednesday: It became clear that the banks in these countries were facing illiquidity and closure, since the ECB felt unable to help further. The result was then effectively inevitable, and involved, for these countries, 1. Putting in place exchange controls and an Argentine-type ‘corralito' on depositors bank withdrawals; 2. Calling a bank holiday, until new national notes, reverting to drachma, pesetas and escudos, could be printed and distributed; 3. Abandoning the euro, and passing a decree that all foreign debts, whether public or private, were now to be payable in local currency, in effect a default; and 4. Recapitalising locally head-quartered financial intermediaries by issuing them with local currency bonds, with a counterpart equity participation. The Birth of the Medi New currencies devalue sharply: The currencies that had exited the euro immediately suffered a major devaluation, of about 35-40%, and nominal interest rates on their bonds rose sharply. Although their departure from the euro was, in a sense, both inadvertent and unwanted, steps were put in motion to expel such countries from the EU, unless they agreed to honour their debts denominated in euro, which by then had become effectively impossible for them to do. Further bank solvency pressure: The default of these countries, and the collapse in the euro-value of credits against them, both public and private, such as interbank claims, placed great pressure on the solvency of those banks, especially in France, Germany and Ireland, that had lent to the defaulting countries. The immediate response of governments in the EU (exclusive of the defaulters) was, as it had been in October 2008 (after the Lehman collapse) both to guarantee, once again, all bank liabilities and to purchase bank equity in sufficient amount to meet the higher Basel III core tier 1 requirements. A problem for both Ireland and Italy was that this pushed up yet further their own debt/GDP ratios which were already regarded, by markets, as dangerously high. Another bout of contagion: The euro's foreign exchange market value against the dollar was subject to much uncertainty and enhanced volatility. On the one hand, shorn of the weaker Mediterranean brethren and ever closer to a DM grouping, it could be expected to soar. On the other, both the banks and public sector finances in the eurozone had been damaged by the default of the leavers, and so the eurozone itself was weakened. Such weakness, however, was not evenly spread, with Ireland, Italy and then France in that order falling under suspicion. Credit ratings, other than those of the ERA, for Ireland and Italy fell further, and their CDS rates rose sharply. These countries were next in line for contagion. Different paths for Italy and Ireland: At that point, the Italians had a difficult choice to make. They could either withdraw from the (northern) euro, and put themselves in a position of leading the southern bloc of European countries, or they could try to hang on, with enforced deflation, as the ‘weakest link' of the euro. Much the same dilemma faced the Irish; rejoin sterling (an option dismissed on political grounds); go it alone (dismissed since Eire was too small on its own); join the southern bloc of countries; or tough out continuing deflation in the remaining eurozone. It was a very close call in both cases, but they chose differently. The Italians decided that they would rather dominate a Mediterranean tier of countries than be a weakened appendix to a northern eurozone, while the Irish concluded that their ability to generate FDI from the USA depended on them staying in the eurozone. The establishment of the medi: Following the Italians' decision, a new Southern European currency, the medi, was established with an accompanying MCB (Medi Central Bank) set up in Florence. The medi depreciated further against the US dollar, while the Euro appreciated. In Germany and France those in work enjoyed sharp increases in real incomes, even though unemployment rose. Feeling richer they consumed more. The sharp decline in competitiveness in the euro-area countries led manufacturers there increasingly to invest abroad, including in the medi countries, much to the disquiet of their governments. Imbalances finally start to correct...at enormous cost: The sharply divergent path of exchange rates, depreciating for the medi, appreciating for the euro, was accompanied by an increase in inflation in the medi countries and deflation in the euro. Real interest rates rose in the eurozone and fell in the medi countries; investment ratios and net exports fell in the euro-countries and rose in the medi countries. Consumption, as already noted, rose in the euro-countries, while in the medi countries the experience