26 May 2011

Charles Robertson +44 (207) 367-8235 CRobertson@rencap.com

Thoughts from a Renaissance man
Eurozone debt and the rise of DM political risk
As we are repeatedly asked about our views on the eurozone, we have compiled what we believe are the key graphs to look at.

Greece’s public debt ratios are 33% worse than the next highest country, Italy, and appear to be
unsustainable. This is not true of Portugal or Ireland, whose debt ratios, even by 2012, are on course to be below Italy’s, which has managed a debt ratio of 120% for roughly 20 years (albeit helped out along the way by the 1992 devaluation).

As Greece would still run a budget deficit roughly equivalent to its education budget even if it wrote off
100% of its debt, then we believe no default or restructuring can occur without the permission of the EU and IMF. Or rather, Greece can of course do what it likes, but no one will fund its residual primary deficit, so very painful cuts would still be required. The EU does not expect Greece to achieve a primary balance in 2011-2012.

Few trust Greece to deliver the austerity it needs to manage its debt burden, in part because previous
governments blew up a good fiscal position even when the economy was booming. Debt restructuring, with the imposition of losses on the ECB and others, is our base case for 2013 at the latest.

The major problem for others on the periphery of Europe is not sovereign debt but private sector debt. The total debt burden is actually higher for Ireland, Portugal and Spain than for Greece. We struggle to see how any of these
countries will improve living standards in the coming decade. The private sector debt boom which fuelled the good times of 19902008 is over, and finance, construction and retail are presumably dead in the water for years to come. Ireland might at least benefit from exports of goods and service (over 100% of GDP), but Portugal and Spain do not have this advantage. All face tax hikes, government spending cuts, less bank lending to fuel consumption or investment, and years of tough choices. Private sector debt defaults will presumably be a theme for the coming years.

Voters are already rebelling against the austerity required, with the worst government defeat in Irish history
occurring this year and the worst election result in thirty years for the incumbent Socialist party in Spain. Meanwhile, voters in northern Europe are rebelling against the bail-outs for peripheral Europe and seem likely to resist any significant move towards a federal Europe.

The obvious economic solution is for countries to leave the eurozone. Argentina’s economy returned to strong
growth after devaluation even though exports were just 10% of GDP (similar to Greece). Unfortunately, it would probably trigger a banking collapse as depositors fled to euro accounts in Germany, and could perhaps force the imposition of capital controls. Eurozone leaders will try to resist this, but they cannot prevent voters from choosing this option.

Therefore, it is now political risk which markets must watch, with elections in Portugal (2011), Spain (2012), Greece (2013), France (2012) and many others. European political risk might displace emerging market (EM)
political risk as a major cause of market distress over the coming years.

In the meantime, we would not be surprised by an earlier Greek debt restructuring, even as we assume the
EU will do what it can to push the problem into the future, in the hope that a weaker euro, falling commodity prices, surprisingly successful productivity improvements in peripheral Europe or the arrival of magical leprechauns with pots of gold will rescue the situation. Given the options, we believe investors are better off in EMs and future reports will concentrate on those opportunities instead.

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26 May 2011

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The debt problems in the eurozone are particularly acute for Greece. Its public debt in 2011 of 158% of GDP will be nearly one-third higher than Italy’s public debt of 120% of GDP, and nearly double the average eurozone debt level of 88% of GDP.
Figure 1: Public debt-to-GDP ratios in the EU, 2009-2011 2009 160% 140% 120% 100% 80% 60% 40% 20% 0% Estonia Lux Bulgaria Romania Sweden Lithuania Czech Rep Slovenia Slovakia Latvia Denmark Finland Poland Cyprus Netherlands Malta Spain Austria Hungary Germany UK UK France Eurozone Belgium Portugal Ireland Italy Greece
Source: Eurostat, EU Commission forecasts



