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World Risk Developments - August 2011 (Size 3Mb)
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The Age of Austerity
One legacy of the global financial crisis is G7 fiscal imbalances. Public debt/GDP ratios in the G7 are now 30% pts higher than before the crisis. The fiscal stimulus and bank bailouts behind this increase helped avert a depression. But it is now undermining the ability of the world economy to rebound as countries on both sides of the North Atlantic, and in the core as well as the periphery of the eurozone, rein in spending to stabilise public debt, often in the face of skittish bond markets.
This fiscal retrenchment comes at a difficult time for the world economy – the US recovery appears to be faltering, European growth is softening, and China and India are battling to restrain inflation. On one level, the troubles in the North Atlantic should not be overly concerning for Australia. After all, 70% of Australia’s exports go to Asia and while Asia is slowing, our base case is that it will be relatively resilient to low North Atlantic growth. But if the US and Europe slip back into recession, Asia’s resilience will be tested.
Greek rescue. In late July, the EU announced a new assistance package for Greece. There was an assurance that maturing debt would be refinanced until 2020. Private investors were also persuaded to take part in a ‘voluntary’ debt exchange involving a 21% NPV ‘haircut’. For all its size, however, the new rescue may not restore Greece’s solvency given its large public debt stock (142% of GDP at end-2010) and low growth prospects.
The EU’s attempt to build a firewall around Greece also appears to have done little to quell market concerns. The crisis now threatens to drag in Italy and Spain, and is even threatening to extend to France, a country that has long been rated AAA.
Bond market pressure. Borrowing costs for Italy and Spain surged in early August before retreating after the ECB stepped in to buy their bonds in the secondary market (Chart 1). French yields actually fell, but their premium over German bunds widened markedly.
ECB purchases. The ECB’s challenge is to buy enough Italian and Spanish bonds to restore market confidence in the two countries’ solvency. But since there is about €650b of Spanish debt on the market and €1,800b of Italian debt, purchases of at least several hundred billion might be needed to make the market take notice.
Why now? On one level, the heat on Italy and France seems misplaced. The average maturity of Italy’s public debt is seven years and Rome expects to achieve a primary fiscal surplus (excluding interest) of 0.9% in 2011, and even more in the future. Consequently, the debt/GDP ratio, while high, is stable at 120% (Chart 2). Moreover, half of the debt is owned by domestic investors.
In France, the budget is expected to rapidly return to (primary) surplus and the public debt burden is much less onerous at just over 80% of GDP (Chart 3).
Budget cuts. But in both countries fiscal consolidation will be difficult. First, the planned fiscal austerity comes at a time when GDP growth is weak. Second, political hurdles need to be surmounted. In Italy, delivering on promised budget cuts will require a potentially uncooperative parliament to pass enabling legislation, particularly around pensions. In France, presidential elections are due to be held in mid-2012. Finally, to secure long-term fiscal sustainability much deeper reforms of pension and health care programs may be required, than is currently being contemplated.
Broader worries? The bond market’s worries about France and Italy don’t just reflect home grown sovereign issues – they also seem worried that a European funded rescue of another troubled sovereign, say Spain, would really stretch core Europe’s public finances.
Investors also seem worried about the Italian and French banking systems. Banks in both countries have taken a hammering even compared with the general stock market slide of the past three weeks. Société Générale’s stock price is down by about a third in the last three weeks; those of BNP Paribas, Unicredit and Intesa Sanpaolo by more than 20% (Chart 4).
Such a selloff could be an overreaction. French banks, at least, are beginning to write down their investments in the troubled eurozone periphery. Nevertheless, the pressure on bank shares does suggest that markets are worried about the potential for a sovereign cum banking crisis in the eurozone, particularly since recent bank stress tests did not provide much reassurance about the ability of European banks to cope with a potential sovereign default.
Future of the Eurozone. The debt crisis could also have political implications for the European project. The big question is whether the eurozone will pull through the crisis intact. Some think not, speculating that the euro’s weaker members will ultimately leave the single currency, either by choice or at the urging of more creditworthy members. An alternative version of the ‘breakup’ hypothesis would see the stronger members, like Germany, leave the monetary union. Others argue that the crisis will lead to the creation of a ‘transfer union’ where Germany and other stronger members are forced to permanently underwrite weaker ones.
However, there are reasons to be optimistic about the ability of the EU and eurozone to pull through the crisis intact. Many commentators appear to have overlooked the range of existing EU and euro area institutions and arrangements that could be used to support sovereigns and banks. The ECB, for example, has very deep pockets and the capacity to act as lender of last resort and market maker for sovereigns and banks. And the enhanced EFSF, which could be up and running by September, will pave the way for the EFSF to recapitalise banks, and enable it to lend directly to countries without the need for the involvement of the IMF.
Rating downgrade. In early August, the US Congress finally raised the federal government's debt ceiling in return for up to US$2.4 trillion in spending cuts over the next decade. This announcement averted a government shutdown, but did not mollify S&P, which downgraded US debt to AA+ anyway.