of over-indebtedness, followed by austerity and crisis, restrained consumption. At least this time the fall in real interest rates encouraged business investment, not housing and commercial property, in the southern bloc. Thus the intra-European imbalances were, finally, being corrected, but at what enormous cost? Even after the event one has to wonder whether there could have been a better way of sorting out Europe's internal difficulties. Lessons from the Crisis The origins of this crisis went back a long way in history, back to the debates in the 1970s and 1980s between the French ‘monetarists' and the German ‘economists'. The French ‘monetarists' believed that political and economic union could, and should, be driven forwards by adopting monetary union. Whereas a monetary union without prior political and fiscal unification would surely cause tensions, these could, it was hoped, be creatively harnessed to push forward to ever closer union. In contrast, the German ‘economists' felt that monetary union should properly come last in the sequential build-up to political and economic union, the final coronation of a successful process. The German economists lost the key battle in 1990 when Gemany's Chancellor Kohl agreed to accept a single European monetary system, but the debacle in Europe in 2012-13 suggests that they have won the longer war. The crisis was essentially about the broader politics of Europe and to a lesser extent about the economic details of deficits and debt ratios. A major political problem had been that the European executive, e.g., the President of the European Commission, was not democratically elected and had no popular mandate. Instead, they were appointed by national leaders responsible to them (i.e., to the leading national political figures) rather than to the people of Europe. Imagine how the USA might have developed if the President was appointed by the leading politicians in the big States rather than by a Presidential election. Instead, what was needed, we can see with hindsight, was a new political initiative.
United States
Review and Preview August 03, 2010 By Ted Wieseman | New York The Treasury market posted strong 5-year and 7-year gains over the past week and smaller upside at the short and long ends as investors continued to put money to work in the most attractive areas of the curve from a carry and rolldown perspective. Economic data were mixed on the week, which left investors comfortable that the Fed is not going to do anything for quite some time, keeping the ongoing grab for yield and collapse in volatility running full steam through the week's run of auctions and into an added boost from Friday's month-end portfolio adjustments. In an extended further period of the Fed being on hold, 5s entered the week as the most attractive part of the curve followed by 7s, driving money from longer maturities into this area through much of the week and supporting a blowout 5-year auction on Wednesday followed by only a brief market setback Thursday afternoon before a move to new highs Friday after a much softer 7-year auction Thursday when market enthusiasm temporarily got a bit ahead of itself in a good rally right into the 7-year bidding. Even after a big week of outperformance and seeming richness versus 2s and 10s, the 5-year area is still the most attractive part of the curve on a carry and rolldown basis (outright and volatility adjusted) according to our interest rate strategy team (see the July 29 report, US Interest Rate Strategist: A Risk Case for Rising Yields: UST 10y 3.10% to 3.25% by Jim Caron and team). As well as the Treasury market performed on the week, it again lagged within the broader interest rate space, with swap spreads coming down and current coupon mortgage yields moving to new record lows (though with higher coupon MBS underperforming significantly on investor worries about the policy changes that could sharply accelerate stalled refis in these issues), which was most shockingly seen in 3.5% MBS rallying moving above par after surging more than a half point on the week. Swap spread narrowing was supported by a sizable further improvement in interbank lending conditions, with Libor and Libor/fed funds spreads on a spot and forward basis moving significantly lower, while the continued run of mortgage market strength was helped by an extension of the renewed collapse in volatility, which mostly has now reversed back down to post-2007 lows previously seen in March after a modest move higher in April and May during the height of concern about European fiscal issues. Of course, a carry and rolldown based investment strategy only ends up working out well if rates actually roll down the yield curve and there isn't a hawkish shift