2010-06-18 09:00
Strategy Team, Saxo Capital Markets
SINGAPORE, June 18 /PRNewswire-Asia/ --
We have reached the stage where almost every bank in the western world is trading on the strength of the public finances of the country that back-stop the banks' liabilities. This means that everyone should now focus on public finances... which they are.
No doubt we have some problems in the PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries and some Eastern European (EE) countries like Romania and Hungary. Barring any meaningful and "hard choice" reforms in these countries, we should fear default in the not so distant future. But even if one or more of these countries would fail and restructure debt, we will still be okay if the majority of the G10 countries have sustainable finances. The problem is that they don't.
The "extend and pretend" game has continued for too long and the total leverage of the Western economies has increased during the crisis. And yet nothing has been resolved:
-- Consumers have only moderately reduced their spending. The consumption/GDP ratio of the US economy is still hovering at around 70%, which is way too high to ensure long-term growth.
-- Banks are still lying about their balance sheets and we suspect that majority of the banks are still insolvent either due to the massive defaults on mortgages (US and European banks), or irresponsible exposure to Southern Europe (European banks). As a result, banks are unlikely to start the securitization/lending machine anytime in the next decade.
-- Government spending continues almost unabated with very little attempt to reduce it. The lavish entitlement programs are left untouched in most European countries and as a result budget deficits are likely to continue over the next 3-5 years, if not longer.
In a recent BIS Working Paper # 300, researchers attempted to forecast the government debt / GDP ratios of several developed economies under three different scenarios. The ratios are predicted on a 30-year horizon and we end up with a completely impossible scenario in most cases.
In the baseline scenario, where no change on government entitlement programs and age-related spending is made, the UK is expected to reach a government debt / GDP ratio of 540% in 2040. For the US and Japan, the numbers are 450% and 600% respectively.
Naturally, this will not happen. Either governments will make small or gradual adjustments (scenario 2) or they will make small and gradual adjustments and keep age-related spending constant (scenario 3). If we assume scenario 2, the "middle-scenario", and use this to predict the government debt / GDP ratio with the assumption that household and corporate debt to GDP remains constant at the 2010 level, we reach the situation in below graph.
(PHOTO: http://www.prnasia.com/sa/2010/06/17/20100617373484.html )
The total Debt / GDP is set to surpass 500 percent in 8 out 14 of the economies in question, including the US, the UK, Japan, Spain and France. From 1997 to 2040, the ratios will increase by 66% on average. This works out to more than 200 percentage points of GDP. In short, everybody will look like Japan in 30 years time.
But this will not happen. The only reason why Japan managed to stay afloat until now is because their household savings were so large. However, this is no longer the case and Japan is now entering the extreme danger zone where it would be foolish to assume that domestic investors will continue to roll the ever-greater debt at ever-lower yields.
But none of the other countries in question have domestic savings sufficient to finance such public sector profligacy. The idea that governments will make "small and gradual changes" is a harsh assumption and we have only very few examples in history where hell-bent administrations actually succeeded in reducing government expenditure. Margaret Thatcher is about the only politician who achieved a significant adjustment of government spending to GDP through her rule.
European voters and policy makers are seemingly still ignorant of the size of the problem and have so far focused on outlawing "speculation" rather than facing the real problem: budget deficits and debt burdens.
Safe Havens in Northern Europe
We therefore expect Europe to do "business as usual" until bond markets clearly refuse to finance more government consumption. Interest rate spread versus Germany will move higher and fiscal sustainability will be centre-stage for the bond market. Germany, Denmark, Norway and Sweden will continue to benefit from their safe haven status and strong public finances. At the same time, PIIGS spreads versus Northern Europe will continue to edge higher as they have been doing lately.
This development sends out an important message: If we assume that the inflation/deflation outlook for Europe is roughly the same and with spread on 2-year notes (PIIGS-Germany) moving higher and with Germany et al verbally committing to a bail-out of the PIIGS; this can only mean that the bond market is ignoring cheap talk and actually believes that Germany et al will ultimately NOT be liable for the PIIGS debt problem.
Investors could in other words count on some sort of restructuring within the Euro-zone. This may make a lot of sense and could be the only way out of the debt trap Greece is caught in.
Crisis Continues to Drift East?
We believe that the focus of the market will continue its gradual move to the East. This began in 2008 with the subprime crisis, then the UK with the big financial sector and now Europe with the PIIGS debt problem. The debt crisis has since spread to the Eastern European countries and we are already seeing concerns about Romania and Hungary. With the International Monetary Fund (IMF) cash-strapped, the market will increasingly expect EE restructuring to take place in the near future. Since IMF is the determining factor, one should also worry about the Baltic countries again. We expect this to be an on-going topic over the next three months.
But Can Asia Lift The Global Economy?
The next phase in the "focus-shift" will be China, the global growth engine which consumes between a fifth and a seventh of all global commodity production. With China being the marginal buyer par excellence, it is not difficult to imagine what will happen to the commodity complex if the China recovery runs out of steam. Is that likely? Recent data is pointing to a slowdown in China commodity imports and hence a slump in demand. However, as you look deeper into the trend, it seems that China has been delving into their personal reserves of copper, iron ore and various basic materials and we expect the uptrend in consumption to continue.
Asia ex-Japan has been performing well and exports have been growing, despite Asian currencies appreciating against the US and Euro-zone. In addition, Asian banks have come out relatively insulated due to the lack of toxic exposure to US subprime and Euro-zone debt. We continue to see favourable operating conditions here as growth continues to surprise to the upside.
What will it take?
Policy makers are moving slowly to reduce the deficits everywhere, but it actually doesn't require that much to calm down markets. Hiking the retirement age by 2-3 years, cutting public employee wages by 5-10% and social transfers by 5% would generally be enough balance the budgets in many countries.
Yes, GDP figures would look awful in one or two quarters and real disposable income would for many groups be slashed to 2001 levels or so, but in hindsight 2001 was not that disastrous. Try to imagine the market if such measures where implemented... stocks and bond markets would immediately stabilize and so would the interbank markets, since the guarantees on bank liabilities would no longer be drawn in doubt.
All in all, there appears to be only two viable solutions to this crisis: Either restructure debt (like Greece will have to) or cut the deficits now. On that note, it is encouraging to see that Germany will implement a cut that amounts to 3.5% of GDP. This is a good start, but not enough. Mid-term elections in the US will probably mean that we will see more austerity measures and less bail-outs. Let's hope that Germany will provide the good example for the rest of the European countries, despite history showing that no political leader has yet to provide the vision and guts to demand it.
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