Italy has sustained public debt of 120% of GDP for decades, which suggests Ireland and Portugal can manage such loads; Greece's public debt will be nearly 160% of GDP in 2011

Figure 2 shows that Italy has been able to sustain a debt level of 120% of GDP since the early 1990s. This suggests Ireland (118% of GDP in 2012) and Portugal (107% of GDP in 2012) could manage a burden this large. Note that while Belgium survived a debt burden of 140% of GDP, this was sustainable thanks to a devaluation in the 1980s and only rising interest rates associated with German reunification delayed a quicker reduction in Belgian debt after this.
Figure 2: Public debt as % of GDP in high debt eurozone countries 1992-2012 Belgium Italy 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Belgium's situation is not as encouraging for Greece as it looks France Portugal Greece Spain Ireland Eurozone





















Source: OECD 1992-2008, Eurostat 2009-2010, EU Commission forecasts 2011-2012

At the sovereign level, Greece looks to be in a unique position in Europe. From a global perspective only Japan has a higher debt burden.



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Thoughts from a Renaissance man

26 May 2011

Figure 3: Flow and stock of public debt as % of GDP Public debt as % of GDP, 2010 0 0 -2 Budget balance as % of GDP, 2010 Estonia 20 China Kazakh Bulgaria -4 -Russia -6 S Korea 40 60 Sweden Indonesia Mexico Finland Denmark Germany Phillipines Israel Turkey Serbia Thailand Brazil Hungary Belgium Czech Rep Austria Ghana Croatia Romania -8 Nigeria Netherlands Eurozone France Egypt India UK US -12 Ireland (exc bailout)
Source: Eurostat, national sources









S Africa Kenya Malaysia Latvia SlovakiaPoland Spain



Portugal Greece


The key difference between Greece and Japan is that Japanese household savings of nearly 170% of GDP in cash and bonds are almost equal to the government debt level. This means that not only can Japan finance its own debt but it can do so at very low interest rates, allowing the fiscal burden to be managed (for now). In Greece, the relative numbers are household savings of around 85% of GDP against a debt level of nearly 160% of GDP. This huge gap means that Greece looks particularly dependent on foreigners at the sovereign level.
Figure 4: Household savings data from 2008 (unless otherwise stated) as % of GDP and public debt in 2011 as % of GDP HH cash and bond savings 250% 200% 150% 100% 50% 0% France 2007 Japan 2007 Germany Portugal Greece Spain Austria UK US Italy
Source: Eurostat

Public debt (2011)

Greece cannot finance its own debt

Therefore, to get external support for a high level of government debt requires: 1) a high level of domestic savings, or 2) a high level of external trust that the debt burden is sustainable. Greece has neither. The key problem for Greece is not actually the debt burden itself, although it is far more expensive for Greece to manage than for Japan. After all, Greece was able to sustain interest payments of 11% of GDP annually from 1992-1996 (although


26 May 2011

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inflation was higher then, so the real burden might not have felt so harsh), while in 2012, the EU Commission expects Greece to only be paying 7.4% of GDP. Rather, the problem is that Greece might never get its budget deficit under control. The EU Commission believes that Greece will still be running a budget deficit of 9.3% of GDP in 2012, so the debt burden will continue to mount. Greece needs to run a budget deficit of 3% of GDP and have a growing economy to stabilise the debt burden.
Figure 5: Budget balance as % of GDP, 2009-2012 2009 -2% -4% -6% -8% -10% -12% -14% -16% France Eurozone Portugal Portugal Belgium Spain Greece 2010 2011F 2012F