in expectations about the medium-term path for policy. And while there was nothing in the past week's run of mixed data to make anyone think the Fed will be anything but firmly on hold for a good while longer, we continue to think the market is being too complacent about the prospects for a reversal in policy next year. The market is already acting increasingly as if the US is moving towards a prolonged Japan-type morass (making warnings about this from St. Louis Fed President Bullard the past week unhelpful in guiding expectations), continuing to price out Fed tightening for longer and longer. There wasn't much additional movement in the latest week (but then there really isn't much space to move at this point), but after small additional gains, fed funds futures are pricing in no change in rates through mid-2011, only a move up to 0.50% or 0.75% at the end of next year, and just a 1% fed funds target in mid-2012. Correspondingly, as such a policy scenario has been priced in, excess carry was first wrung out of 2s and now 5s and perhaps next 7s, and volatility has been grinding persistently lower in what looks like the start of a repeat of what happened in Japan (see the January 14, 2003 note Japan Economics: Evaporating Yield Curve by Takehiro Sato). There is unlikely to be anything to derail these expectations for now - though a major mortgage refinancing wave that looks imminent to us could certainly shake things up from a market flows perspective - but we continue to think that investors are too bearish on the growth and inflation outlook for the next couple years and too complacent about the risks of a quicker return towards the policy exit strategy that was starting to move forward in the spring before the recent modest soft patch in the data in the wake of the European turmoil. For sure, overall GDP growth in 2Q was a bit disappointing, but domestic demand growth posted its strongest gain in four years, as expected, which spilled over into a surge in imports that depressed GDP. And while consumption growth was sluggish in 2Q and revised lower the past few years, with income growth adjusted up to show less weakness during the recession and an acceleration to robust 4.4% growth in 2Q, the personal savings rate is now shown to be at a generational high, a couple points above what was previously being reported for 2Q, so consumer rebalancing is more advanced. We continue to see 2H growth on pace for a rise near +3 1/4%, close to the first half pace. Meanwhile, we continue to believe that core inflation has bottomed and will gradually turn up in the months ahead, with the significant ongoing acceleration in rental costs across the country a key driver. This component is more important for the core CPI turn than core PCE, but revised core PCE inflation is now already higher than expected, with the year-on-year pace in 2Q coming in a quarter point higher than expected at +1.5%, making the Fed's forecast of a 0.9% gain in all of 2010 unlikely. Looking to the near-term data flow, the second round of regional surveys released the past week were much better than the previously released Philly and Empire reports and supported our expectations for a strong ISM report for July. We'll probably see a somewhat sluggish gain in private sector payrolls in the July employment report, but the last couple jobless claims reports suggest some notable renewed underlying improvement beneath the recent auto sector led volatility. For the week, benchmark Treasury yields fell 4-17bp led by the 5-year. The old 2-year yield fell 5bp to 0.53%, 3-year 12bp to 0.82%, old 5-year 17bp to 1.56%, old 7-year 14bp to 2.28%, 10-year 9bp to 2.90%, and 30-year 4bp to 3.98%. TIPS had a great week, outperforming the rally in nominals to slightly extend a rebound in inflation breakevens from the lows of the year hit a couple weeks ago. Month-end-related buying was particularly helpful to TIPS on Friday with the big new 10-year having been sold this month, but the strong relative performance on the week without any support from energy prices, which were flat, is consistent with the underlying nature of the recent decline in rates as being focused more on expectations of lower real rates for longer rather than rising deflation concerns. The 5-year TIPS yield plunged 20bp to 0.10%, 10-year 11bp to 1.11%, and 30-year 7bp to 1.85%. The benchmark 10-year inflation breakeven fell to 1.69% on July 19, low since last September, but has since rebounded to 1.79% as a 17bp drop in the TIPS yield over the time has outpaced a 6bp decline in the nominal yield. Swaps outpaced Treasuries on the week, with the benchmark 10-year spread falling 2.5bp to -1bp, while the benchmark 2-year spread plunged 4.5bp (accounting for the roll into the