Last week saw a generally higher level of confidence in euro-zone government bond markets as Greece announced a further €4.8bn of fiscal consolidation measures and launched a keenly anticipated €5bn 10-year bond issue. In response, the spread of 10-year Greek government bond yields over comparable German bunds has narrowed further to around 290bp, compared with 350bp or so a week earlier. But for all this relief, Greece remains under pressure from the ratings agencies and so must adhere to the fiscal consolidation plan in its enhanced form. That will involve considerable sacrifice for some time to come. Following March’s ECB monetary policy decision where the main refinancing rate was left on hold at 1% but further steps were taken to unwind ‘unconventional’ policy stimulus measures, this week sees a fairly light economic data calendar.Greek refinancing risk fell substantially after the country successfully issued a EUR5bn 10Y bond on Thursday, which calmed down the market with spreads generally moving tighter. The European Commission said on Thursday that measures taken by Greece to address its financial troubles are enough for 2010, but further measures will be needed in 2011 and 2012. EU Economic and Monetary Affairs Commissioner Olli Rehn also said that “the eurozone is ready if necessary to take coordinated measures to guarantee its stability”, “We have the resources to do so”. It is in Danske’s assessment that a rescue package involving German KfW buying Greek bonds is most likely ready to be implemented, but the Eurogroup is still hoping that Greece can handle this on their own. If Greece is rescued there is a moral hazard problem and the solution is probably closer fiscal monitoring and a stricter application of the rules. Looking at the macro picture, the euro zone’s public finances compare favourably with those in the USA, UK and Japan, whether in terms of budget deficits or debt ratios. Moreover, the euro zone has adequate domestic savings, as shown in virtually balanced current accounts. Even so, worsening government accounts within the euro zone have unnerved investors, who have focused particularly on Southern Europe, starting with Greece and spreading to Portugal and Spain. There is no escaping the fact that Greece, Portugal and Spain have very high budget deficits and steeply rising government debt ratios, and that their real and nominal growth prospects have worsened since the crisis broke. And given their euro zone membership, the adjustment via exchange rates is no longer open to them. The adjustment process will therefore be painful, as in a context of low inflation it could mean very limited wage growth and even a decline in wages in real terms. To make matters worse, the deterioration in public finances has coincided with the beginning of a demographic transition within Europe that will create serious budgetary problems of its own in the years ahead. There are real differences between the state of government finances in Greece, Portugal and Spain, however. Their budgetary problems are not of the same gravity, do not necessarily have the same causes and do not necessarily require the same remedies.
Greece’s public finances were already weak when the country joined the euro zone. Government debt amounted to over 100% of GDP, while the general government deficit totalled 4.4% of GDP. It has since become apparent that the Greek authorities were already concealing part of the deficit in order to meet the requirements for euro zone membership. The primary balance (i.e. the budget balance excluding interest payments on debt) deteriorated particularly sharply from 2001 onwards, largely because of increases in current expenditure. Despite the decline in interest rates on government bonds and the reduction in debt service costs that followed euro zone entry, the general government deficit gradually widened to 7.4% of GDP in 2004. The period between 2005 and 2007 saw a modest improvement, with primary surpluses in 2006 and 2007. The financial crisis ended this tendency, however, and trends in Greek government finances in the run-up to the crisis were similar to those noted in other euro zone countries (Italy, for example), but with very different real and nominal growth rates. Between 2001 and 2007, Greece’s real GDP increased by an annual average 4.3%, compared with 1.9% in the euro zone as a whole and 1.2% in Italy. Greece therefore proved itself incapable of profiting from its rapid growth over the past decade to consolidate its public finances. The financial crisis and the recession had a disastrous impact on the government’s finances. The primary balance slumped into deficit, amounting to 3.2% of GDP in 2008 and 7.7% in 2009, causing the overall budget deficit to widen to 12.7% of GDP (following a massive adjustment in the autumn of 2009). Government debt soared to 112.6% of GDP in 2009 (compared with 114.6% in Italy, for example). This sudden deterioration in public accounts prompted two rating agencies (Fitch and Standard & Poor’s) to downgrade