Source: Eurostat 2009-2010, EU Commission forecasts 2011-2012

How can Greece grow? In expenditure terms, government consumption is ruled out. In 2011, Greece will be spending 50% of GDP and it needs to cut spending, not increase it. Higher taxes to reduce the budget deficit are likely to hurt private consumption, and banks are going to be reluctant to lend. Net exports are unfortunately not going to help much either as exports account for a small share of Greek GDP. Meanwhile, which companies will invest heavily in this environment? Presumably very few. To cap it all, Greece’s central bank (the ECB) is raising interest rates. The EU Commission expects Greece to record only marginal growth in 2012, after three years of GDP contraction. Argentina’s record suggests three years of contraction is as much as a population is prepared to take before politicians give up.
Figure 6: No decent growth in these countries, GDP % change YoY, 2009-2012 2009 4% 2% 0% -2% -4% -6% -8% -10% Eurozone Belgium Ireland Greece Spain France Italy 2010 2011F 2012F

Source: Eurostat 2009-10, EU Commission forecasts 2011-2012

Why are the EU Commission and the market so pessimistic on Greece? Is it unrealistic to assume that Greece might push through harsh austerity?



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26 May 2011

The IMF produced a research report in 2010 (click here to access Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely) which showed that many countries with high debt burdens were able to avoid default through the 1980s and 1990s. What the authors failed to highlight is that nearly all these countries devalued their currencies significantly to achieve the growth needed to improve their budget picture. So, history is not an encouraging guide. Nor is Greek fiscal history very encouraging. Leaving aside the often-quoted comments that Greece has spent 100 of the past 200 years in default, we only need to look back at the 2000s to make a call on the Greek appetite for austerity. In the early 1990s, the Greek economy grew at just 1% annually, and the government’s primary surplus, its revenues minus its expenditure excluding interest payments, was 1.6% of GDP. Attracted by what would be a 6.3% of GDP annual saving in interest payments, and helped by a currency devaluation in 1998, the government had political support to increase the primary surplus by 1.9% of GDP annually to 3.5% over 1997-2001. This would not have felt too painful as the growth rate trebled to 3.8% of GDP annually, and as banks were lending large amounts to households and corporates. Today there is no such pot of gold at the end of the austerity rainbow. Once Greece was in the eurozone and interest rates had fallen, the interest burden was down to 4.8% of GDP over 2002-2006, and despite high growth of 4.2% annually, the government spent so much it ran a 0.9% primary deficit. This is remarkable to us. Despite everything working in its favour, and despite it being given an extra 2.9% of GDP annually from saved interest payments, the government cut taxes by 2% of GDP and increased non-interest spending from 37.4% of GDP to 40.0% of GDP. It worsened its fiscal position by 4-5% of GDP. It is little wonder that now, when nothing is working in Greece’s favour, few believe that Greece can achieve a primary surplus.
Figure 7: How Greece blew its primary surplus: GDP % change YoY and key budget data as % of GDP GDP % ch 15% 10% 5% 0% -5% -10% -15% -20% 1992-96 1997-2001 2002-2006 2006 2007 2008 2009 2010 2011 2012 Interest expenditure Primary balance Budget balance

Source: EU Commission

Greece can only afford to default with permission from the EU/IMF This primary deficit position is extremely important. It means that, even if Greece wrote off all its debt, the government still could not cover its expenditure. Last year, excluding interest payments its deficit was 5% of GDP – even closing down all education (roughly 4% of GDP) would not have covered the gap. To close the forecast primary deficit of 2% of GDP in 2012 would still require half of the Greek education budget to be removed.


26 May 2011

Thoughts from a Renaissance man

Renaissance Capital

But even the most aggressive forecasts do not assume a total write-off of Greek debt, so Greece still needs to borrow considerably more than 2-3% of GDP in 20112012, and as the markets will not fund Greece, that makes it dependent on the eurozone and IMF. Debt restructuring can only take place with their consent. So, the question is when does Europe want to accept a Greek default? Media noise out of Germany suggests they might be prepared to accept this in 2011 under a different name, such as restructuring or re-profiling; but the ECB is opposed, arguing that restructured bonds will not be acceptable collateral for the ECB, so it would stop providing liquidity to Greek banks which would then go bust. It is not clear to us what solution the ECB sees for Greece’s problems, but, in the end, we assume the ECB will have to change its tune as it did in 2010 when it decided to accept subinvestment grade debt as collateral We would not be surprised by a restructuring this year, and expect a default no later than 2013, which happens to be an election year.