new 2-year Treasury) to 18bp. Major further movements towards normalization in dollar interbank lending markets after the strains caused by European bank funding issues in the spring supported the spread narrowing. Spot 3-month Libor fell 4bp on the week to 0.453%, low since mid-May after twelve straight declines. The spot Libor/OIS spread fell 5bp to 26bp and more improvement was priced in for coming months as the Sep 10 eurodollar futures contract gained 6bp to 0.41%, Dec 10 7.5bp to 0.445%, and Mar 11 8.5bp to 0.51%. This lowered the forward Libor/OIS spread for September, which peaked above 70bp in the spring episode, by 7bp to 22bp, December 9bp to 24bp, and March 9bp to 22bp. There was substantial divergence along the mortgage coupon stack on the week, as lower coupon issues surged in a further outperformance of Treasuries - potentially pushing the market towards a big refinancing acceleration - while the super-premium higher coupon issues lagged significantly. Higher coupons were hurt as investors reassessed the risk/reward of the small extra carry that can be earned in these issues versus the possibility of a big price adjustment if policy changes are implemented (see the July 27 note US Economics: Slam-Dunk Stimulus by David Greenlaw for our recommendations) to allow more refinancing of these issues. Much tighter credit standards and lower prices since the mortgages underlying 5.5%, 6%, 6.5% MBS have resulted in much slower rates or refinancings in the mortgages underlying these pools than was expected, as average 30-year mortgage rates plunged to current record lows near 4.5%, about 150-225bp less than the rates on mortgages underlying these high coupon MBS. Surprisingly low prepay rates as mortgage rates plunged allowed these securities to surge to unprecedented dollar prices, almost 8 points over par for Fannie 5%, 8 1/2 points over par for 6%, and 9 1/2 points over par for 6.5%. At such levels, our desk thinks that there could be a quick drop of a couple points if policy measures were taken to make it easier for homeowners stuck in these high mortgage rates and currently unable to refi under current tight standards to do so. As this possibility became a much greater market focus over the past week, these issues lagged the rally substantially (though they didn't actually lose much ground in absolute terms). Fannie 5% MBS lagged Treasuries on the week by 5 ticks, 6% by 22 ticks, and 6.5% by 10 ticks. On the other hand, lower coupon issues substantially extended their upside through most of the week before giving up some relative ground Friday when the move became big enough that it made a major refi wave an imminent possibility. Current coupon yields were down about 15bp on the week to near 3.45%, a record low. As MBS yields have plunged to new lows the past several weeks, the spread between MBS yields and mortgage rates has been holding at unusually high levels, with average 30-year mortgage rates stuck at 4 1/2%. With this latest market rally, this should start increasingly setting down to 4 3/8% and 4 1/4%, at which point the large amounts of 4.5% MBS (with underlying mortgage rates around 5 1/8%) should start to see a significantly accelerated pace of refinancings. These are mostly very high credit quality mortgages since they were written largely last year at the worst of the credit crunch and the lows in home prices, so there won't be the same issues that have sharply slowed high coupon refis. Interestingly, the Fed owns a ton of 4.5% MBS, so a big pickup in refis in those issues could actually result in a noticeable decline in the size of the Fed's balance sheet and a corresponding drop in excess bank reserves if the FOMC continues with its current policy of not reinvesting mortgage maturities. The past week's economic data flow was mixed. New home sales surged in June, but May was so weak that June's level was still the second worst ever, even after a 24% rebound. Consumer confidence was soft in July, as survey respondents expressed more pessimism about the labor market and about the prospects for economic growth over the next six months. The durable goods report was much weaker than expected on a headline basis, largely as a result of big drop in the volatile aircraft category. Underlying capital goods orders and shipments remained quite robust. This was very clear in the GDP report, with the biggest gain in equipment and software investment in twelve years leading to the biggest gain in overall domestic demand in four years. This demand spurt ended up being met by a surge in imports to a large extent, however, leading to a somewhat disappointing gain in GDP in 2Q. There wasn't anything in the GDP report that changed our outlook for continued moderate growth