Greece’s sovereign debt ratings. Under pressure from the markets, and in accordance with its European commitments, Greece has promised to consolidate its public finances quickly. Under somewhat optimistic assumptions, the adjustment required to stabilise the government debt ratio is 7.8 points of GDP, compared with 9.8 points for Spain and 6.7 points for Portugal. These figures show that Greece indeed has to make a major effort, but that Spain will have to do even more. The long term outlook will be tough. Because of a combination of rising life expectancy and declining birth rates, Greek public finances will inevitably deteriorate in the future. The bulging of the population pyramid will eventually reduce the size of the labour force and increase the number of pensioners. In 2008, the dependency ratio – the ratio between the number of people not in the labour force and the number in the labour force – was 27.8%, compared with 24.2% in 2000. According to European Commission projections, government spending related to an ageing population will increase by 16 points of GDP by 2060, compared with 5.1 points for the euro zone as a whole. Greece is not without advantages in its bid to consolidate its public finances. Firstly, its potential growth rate is still higher than in the rest of the euro zone. According to the OECD, productivity growth and the expansion of the population of working age suggest a potential growth rate of about 2.5%. This suggests that the gap between real interest rates and real growth will be smaller than in other euro zone countries, particularly Spain and Portugal. Secondly, private agents’ debt levels are relatively low and could comfortably rise, stimulating short- and medium-term demand. Thirdly, Greece will continue to benefit from European structural funds, which represented over 3.5% of GDP in 2007. Lastly, Greek living standards are still much lower than the euro zone average, with per capita income of about €13,000 per year, implying further convergence that continues a trend dating back to euro zone entry.
Having done what was necessary to meet the euro zone’s entry criteria, Portugal has seen a gradual slide in its public finances. The ratio of government debt to GDP increased steadily between 1999 and 2006, from 51.4% to 64.7%, while the general government deficit has often exceeded 3% of GDP. Indeed, it averaged about 3.7% between 1999 and 2006. In 2007, GDP growth peaked at 1.9%, enabling the deficit ratio to fall to the decade’s low at 2.7% of GDP. In the first half of the 2000s, deficits greater than 3% of GDP were accompanied by an uptrend in the share of government receipts and expenditure in GDP. This trend reversed between 2005 and 2008. Thus government expenditure decreased from 47.6% of GDP in 2005 to 45.8% in 2007, while receipts rose from 41.6% to 43.2% of GDP. The result was a slightly positive primary balance in 2007, worth 0.2% of GDP. Unlike Greece and Spain, Portugal did not benefit from particularly high real or nominal growth rates during the period. Its GDP increased by an annual average 1.1% between 2001 and 2007, compared with 1.9% for the euro zone, 3.6% for Spain and 4.3% for Greece. This phenomenon only increases respect for what José Socrates’ government was able to achieve during the previous parliament. The crisis badly weakened public finances, and by so doing led Standard & Poor’s to downgrade the country’s sovereign rating from AA- to A+. The primary balance switched from a surplus worth 0.2% of GDP in 2008 to a 5% deficit in 2009 – in terms of points of GDP, the deterioration was in line with France’s – and the general government deficit widened to 9.3% of GDP. At the same time, government debt rose to 77.8% of GDP in 2009. While this compared 78.7% for the euro zone as a whole, the increase in Portugal’s ratio was particularly dramatic (11.1 points of GDP, compared with 8.9 points for the euro zone). According to BNP Paribas calculations, the adjustment required to stabilise the government debt ratio is 6.7 points of GDP, compared with 9.8 points for Spain and 7.8 points for Greece. This effort will clearly be onerous, but less so than for Spain and Greece. All in all, Portuguese public finances are clearly not healthy but its deficit and debt are not significantly worse than those for the euro zone as a whole. Portugal’s recession ended in the second quarter of 2009, when GDP increased 0.3%. Confirmation of recovery followed in the third quarter, with a 0.9% gain. Less affected than Spain, Portugal has benefited from the rebound in world trade and a smaller contraction in investment. BNP Paribas are cautious on the country’s growth prospects, however. Private consumption will stagnate this year because of mounting unemployment, tighter credit conditions and poor consumer confidence. The household savings rate will rise to 11% in 2011. Given high household debt levels, the recovery in private consumption will probably be gradual. Despite trends in international trade, export growth will be modest in