Greek default contagion to other sovereigns.
The charts above show that Greece is a unique case. No other country matches its high level of public debt or the low coverage of this debt by household savings. Ireland’s fiscal mess is similar to Greece’s, but its growth is better, while Portugal’s GDP performance will be nearly as weak as Greece’s, but its debt-to-GDP ratio looks better. The EU may be prepared to deal with the consequences of Greek default, but we think it will not see the same justification for default by Ireland or Portugal. Of course, Greece’s unique public sector debt problem did not stop Ireland and Portugal both having to turn to the EU and IMF for support, and Spain may follow later this year. A key signal of market distress is evidently the yield of Spanish debt over German bunds. But just because these countries borrow from the IMF and EU does not necessarily mean they will also have to restructure their public debt. But what about the private sector? This is where the real problem lies for peripheral Europe, except, surprisingly, for Greece. Private sector debt is around 200% of GDP in Ireland, Spain and Portugal, against 114% in Greece or 125% in Italy. Note that we include two data series here – for internal bank lending and eurozone-wide bank lending to each country. We will use the former series in the subsequent charts as it gives us more history.
Figure 8: Private sector (household and corporate) debt as % of GDP in 2010 Internal lending to 250% 200% 150% 100% 50% 0% Ireland Spain Portugal Eurozone Italy Greece France Belgium
Source: IMF, CEIC

Europe-wide lending to


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Thoughts from a Renaissance man

26 May 2011

If we add the private sector (internal only) and public sector debt levels together, we get quite a different picture.
Figure 9: Private sector (non-bank) and government debt as % of GDP in 2010 Private sector debt 2010 (internal) 350% 300% 250% 200% 150% 100% 50% 0% Ireland Portugal Spain Greece Italy Eurozone France Belgium Public sector debt 2010

Source: Eurostat, IMF, CEIC

Now it is Ireland, Portugal and Spain that look in a worse position than Greece. The default story is hitting Greece now because it is one single borrower that is having a severe refinancing problem. But the debt burden is greater for the others. If we do not believe that Greece can grow out of its problems, should we be more optimistic about the others? The short answer is no. All four of the peripheral countries boomed from the early 1990s on the back of a private debt explosion, from an unweighted average of 60% of GDP in 1992 to 102% in 2001 and 185% by 2010. The resultant rise of the financial and construction sectors, as well as the retail sector, is now presumably over.
Figure 10: Private sector (household and corporate) debt as % of GDP (LHS) and GDP % change YoY since 1992 (RHS) Ireland - GDP % ch Portugal- GDP % ch Ireland private sector debt/GDP - end-period Portugal private sector debt/GDP - end-period 250% Spain - GDP % ch Greece- GDP % ch Spain private sector debt/GDP - end-period Greece private sector debt/GDP - end-period 12% 10% 200% 8% 6% 150% 4% 2% 0% -2% -4% 50% -6% -8% 0% 1997-2001 2002-2006 1992-96 1992 2006 2007 2008 2009 2010 2011 2012 -10%


Source: IMF, CEIC, EcoWin, EU Commission


26 May 2011

Thoughts from a Renaissance man

Renaissance Capital

We should therefore assume a long drawn-out period of many years where sluggish growth becomes the norm and debt burdens rise, a little like Italy in a best-case scenario. Wages need to fall relative to Germany, while unemployment has already increased, which will make existing debt harder to afford. Rising ECB interest rates will add to the actual cost of existing debt – in Spain, most mortgages are variable. Governments will have to follow austerity policies. Investment will be sluggish. Countries like Spain, where household debt is very high, will look enviously at the US and UK as they inflate away their debt.
Figure 11: Household cash and bond savings minus household debt as % of GDP 140% 120% 100% 80% 60% 40% 20% 0% -20% Japan 2008 Germany Hungary Portugal Poland Indonesia Romania China Greece Austria Turkey UK France Czech Rep US 2007 Ukraine Spain Italy Inflation should be politically popular in these countries Deflation should be politically popular in these countries The Spanish should want to inflate their debt away - like the US or UK