near 3 1/4% in the second half and 3% in 2011. Looking to next week's key data, after pretty dismal results from the early regional manufacturing surveys, the second round of reports out of Richmond, Kansas City, and Chicago were much better, and we raised our ISM forecast a half point to 55.5 as a result. Jobless claims also showed a surprising decline in the latest week that brought the 4-week average down to its lowest level since early May. This was too late in the month to impact our July employment forecast, but if it continues would point to some improvement next month. Real GDP grew 2.4% annualized in 2Q, with final domestic demand surging 4.1%, high in four years, and inventory accumulation (+1.1pp) providing a further boost, but net exports (-2.8pp) plunging as a spike in imports (+29%) far outpaced a good gain in exports (+10%). The unusually big estimated drag from net exports incorporated BEA's assumption of a very large widening in the trade gap in June, so there could be an upward revision if the results aren't as bad as that. Growth was revised up a point to +3.7% in 1Q - which left 1H growth of +3.1% a quarter point better than we were estimating before this release - but adjusted down a quarter point to +0.2% annualized from 4Q06 to 1Q10 and to -2.8% from -2.5% during the recession from 4Q07 to 2Q09. Demand upside in 2Q was led by a surge in investment, as expected. Overall business investment rose 17%, with equipment and software at +29%, high since 1998, and structures at +5% after a run of seven straight declines cumulating to a 32% collapse. Residential investment was also strong, rising 28%, the biggest gain since 1984. Underlying new home building activity rose 16%, and there was sizable additional upside in home improvements as homeowners took advantage of the ‘cash for appliances' incentives and in brokers' commissions as home sales surged ahead of the homebuyers' tax credit expiration. Government spending accelerated to +4.5%, with the smaller and more volatile federal government component jumping 9.1% and state and local government spending gaining 1.3% after one of the worst declines on record in 1Q. A sharp pickup in state and local government construction spending as infrastructure spending from the 2009 stimulus bill finally started to materialize accounted for the improvement. On the softer side, consumption was sluggish at +1.6% and there were sizable downward revisions back through 2009 on significantly lower spending on services. Consumer fundamentals looking forward, however, looked better, thanks to upward revisions to income growth over the past few years that lifted to personal savings rate in 2Q to +6.2% from less than 4% in the pre-revision monthly results for April and May. Outside of a temporary bump in 2Q09 after the stimulus bill was implemented, this was the highest quarterly savings rate since 1992. Core inflation numbers were revised a bit higher, likely putting the FOMC's mid-year forecast for a deceleration by 4Q in core PCE inflation to a range of +0.8% to +1.0% out of reach. Core PCE inflation was up 1.5%Y in 2Q after previously reported monthly results of +1.2% for April/May. The June monthly result that will be released Tuesday will probably show a +1.5%Y rate and muted comparison with a year ago (the average sequential gain in the three months of 3Q09 was only +0.08%) points to move up another couple tenths in the next few months. Full underlying details on the GDP revisions won't be released until Tuesday's personal income report, but there wasn't anything in these results that pointed to a significant adjustment to our medium-term outlook. We had been looking for GDP growth of 3.4% in 3Q, 3.3% in 4Q, and 3.0% in 2011 on a 4Q/4Q basis and that is unlikely to change much at this point. There is a busy economic calendar in the coming week, as we get the initial run of key data for July - manufacturing ISM Monday, motor vehicle sales Tuesday, nonmanufacturing ISM Wednesday, chain store sales results Thursday, and the employment report Friday. In addition to this run of key data releases, Treasury's quarterly refunding announcement will be Wednesday morning. We look for a $33 billion 3-year ($2 billion smaller than last month), $24 billion 10-year (unchanged), and $16 billion 30-year (unchanged) to be announced for auction the following week. At the announcement, we will be looking for any additional guidance from the Treasury about goals for average maturity of the outstanding debt and the related question of bill sector paydowns. Treasury's previously persistent series of moves towards extending the average maturity of outstanding Treasury debt after it fell to an unusually low level at the end of fiscal year 2009 has been scaled