Special Research Note European Debt Worries

In this special research note on Europes debt worries our Head of Investment Strategy digs deep into the numbers and asks if this is potentially another global financial crisis. He concludes that while Greece is in dire straits, a re-run of the dark days of 2008 looks highly unlikely at this point. Next our Chief Economist updates us on developments over the weekend and it appears Europe is finally getting its act together. A recent note Is Contagion Risk Overdone? puts these developments into context. Assessing Peripheral Europe Risk
Keith Poore Head of Investment Strategy The sovereign debt drama presently playing out in Europe raises some important questions. Not least of which is: is this potentially another global financial crisis (GFC), or to be more specific, if things go wrong could the writedowns be of GFC proportions? The IMF estimates 4.1% of total bank loans & securities will be written down as a result of the GFC. The equivalent ratio for US banks, the epicentre of the crisis, is 7.0%.
US$Bn European Banks UK Banks US Banks All Banks GFC writedowns 821 455 885 2,276 Total Loans & Securities 26,871 8,369 12,561 55,680 % Total 3.1% 5.4% 7.0% 4.1%

Source: IMF, AXA Global Investors

Estimating the same regional bank exposures to debt from Greece, Portugal, Spain, Ireland and Italy using Bank of International Settlements and IMF data gives the following:
Bank Foreign Claims / Total Assets Greece Portugal Spain Ireland 0.7% 0.8% 2.7% 1.4% 0.2% 0.3% 1.3% 2.1% 0.1% 0.0% 0.5% 0.5% 0.4% 0.5% 1.7% 1.2% Aggregate / Total Assets 9.1% 4.8% 1.5% 5.7%

European Banks UK Banks US Banks All Banks

Italy 3.5% 0.9% 0.4% 2.1%

Source: BIS, IMF, AXA Global Investors

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In the table Bank Foreign Claims includes government and private sector debt. It is important to also account for private sector country debt, as this is likely to be (at least) as risky as sovereign debt. The table shows that European banks are most exposed to the five countries with Spain, Ireland and Italy representing the lion share of that exposure. Remember the table above is the total exposure to these countries. For bank writedowns to be of GFC proportions (i.e. 4% of total loans or ~7% of epicentre) all these claims would need to effectively default, with a recovery rate of only 30%.
Assuming 70% writedown / Total Assets Greece Portugal Spain Ireland Italy 0.5% 0.6% 1.9% 1.0% 2.5% 0.1% 0.2% 0.9% 1.4% 0.6% 0.1% 0.0% 0.3% 0.3% 0.3% 0.3% 0.3% 1.2% 0.8% 1.4% Aggregate / Total Assets 6.4% 3.3% 1.1% 4.0%

European Banks UK Banks US Banks All Banks

Source: BIS, IMF, AXA Global Investors

This seems very unlikely. Spain and Ireland have lower sovereign debt / GDP ratios than Germany and France (~75%) whereas Portugals is on a par with these two. Greece and Italy have debt ratios closer to 115% of GDP, but at least with Italy less than 60% of government debt is held abroad, compared to 99% for Greece. Greeces high foreign ownership of Government debt can largely be explained by its negative household saving rate, whereas Italys saving rate is typically around 15%, about the same as Germany and Frances.
Household Saving v Offshore Gov. Debt Ownership Govt Debt % Held Offshore 120 Greece 100 80 Portugal 60 40 20 0 -5 0 5 10 15 Household Saving Rate % (2004-08 average) 20 Ireland Spain Italy France Germany

Source: IMF, Eurostat, AXA Global Investors

The reason Greeces finances are in such dire straits is it has been running budget deficits even before taking into account its high interest payments, i.e. its Primary Balance has been negative. Portugal has also been running primary deficits but its interest payments have been much lower than Greeces.
2009 % GDP Ireland Greece Spain Italy Portugal Govt Debt 64.0 115.1 53.2 115.8 76.8 2004-08 average Budget = Pimary + Interest Deficit Balance Payments -0.2 0.9 -1.1 -5.8 -1.3 -4.5 0.1 1.8 -1.7 -3.1 1.8 -4.8 -3.8 -1.0 -2.7