Source: Eurostat, Japanese central bank, Federal Reserve, BIS

Figure 12: The unemployment rate in Spain has returned to 1993-1994 levels, but without the prospect of a private sector debt boom to reduce it 25% 20% 15% 10% 5% 0% Apr-86 Apr-87 Apr-88 Apr-89 Apr-90 Apr-91 Apr-92 Apr-93 Apr-94 Apr-95 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10
Source: CEIC

As with Greece, there may be a reliance on exports to boost growth, but a strong euro will hamper this. Only Ireland has a particularly open economy which will benefit from higher external demand. We would not be surprised by increased trade tension with China – which Beijing may try to ameliorate by buying eurozone bonds (including Spain’s).


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Thoughts from a Renaissance man

26 May 2011

Figure 13: Exports of goods and services as % of GDP (balance of payments data) Exports goods 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Ireland Portugal Spain Greece

Exports services

Exports goods and services

The stress will show up in elections. Voters will reject incumbent governments that are unable to deliver even modest improvements in living standards in the coming years. Ireland has already seen the previously dominant Fianna Fail suffer the worst election defeat of a sitting government since independence in 1921. In Spain, the ruling Socialist party suffered the worst defeat in 30 years at the local elections in May 2011, and are expected to lose the March 2012 elections. Portugal’s forthcoming elections are now expected to show a defeat of the ruling Socialist party, and in Greece the Socialist party is set to lose the elections due in 2013 – if the party can even remain united until that point. Incoming governments will not fare well either. They too will be forced to continue with austerity policies, while the ECB hikes rates and perhaps the euro strengthens. Within five-to-ten years, voters may be rejecting both major parties in all four peripheral countries. In Spain, the recently established 15 May movement (15-M) is already doing just that. As politics gets ever tougher, peripheral Europe will be looking for another solution.
Figure 14: Key poll and election figures Opinion poll Marine Le Pen (National Front) Nicolas Sarkozy (incumbent) Martine Aubrey (Socialist) March 2011 23 21 21 Election results Finland True Finns Ireland Fine Gael Fianna Fail (incumbent) Labour Portugal Socialist Social Democrats Spain - local elections Socialists People's Party

2007 4 2007 27 42 10 2009 37 29 2007 35 36

2011 19 2011 36 17 19 2011 ? ? 2011 28 38

Source: Wikipedia, Google

Towards a federal Europe?
An obvious solution is for the eurozone to offer far greater fiscal support to the periphery nations. We see two key obstacles to this. First, when the Germans agreed to sacrifice their beloved Deutschmark in the 1990s in return for French acceptance of reunification, Germany expected the rest of Europe to accept the new euro as a sort of gold standard. When Germans have


26 May 2011

Thoughts from a Renaissance man

Renaissance Capital

faced competitive problems, they have accepted real wage cuts relative to the rest of Europe to regain competitiveness. As there was no bail-out clause in the Maastricht Treaty, they believed the rest of Europe would also have to accept this model. Germany and others with a similar model find the idea of bail-outs very hard to stomach. Second, even if political leaders in Germany and other countries wanted to give more money to peripheral Europe, an ever-increasing number of their voters do not agree. The True Finns, who object to the current bailouts, saw their support surge from 4% in the 2007 Finnish elections to 19% in 2011. We can assume that many others were sympathetic to the party but were not prepared to back such untested politicians. In France, Marine Le Pen might make the run-offs of the French presidential election in 2012 (but few believe she can win), and she has gone still further, suggesting France should leave the eurozone so it can devalue and protect its industry. In Germany, the liberal Free Democrats have been reportedly considering a shift towards euro-scepticism in a bid to improve their standing in the polls. In Slovakia, there was great reluctance to even support the first package for Greece in 2010, which is understandable as the Slovaks are poorer than the Greeks. While peripheral European voters will increasingly vote against the austerity policies demanded by the north, northern European voters look increasingly likely to vote against policies offering more support for the south.