back somewhat in recent months with the paring back of 2-year, 3-year, 5-year and 7-year sizes (but not 10s or bonds) and some corresponding slowing in the rate of debt paydowns in the T-bill sector. With yields where they are, however, and the recent experience in Europe highlighting the advantages of terming out debt to lower rollover risk, we wonder if there might be thoughts of shifting back towards more intermediate and longer-end issuance. On the auction calendar, the main shift we see as likely at some point will be to introduce a second 5-year TIPS issue each year, which with one reopening would fill in the TIPS auction schedule to one a month. Currently, a new 5-year TIPS is auctioned in April and reopened in October, and the likely move we expect next year would be to have new issues in April and October that are reopened in June and December (the two months that currently have no TIPS auctions). This would probably not need to be announced until the November refunding, however. Data releases due out this week include ISM and construction spending Monday, auto sales and personal income Tuesday, and employment Friday: * We look for the ISM to decline slightly in July to 55.5. The regional surveys were all over the map this month. On an ISM-weighted basis, Empire, Philly and Richmond registered declines while Dallas, KC and Chicago posted gains. We believe that it is no coincidence that the districts with the most exposure to the auto sector showed the best performance. As we have been highlighting, assembly schedules point to about a 15% jump in motor vehicle production during July. However, this may not be enough to offset some moderation in other industries, so we look for a slight dip in the overall diffusion index this month (relative to the 56.2 seen in June). Finally, the price gauge is expected to edge down a point to 56.0. * We forecast a flat reading for June construction spending. The housing starts data point to a further pullback in the residential category, but this is expected to be just about offset by another gain in the public sector. Indeed, over the past few months, infrastructure spending has started to show some signs of life - likely a reflection of stimulus dollars finally being put to put work. * We look for 0.1% gains in personal income and spending in June. The labor market report points to only a fractional rise in personal income. Meanwhile, the retail sales data imply a similar advance in consumer spending. Finally, the CPI results point to a 0.16% rise in the core PCE price index for June. But, the annual revisions should contribute to a higher year-on-year rate of +1.5% in June (versus the previously reported reading of +1.3% for May). * We forecast a jump in July motor vehicle sales to a 12.1 million unit annual rate. The June selling rate was 11.1 million units, which matched the average seen during the entire 1H10. Although there are widespread indications that lean inventories are acting as a significant restraint on sales volume at the point, industry surveys point to a solid pick-up in the July selling rate. Indeed, if we exclude the cash-for-clunkers spike seen in August 2009, the sales pace this month should be the best since September 2008. * We forecast a 5,000 dip in nonfarm payrolls in July, with ex census jobs expected to be up 135,000. During 1H10, payrolls rose an average of about 100,000 per month (excluding the impact of census workers). We look for a pick-up to a monthly pace of close to +200,000 during 2H10. This type of acceleration would be consistent with the recent improvement in federal government withheld tax collections, the steady rise in temp help hires, and the sharp decline in layoff announcements. In July, payrolls and the average workweek should get a modest boost from the situation in the auto sector (where some plants avoided the typical summer shutdowns). Also, as we noted last month, there appears to be a historical tendency for private payrolls to show at least a slight elevation as census workers depart. And government data point to a further 140,000 drop in the number of census workers in July. On a related front, we are skeptical about the recent jump in federal government non-census employment and there might be some pullback in this sector. Interestingly, climate data show that average temperatures across the US were much, much hotter than usual around the time of the July labor market survey. While unusual weather events can have important effects on payroll employment in certain months, we do not detect a noticeable correlation for the month of July. Finally, the unemployment rate is expected to tick up slightly to 9.6% - however, it's worth noting that we have unusually low confidence in our short-term forecast of the unemployment rate at this point due to the historically unprecedented volatility in the labor force participation rate experienced during the past few months.