S&P noted that the cuts do not stabilise the debt/GDP ratio. ‘America's governance and policymaking are becoming less stable, less effective, and less predictable’ according to S&P. In other words, reaching agreement on the main issues hurting the budget – health care, social security and tax reform – looks difficult. Moody’s and Fitch have kept the US at AAA, albeit with concerns. S&P has kept its US rating on watch for further downgrades.
Safe haven, still. In itself, the downgrade is not much of an issue. Most investment managers are not restricted to ‘AAA only’, so there has been little forced selling of US Treasuries. Moreover, what matters is relative, not absolute, quality. Indeed, 10-year Treasury yields have slumped to almost 2% – a historical low – as concern over the US’ economic prospects comes to outweigh worries over creditworthiness (Chart 5).
Medium term. The downgrade does, however, highlight that more needs to be done to stabilise the government’s medium-term debt dynamics. According to the OECD, just to stabilise the gross debt/GDP ratio by 2026 at 150%, the underlying primary fiscal balance needs to rise by 10% of GDP from its 2010 position (Chart 6). To achieve a debt ratio that provides a margin to deal with any future economic shocks, the OECD concludes consolidation of nearly 20% of GDP is required by 2026.
Closer to home, the downgrade is a further push for the Asian central banks to diversify their reserves away from the US dollar. This will not be immediate, however. There is no alternative debt market as deep and liquid as US Treasuries. Moreover, what alternative currency could the central banks hold? Euro? Yen? Sterling? All these economies have significant fiscal issues of their own (Chart 6).
‘Soft patch’ continues
Apart from US and Eurozone fiscal issues, the major trigger for the global financial market turmoil was further evidence that growth on both sides of the North Atlantic is faltering.
In the first half of 2011, US GDP growth slipped below what economists call ‘stall speed’ of around 2% pa. Below this rate, unemployment begins to rise and confidence weakens and the risk of recession rises. According to a working paper issued by the Federal Reserve, if two-quarter annualised GDP growth falls below 2%, recession follows nearly 50% of the time. Indeed, following the deepest recession in the post-war period, the current recovery has been the weakest, with the exception of the 1981-82 ‘double-dip’ (Chart 7).
In response to the slowdown, the Federal Reserve has committed to keeping interest rates close to zero until mid-2013. Many expect the Fed will also announce another round of quantitative easing – ‘QE3’. However, it may hold fire. After all, there were three dissenters on the Fed board to the latest announcement. In addition, the Fed may be unwilling to further ease monetary conditions unless inflation abates. Another factor that may stay its hand is doubt about whether QE3 will have any significant effect. Yields on US Treasuries are already at historical lows. QE2 may have boosted growth in late 2010, but it quickly faded in the first half of 2011 and some argue that the increased liquidity boosted commodity prices. QE3 will have to battle fiscal consolidation, which could shave 1.8% pts off growth in 2012.
Growth in the euro area also turned down in the June quarter. The weakness was relatively broad-based. After a period of relative strength, activity in the core slowed noticeably, with French and German growth stalling. Meanwhile, the periphery (Ireland, Greece, Italy, Spain) continued to struggle; its GDP remains well below pre-crisis levels (Chart 8).
Monthly manufacturing and confidence data suggest economic weakness will persist into the second half of 2011. Any difficulties in bank funding markets could also weigh on bank lending. Bank credit to the private sector grew by just 1½% in the June quarter and is falling in real terms. This could threaten business investment – the one area of relative strength.
How insulated is Asia?
A North Atlantic double-dip is likely to have a material effect on Asian growth. Asia is structurally decoupled from the North Atlantic – thanks to higher potential growth – but it is still cyclically coupled (Chart 9). This was evident through the GFC, when many countries in the region still experienced deep contractions or sharp slowdowns.
- Export dependence. While intra-regional trade had risen, industrialised economies still account for the majority of final demand for Asian exports (Chart 10). This is not surprising. Despite the rise of China and India, industrialised economies still account for 60% of world GDP at market exchange rates. The smaller, wide-open economies of Hong Kong, Singapore, Malaysia and Taiwan are most exposed to any export slowdown. The larger, more closed economies of Indonesia, China and India, potentially less so.
- Financial linkages. Net capital outflows could weigh on investment, credit availability, asset prices and confidence. Countries with large current account deficits and low FX reserves could also suffer balance of payments issues. On this front, Vietnam and Pakistan are more exposed.
Even though Asia’s manufacturing output and export growth have turned down in line with the global slowdown and the Japanese earthquake and tsunami in March, strong underlying growth in China and India should help Asia outperform other regions. Asia also has room for fiscal stimulus with public debt ratios much lower in Asia than in the industrialised economies (Chart 11). The exceptions are India, Sri Lanka and Pakistan.
However, fiscal stimulus from China would probably be smaller this time round. Beijing’s fiscal package during the GFC boosted GDP growth, but as it was focused on investment it delayed much needed internal rebalancing; the investment/GDP ratio has risen to an unsustainable 50% of GDP. The authorities are also battling asset price bubbles, inflation and non-performing loans – all hangovers from past stimulus. If they were to announce another stimulus package, it will probably focus on consumption. In turn, its impact would be less immediate and provide less support for commodity prices than another investment focussed stimulus package.
Dougal Crawford, Senior Economist
Ben Ford, Senior Economist
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.