Why not leave the eurozone?
The most logical solution for those countries looking for an export boost, additional jobs, a budget revenue boost and a return to GDP growth is, evidently, to leave the eurozone. Time and time again in EMs, when excess debt was built up, devaluation proved to be the right (political) answer; however, many arguments were made against this solution. Even in Argentina, where exports of goods were just 10% of GDP in 2000-2001, devaluation did work. After an 11% GDP fall in 2002, Argentina recorded average growth of 8.8% over 2003-2007. The main difficulty is that it is likely to result in the bankruptcy of the banking system. For anyone holding euros in Spain, it would make sense to shift those deposits to a German bank in Germany, so we would see a run on the banking system. The problem then is that European banks are so intertwined with Spanish banks, that the global financial system would again be threatened. Capital account restrictions could be imposed, but this would run counter to the European single market. Leaving the eurozone would be more manageable if it was just Greece alone, but would be seen as contagious.

So we’re stuck with the current mess?
Hence we’re stuck with the current mess. The most stable scenario is for Greece to restructure its debt, by no later than 2013, and for Europe to accept the loss this will entail for the ECB and other holders of Greek bonds. We should expect European banks to raise capital against this forthcoming loss. We should assume the Greek banking sector will be supported to prevent it being wiped out. Meanwhile, the Portuguese and Spanish private sectors will suffer the pain of eurozone membership for many years to come, while Ireland will hope to benefit from broader eurozone growth. This seems to us to be the eurozone’s plan.


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Thoughts from a Renaissance man

26 May 2011

The most positive scenario is a weakening of the euro and falling commodity prices, with a rise in Iberian innovation, which would help produce better-than-expected growth. A more worrying scenario would be for Greece to leave the eurozone, which might be right for Greece but would then lead to speculation that others could follow, with destructive effects for banks around the region.

Impact on EMs
The current situation offers some advantages for EMs. The periodic return of risk aversion helps reduce EM currency and commodity appreciation pressures, and slows the rise in EM stock markets, helping to prevent bubbles. At the same time, the stark contrast between the near bankruptcy of some developed markets and the far better debt profiles of EMs only underline the relative attractions of EMs. We, of course, have to fear the worst-case scenario of eurozone defaults spreading to Spain, or multiple breakaways from the eurozone coinciding with banking collapses in peripheral Europe. But unlike a typical EM crisis of the 1990s, it is hard to see how markets can force this to happen now they have been removed from the financing equation by the EU and IMF in Greece, Portugal and Ireland, which means we will have to watch the political calendar in Europe. Enough political shocks in peripheral Europe might result in unilateral withdrawal from the euro. Political risk in Europe may therefore displace EM political risk as the main threat to market stability over the coming years.
Figure 15: Key economic data, 2010 GDP (EURbn) Goods (EURbn) as % of GDP Services (EURbn) as % of GDP Exp GS as % of GDP Debt as % of GDP Debt (EURbn) Budget balance as % of GDP Budget balance (EURbn) Outstanding value of bonds (EURbn) Ireland 154 84 54 73 48 102 96.2 148 -32.2* -50* 89 Portugal 173 37 21 18 10 32 93 160 -9.1 -16 108 Spain 1,063 191 18 94 9 27 60.1 639 -9.2 -98 465 Greece 230 16 7 28 12 19 142.8 329 -10.5 -24 255

Note: *Budget was -12.2% and EUR19bn excluding the banks bail out

Source: Bloomberg, Eurostat, CEIC


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