United States
Extending the Tax Cuts: The Fiscal Debate Begins August 03, 2010 By Richard Berner | New York Preserving stimulus. The debate over extending expiring tax cuts has begun in earnest, now that the President has signed landmark healthcare and financial regulatory reform legislation. The tax cuts enacted in 2001 and 2003 all expire on December 31, including those on ‘earned' income and on income from capital gains and dividends. If Congress fails to act on these expiring tax provisions, income taxes will rise by $125 billion more than we've assumed in FY2011. The resulting fiscal drag likely would trim growth in 2011 by half a percentage point or more from our 3% baseline. In addition, absent Congressional action, the Making Work Pay tax credit, part of last year's stimulus package, and several other provisions will also expire at the end of the year. The expiration of all of these tax cuts and credits (not including the AMT) would impose fiscal drag on the economy amounting to $145 billion in fiscal 2011 ($175 billion in calendar 2011), or about 1% (1.2% in calendar 2011) of GDP. To preserve most of the fiscal stimulus now in place, in our forecasts we have assumed that today's tax rates and credits (excluding the Making Work Pay credit) would be extended for lower- and middle-income taxpayers, that rates on capital gains and dividends would be raised to 20%, and that Congress would enact a fix for the estate tax and an AMT patch. Rising uncertainty. But delay on those extensions has started to undermine that assumption. The debate around taxes is already fierce, with Democrats and Republicans each arguing that the other side will raise taxes on January 1, thus imperiling the economy. Partisan divisions, a limited Congressional calendar, and a difficult legislative process all add up to either gridlock or kicking the can down the road. In our view, that's a recipe for deferring decision, so a one-year extension of all provisions prior to the mid-term elections in November now seems to be the most likely outcome. While that would temporarily preserve stimulus, it would also leave tax and fiscal policy unusually uncertain for an extended period. Such policy uncertainty could blunt the intended impact of maintaining the stimulus. Quantifying expiring tax cuts. The debate around required action by the end of this year involves far more than whether to extend the Bush tax cuts enacted in 2001 and 2003 under EGTRRA and JGTRRA; nearly one hundred provisions of the tax code will expire at the end of 2010. Extending the Bush tax rate and bracket cuts and maintaining the tax rate on dividends and capital gains would cost the Treasury roughly $120 billion in FY 2011 compared with their expiration under current law. In his FY2011 budget, President Obama proposed ending the individual income tax cuts begun under EGTRRA and JGTRRA only for upper-income taxpayers. Under the President's proposal, the top marginal tax rates for married couples filing jointly with incomes above $250,000 would go from 33% and 35% to 36% and 39.6%, levels last seen in 2000. Married couples with incomes below that threshold would continue to enjoy current tax rates. The current 10% tax bracket would be maintained, compared with the lowest tax rate of 15% prior to 2001, preserving for 88 million taxpayers an average of $503 in lower taxes next year. The Congressional Budget Office (CBO) estimates that this proposal would cost the Treasury $67 billion in FY2011 relative to current law. Extending today's middle-income tax rates isn't controversial and would not require Congress to find ‘pay fors' required for other fiscal actions under the PAYGO rules Congress adopted at the start of 2010. In contrast, extending the rate cuts and deductions for upper-income taxpayers is a hot issue: All Republicans favor it, but Democrats are divided. Some Democrats favor temporary extension until the economy is on firmer ground, but most, including the Administration, oppose any extension. And while increasing the rates on capital gains and dividends taxes would not net much revenue, here, too, there is division among Democrats. Treasury Secretary Geithner would equalize both at 20% to minimize distortions between debt and equity financing, but some Democrats favor boosting both. Other expiring provisions. In addition, in order to limit the increase in taxes, Congress would have to fix the estate and gift tax laws that revert back to 2000 levels at year-end, extend relief from the marriage penalty, and extend a patch for the Alternative Minimum