Source: IMF, Eurostat, AXA Global Investors

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A countrys primary balance can be negative without a deteriorating debt/GDP profile only as long as nominal GDP growth is above the effective government interest rate. When growth is below the effective interest rate, the primary balance needed to stabilise the debt profile is
Required Primary Balance = (Interest Rate Nominal Growth) x Debt / GDP

The higher the interest rate is above nominal growth, and the higher the Debt / GDP ratio, the higher the required primary balance. This also illustrates the sensitivity to rising market yields for given Debt / GDP ratios. For every 1% rise in Greek bond yields the primary balance needs to increase by 1.15% (with all the spending cuts and tax hikes that entails). For Spain, a 1% rise in yields equates to a 0.53% required rise in the primary balance. Greeces 10-year government bond was 9.0% at the end of April, which is 5% more than the average of the last few years. This means a primary balance improvement of over nearly 6% is needed just to account for the higher yield. Add another percent or two for the lower nominal growth forecast and little wonder there is rioting in the streets.
Govt Debt 10Yr Govt Rate / GDP (30-Apr-10) 64 115 53 116 77 5.1 9.0 4.0 4.0 5.1 2010-15 Nominal GDP Forecast 4.2 1.7 2.9 3.2 2.7 Required Primary Balance 0.6 8.4 0.6 0.9 1.9

% GDP Ireland Greece Spain Italy Portugal

Source: IMF, Eurostat, AXA Global Investors

Greeces required primary balance looks nigh on impossible; this is why some kind of debt restructuring may be inevitable. The IMF/ EU combined 110bn rescue package will at least put this off for a few years. The remaining countries required primary balances look eminently achievable. Portugal requires a material, but not insurmountable, improvement to its primary balance. But of course this will get tougher if yields continue to rise. Even so, Greece really does look in a league of its own. But given bank exposure to Greece is relatively small, its debt problem shouldnt be a major issue for the functioning of capital markets. The same goes for Portugal, were contagion to spread there. At this point a re-run of the dark days of 2008 looks highly unlikely. Our portfolios remain positioned for global growth.

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european debt worries

The Politics of Debt

Bevan Graham Chief Economist Last year some folk thought we were premature talking about the importance of well-articulated stimulus exit strategies. Some possibly even thought we were crazy. Yet it is exactly the absence of well-articulated plans to address individual countries budget deficits and debt problems that could be the unwinding of the fragile economic recovery in Europe. Political dithering over the crisis in Greece has been exceptionally unhelpful. As we argue in the note below (Is Contagion Risk Overdone? Yes and No), Greece is a different case, and it could and should have been easily quarantined. To be fair, part of the Greek situation was also the rapid deterioration in history as the deficit from last year was revised down. Nevertheless, political inaction has been reminiscent of the early days of the credit crunch when Europe believed the crisis was an American problem and was Americas to solve. Thankfully Europe appears to be getting its act together. European leaders are currently working on a stabilisation mechanism which will hopefully be sufficient to calm fragile markets. If this does not appease markets, we may be in for a rocky road. We have known for some time that fiscal consolidation meant lower growth it is one of the reasons we expect sub-trend growth in developed markets over the medium term. Continued market fretting would inevitably mean countries having to make more painful fiscal adjustment which would be growth detracting. This is just the situation that could lead to a double-dip in Europe reduce growth expectations in other parts of the world. But on the other hand, weakness in the Euro is also a positive for European economic (export) growth. Every cloud has a silver lining. What members of the European Union need more than anything right now are clear and credible plans towards fiscal consolidation. EU fiscal rules have always been more than a tad loose. The adoption of German-style fiscal rules across Europe seems an inevitable consequence of recent events, and would be welcomed by markets. Recent events should serve as a warning to other countries with large deficits, be they cyclical or structural. Well articulated pathways to fiscal consolidation are essential, otherwise markets will impose a faster but ultimately more damaging solution.