the coming quarters because of weak demand from Spain, which buys 30% of Portuguese exports. The outlook for domestic demand and profits is gloomy. The capacity utilisation rate is mired at record lows, and well off its long-term average. European Commission surveys point to further sharp declines in investment. In annual average terms, this component of GDP is expected to slump almost 3% in 2010. Headline inflation will probably stay very low in the next few years, at an annual average of about 0.5%. Because of the weakness of domestic demand, core prices could even decline until 2011. GDP could increase 1% in 2011 after 0.5% this year. The 2010 finance bill unveiled on 26 January and will be put to a parliamentary vote on 11 and 12 March provides for a 1-point drop in the budget deficit to 8.3% of GDP. This is to be obtained in equal measure by cuts in spending and increases in receipts. As far as spending is concerned, the government aims to freeze public sector wages in 2010, replace only one out of every two retiring civil servants, phase out exceptional stimulus measures and limit healthcare spending. On receipts, the government intends to resume privatisation and tax at 50% bonuses paid by banks. The scope for spending cuts is very limited because considerable efforts have already been made in this direction, notably between 2005 and 2008 (when the government managed to keep expenditure growth below GDP growth). Moreover, Portugal compares favourably with other countries in this respect, with government spending limited to 46% of GDP in 2008, compared with 46.9% for the euro zone. Lastly, José Socrates’ government lacks an absolute majority in parliament (96 seats out of 230, after 121 in the previous parliament). There appears to be more scope for raising taxes, which represented 43.2% of GDP in 2008 compared with 44.9% for the euro zone as a whole. José Socrates has proven ability to achieve reductions in government deficits but could now face greater political and popular opposition. He will struggle to get a majority on the 2010 finance bill and faces industrial unrest. Even so, we should emphasise that the state of Portugal’s public finances is in no way comparable with the situation in Greece. In our view, it does not justify such a dramatic revision of assessments of Portuguese sovereign risk. Portugal’s long-term budgetary constraints will be tighter than in Greece or Spain. The birth rate is among the lowest in the euro zone, at 1.37% in 2008 compared with 1.46% for Spain and 1.51% for Greece, and productivity gains are modest. Moreover, Portugal specialises in low and medium value-added goods that are intensive in unskilled labour. These are precisely the areas suffering competition from emerging countries, particularly those in Southeast Asia. Lastly, Portugal is over-dependent on its main trading partners, with Spain accounting for 25% of its imports and 30% of its exports. In this context, the measures in the finance bill, which aim to bolster the economy’s competitiveness at the price of a slight short-term deterioration in public finances, are welcome however.
From 2000 to 2007, the trend in Spain’s general government budget balance was stronger than that of Germany or of the euro zone. From 2005 to 2007, its budget surpluses averaged 1.6% of GDP, compared with average deficits of 1.6% for Germany and 1.5% for the euro zone. This was associated with a relatively low share for the government in the economy. In 2007, government receipts represented 41.1% of GDP, compared with 45.5% in the euro zone, while government spending represented just 39.2% of GDP (46.1% in the euro zone; cf. chart 7& 8). The primary balance showed record surpluses averaging 3.3% per year between 2005 and 2007, compared with 2.6% for Ireland and 1.5% for the euro zone. The ratio of government to GDP decreased until 2007, when it was 36.1% compared with 64.9% for Germany and 66% for the euro zone. All in all, the government took advantage of the period of strong growth at the beginning of the decade11 to substantially improve Spain’s public finances. But the economic crisis brought this trend to a sudden halt. The severe contraction in activity resulted in a drastic drop in tax receipts and increases in government spending, mainly on unemployment benefits. Moreover, the government launched a €50 billion (about 5% of GDP) stimulus package – “Plan E” – in 2008, to limit the downswing in activity. In conjunction with automatic stabilisers, the package produced a primary deficit amounting to 2.5% of GDP, and that widened dramatically to 9.4% of GDP in 2009 (i.e. a deterioration worth 6.9 points of GDP). The recession has undermined tax receipts by more than in other euro zone countries, explaining a collapse in the government’s tax take from 41.1% of GDP in 2007 to 34% in 2009 (down 7.1 points of GDP, against 3.1 points for Greece and 1.4 points for the euro zone). This phenomenon may be attributed partly to tax cuts implemented after José Luis Rodríguez Zapatero’s re-election