Tax. Moreover, key tax credits such as the child credit and the earned income tax credit will sunset at the end of 2011. Finally, the Making Work Pay tax credit, part of last year's American Recovery and Reinvestment Act (ARRA), will expire at the end of this year, removing $60 billion in fiscal stimulus. Although President Obama proposed a one-year extension in his FY2011 budget, we assume the credit will expire under current law. At the 11th hour, kicking the can down the road. As noted above, Congress is unlikely to settle the tax issue decisively soon; a one-year extension before the mid-term elections in November is the most likely outcome. Most important, the divisions between Democrats and Republicans seem to be widening daily. Sensing an advantage, for example, House Republicans are proclaiming that the Democrats' ticking "Tax Bomb" threatens the economy. Procedure is also a hurdle: Senate Democrats lack the 60 votes needed to pass their agenda, because Congress was unable to agree on and pass a budget resolution for the current fiscal year. Moreover, the clock is running out, favoring a one-year extension: Congress will recess again in August, return to Washington for three weeks in September, and then hit the campaign trail. Action in the weeks following the election makes little sense politically; neither side would benefit from postponing decisions until a lame-duck session following the election. And lawmakers may see benefit in keeping the real debate alive as the Presidential election campaign begins in 2011. Risks to our forecast. If Congress fails to act on the expiring Bush-era tax provisions alone, income taxes would rise by $125 billion more than we've assumed in FY2011 and by more than that in out years. The resulting fiscal drag likely would trim growth in 2011 by half a percentage point or more from our 3% baseline. In contrast, extending all the expiring provisions (excluding the Making Work Pay credit) would add fiscal stimulus relative to our assumptions. However, the way in which lawmakers extend or sunset the provisions matters both for revenue and for economic impact. Regarding revenue, CBO estimates the cost of extending the middle-income tax cuts at $67 billion in FY2011 and at $1.169 trillion during the 10-year window budgeteers use for apples-to-apples comparisons. Correspondingly, theory suggests that permanent tax actions have bigger and more lasting effects than temporary ones. In addition, extending the middle-income tax ‘cuts' would benefit lower- and middle-income consumers, who would likely spend more of the savings than would those in upper tax brackets. We also believe that multipliers from fiscal actions vary depending on other circumstances. For example, in the heat of the crisis in early 2009, wary consumers saved more of their income, but as financial conditions and wealth improved, they opened up their wallets a bit more. With market healing likely to be even more advanced in 2011 than it is today, extending the tax cuts for middle-income taxpayers would probably get substantial traction. The combination of more dollars and more bang for each buck means that such action would offer meaningful stimulus in the short to medium term. In contrast, the effects of a temporary extension would be somewhat smaller, depending on which taxes are affected. Here theory suggests two opposing effects. A temporary extension of some tax cuts could accelerate certain income and economic activity to the present at the expense of out years as people seek to minimize taxes. Think accelerated bonus depreciation and cash for clunkers as extreme examples. In contrast, the overall impact of a temporary extension is less than that for a permanent one because consumers and businesses would plan on higher and less certain taxes in the future. Broader debate. The 2010 debate around tax rates and other expiring tax provisions is merely the opening salvo in a broader narrative. Congress and the Administration will need to reconcile maintaining near-term stimulus with longer-term fiscal sustainability by committing to a credible, long-term fiscal exit strategy. Such a combination would assure the most bang for the buck from any near-term extension of expiring provisions. Both taxes and spending will have to be on the table to achieve that goal, so broadening the tax base and reforming the tax system must be part of the discussion, especially because there is no realistic level of tax rates alone that can bring the deficit down to sustainable levels. Most important, the debate ultimately will have to confront the tough choices required to pare and thus preserve the essential benefits of our healthcare and other safety nets by shrinking them back to their original purpose. |