Is contagion risk overdone? Yes and No The EU/IMF Greece debt rescue package came not a moment too soon
Political dithering meant bond markets were starting to dictate the course of events, which is not healthy. Political realism saw through in the end. In our view, recent fiscal contagion has been more a political than an economic phenomenon. There are, however, still significant fiscal risks. The Greece package is an appropriate mix of support with conditional austerity. This is only right and proper. Initial German reluctance to support the package reflected the fact that Greece had to play their part and, in short, it had to hurt. Otherwise others in a similar position may find EU/IMF support preferable to making (politically) hard fiscal decisions. The German parliament has now endorsed the package.

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The Greek austerity plan is indeed austere. Cuts to public sector wages, pension reform and increases in taxes will all hurt. The plan is to have the Greek budget deficit under 3% of GDP by 2014. It was 13.6% of GDP last year (and still rising due to revisions to historical data). Contagion risks are the order of the day. Concern has centred mostly on Portugal and Spain. Greece is a somewhat special case however. The global financial crisis was, as we have discussed before, a private sector crisis stemming from years of over-consumption and increased household indebtedness. The Greek story is somewhat different: profligate spending was centred in the public sector. The graph below represents the GFC-starting position for household and central Government debt for Greece, Portugal, Spain and Ireland (the first country where fiscal risks were raised, but managed in a more orderly fashion). The US and UK provide a salutary reminder that fiscal risks are not quarantined to EU countries.
Indebtedness: 2008
160 140 120 % of GDP 100 80 60 40 20 0 Greece Ireland Portugal Spain Household UK US

Central Government

Source: IMF and OECD Pre-crisis, household debt in Greece was a relatively low 31% of GDP, yet pubic debt was already over 100% of GDP in 2008 and stood at 115% of GDP in 2009. In most countries the GFC was centred in the private sector and has only more recently become a public sector issue as Governments have bailed out private sector institutions. In those countries the adjustment process is happening in households as well as the government sector. In Greece most of the adjustment process has to happen in the public sector, and the blame for that is being sheeted home to the Government. Public sector adjustment ultimately hits taxpayers and public sector workers. Rioting in the streets in Athens is perhaps understandable. Greece is by no means out of the woods. Central government debt is now projected to hit 150% of GDP by 2014. Some form of debt restructuring in the future cannot be ruled out. But at least that can now happen in the fullness of time and in an orderly fashion. Many developed markets are not yet completely out of the woods yet either. Budget deficits in many developed countries are structural (refer graph over the page) and public debt is rising sharply. The structural nature of the deficits means Governments cannot simply rely on economic growth to close the fiscal gap, at least not in the short-term.

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Structural Budget Deficits

5 0 % of GDP -5 -10 -15 -20 IMF Forecasts

19 90 19 92 19 94

Greece

Ireland

19 96 19 98 20 00

New Zealand

20 02 20 04 20 06

Portugal

20 08 20 10 20 12
Spain

UK

20 14
US

Source: IMF Recent fiscal ontagion has arisen out of political failure. In our view, further fiscal contagion will ultimately come back to individual governments articulating and swiftly implementing pathways back to fiscal sustainability. This goes beyond just a Greece/Portugal/Spain issue to every country with large structural deficits, including the UK and the US. Only by getting these deficits under control, and ultimately public debt trending down, can contagion be truly contained. There are a number of broader question that fall out of recent events in Europe. For instance what it means to be a member of the European Union, and whether fiscal rules and accompanying checks and balances are strong enough. These questions will have to be addressed in the fullness of time. Recent events vindicate our long-held concern about the extreme difficulty (both economic and political) that many countries will face in getting their fiscal houses in order, and our decision in March to increase our underweight to global bonds in the multi-sector portfolios.

Bevan Graham Chief Economist

Keith Poore Head of Investment Strategy

10 May 2010
Disclaimer

The investment views in this publication do not constitute specific advice (whether of an investment, legal, tax, accounting or any other nature) to any person. The information has been published in good faith and has been obtained from sources believed to be reliable and accurate at the time of preparation. The opinions contained in this document reflect a judgement at the date of publication by AXA Global Investors and are subject to change without notice. AXA Global Investors 2010