in March 2008. Taxes on income, inheritance, company profits and low-income renters were reduced and wealth tax was abolished altogether, for example. Another factor was the effect of the recession on VAT and corporation tax receipts. With an overall budget deficit of 11.2% of GDP in 2009, Spain joins Greece and Ireland in the unhappy group of euro zone countries with double-digit deficits. The government debt ratio remains one of the lowest in the euro zone but nonetheless surged a spectacular 14.6 points of GDP between 2008 and 2009, from 39.7% of GDP to 54.3% (compared with 78.2% for the euro zone). It is therefore unsurprising to see the markets reassessing Spain’s long-term solvency and a downgrade from AAA to AA+ from Standard & Poor’s. GDP fell by 0.1% in the fourth quarter of 2009 after a 0.3% drop in the third. This was the sixth consecutive quarter-on-quarter fall in GDP, contrasting with the slightly positive figures recorded by the euro zone as a whole (0.1%). In year-on-year terms, GDP contracted 3.1%, after a 4% slide in the third quarter. The latest trends in industrial production suggest the economy could move back into positive territory in the coming quarters, but the slow elimination of the main disequilibria – high indebtedness among private economic agents, the exorbitant construction sector and a collapsing property bubble – does not point to a strong recovery. Despite relatively low interest rates, private consumption will recover only slowly under the impact of record unemployment (almost 20% of the labour force), the crash in property prices, renewed inflation and an historic fall in outstanding loans. Household confidence surveys indicate a slight improvement, however. In the fourth quarter of 2009, private consumption increased for the first time in seven quarters (by 0.3%). Business confidence has improved but the outlook for demand and profits is still gloomy. Moreover, the capacity utilisation rate remains at a record low, prompting cuts in productive investment. Domestic demand is expected to contract slightly this year and GDP could stagnate after easing 3.6% in 2009. The downturn in the credit market and the impact of the international financial crisis have ended a decade-long debt boom among private economic agents. For the first time since 1962, when the series started, outstanding loans to resident private agents have decreased in year-on-year terms. Households are now seeking to shore up their finances, which is likely to hamper domestic demand for some considerable time and produce higher savings rates. Because of household financial situations amid very high unemployment and saturated borrowing capacity, demand for housing is also expected to weaken further, despite still relatively low interest rates. The fall in housing prices is therefore likely to continue. This adjustment will have a lasting impact on the construction sector, which still accounts for nearly 10% of Spanish GDP after a cycle peak of 13%. The slump on the property market and in the construction sector will durably reduce tax receipts from these activities. Over the longer term, underlying prices are likely to fall given the negative situation in the labour market and an ongoing output gap. The resulting wage moderation may allow Spain to recover some of its cost competitiveness relative to its European trading partners. In the short term, a fall in prices would seem to be the only way of restoring Spain’s competitiveness in the context of economic and monetary union. Up to now, (without any labour market reform) the downward stickiness of Spanish wages has resulted in an adjustment by quantity (increase in number of unemployed) rather than price (wage moderation). The major risk for Spanish public finances in the short and medium term is unemployment. The severe economic downturn, the country’s exposure to cyclical sectors like construction, tourism and industry and the high proportion of temporary jobs in the economy (more than 20% of the total jobs) resulted in a particularly drastic deterioration in the labour market. The number of jobless almost doubled between the beginning of 2008 and the fourth quarter of 2009, rising from 2.2 million to 4.3 million. According to Spain’s national statistics institute (INE), the unemployment rate reached 18.8% in the fourth quarter of last year. As a lagging indicator of activity, unemployment will probably continue to rise over the coming quarters as the government’s public works programmes (mainly amenities) gradually come to an end, at both the national (Plan E) and local investment fund levels. The unemployment rate may average 20% this year, which would automatically dent public finances. In 2009, the budget for unemployment benefits exceeded €30 billion. This explains why the government has announced plans for labour market reform, contrary to its earlier promises. The government has also announced structural reforms aimed at balancing its budget in the longer term. The first concerns pensions. The government wants to raise the retirement age from 65 to 67 by 2025. The pension system posted a surplus amounting to 0.8% of GDP in 2009 but its finances are set to deteriorate. The dependency ratio was 24.1% in 2008. According to European Commission projections, government spending related to an ageing population will increase by 8.3 points of GDP by 2060, compared with 5.1 points for the euro zone as a whole. Most of that gain (6.2 points of GDP) is related to projected increases in pensions. The second reform concerns the labour market. Of the 6 points of GDP in increased government spending over 2008 and 2009, 3 points stem from welfare benefits (essentially unemployment benefit). So far the government has presented an outline project designed to provide a framework for future discussions with unions and employers. Several issues are on the agenda: youth unemployment (39% of 16-24 year-olds are unemployed), the dual nature of the labour market, return-to-work aid schemes, etc. BNP Paribas think several other issues ought to be on the agenda, such as the cost of laying off workers – among the highest in developed countries, according to the OECD – and the stickiness of wages to the downside. Most wages are indexed on inflation. Lastly, the government will need to continue and expand its policy of sector diversification so as to break definitively with Spain’s present model, based on private sector indebtedness, property market and construction, and achieve a return to robust and balanced growth. Any such adjustment will take years, but will not compromise the consolidation of public finances in the long term. A low government debt ratio and significant scope for raising tax receipts should enable Spain to meet this new challenge.
In Euroland the focus is on manufacturing production numbers. These data are likely to attract great attention as the December production numbers, especially out of Germany, were quite dismal being below the September level. Industrial production was otherwise on a strong upward trend from April to September 2009, but weak December data fuelled fears that growth in the Euro area is losing momentum before labour markets stabilise and private spending picks up. In December 2009, eurozone industrial output contracted by 1.6% m/m after increasing by 1.4% in November. The six-month rate of change, which smooth monthly volatility and provides a better gauge of industrial underling trend, continued to increase, signalling that the rebound of industrial output could continue in the first months of the year. Survey data, such as the manufacturing PMI and the Industrial confidence indicator from the European Commission confirmed this trend rising in both January and February. Therefore industrial output should have rebounded in January (to be released on Friday, 12 March). Nevertheless, despite the expected increase, there is a long road to recovery. Output will remain well below the pre-crisis level. In Germany, industrial production fell sharply in December 2009 (-2.6% m/m after +0.7% m/m in November), bringing the Q4 2009 increase to only 0.4% q/q (vs +3.4% q/q in Q3 2009). Poor weather conditions probably continued to disrupt economic activity in early 2010, but recent trends in the PMI and IFO indicators as well as December’s decline suggest that industrial activity picked up in January (figure to be released on Monday, 8 March). Yet industrial production is unlikely to increase but very slightly in the months ahead due to the easing of new orders for manufactured goods since fall 2009 (+0.7% q/q in Q4 2009, vs +8.8% q/q in Q3 2009). In France, recent industrial surveys have been mixed, suggesting that industrial production will have been lacklustre at the start of the year. The fallback of retail sales of manufactured goods is due to the collapse of the auto market as car purchase incentives are phased out. Although non-car sales have remained strong, we expect auto production to react rapidly to this highly expected decline in demand. The other components of manufacturing output should be roughly stable. Food production soared in December, well above trend and adverse weather should send it back below trend in January. This may be partly compensated by energy output. Although GDP growth reached a solid 0.6% q/q in Q4, industrial production has been going sideways in the last few months. BNP Paribas expect this trend to continue in the early months of 2010. Obviously, the y/y change will continue to rocket, but this is due to the massive base effect on the back of the plunge in January 2009. Risk appetite returned and the euro stabilised this week as the markets greeted the announcement that Greece will implement additional EUR4.8bn austerity measures. The ECB signalled that it would proceed very cautiously with its monetary policy exit. According to the ECB the weekly main refinancing operations and the one month auctions will continue to be with full allotment at least until 12 October 2010.
Ashley Ingle website – corporate and personal currency broker
