Monday, June 21, 2010

Importance of SGIP for North-Eastern economies is low

It is well-known that sovereign defaults in Spain, Greece, Ireland and Portugal would have devastating effects on the financial sectors of the rest of the Eurozone. However, I am convinced that while technically these countries might be insolvent they will not need to default given that the EU/IMF/ECB measures will keep them liquid. As I argued in the previous post (see Intra-Eurozone competitiveness: A solvable task) especially Spain, Portugal and Ireland have a high probability of being able to restore competitiveness and bringing their fiscal deficits back on a sustainable path over a period of 3-5 years whereas the outlook for Greece remains more challenging. The price to pay will be a longer-lasting deflationary recession and a significant increase in the sovereign debt-GDP ratio. However, especially for Spain and Ireland this should not be such a big problem as the starting debt-GDP ratio has been fairly low.
For the banking sector of the other Eurozone countries the fact that SGIP remain liquid and do not need to default while the ECB provides a floor to government bond prices means that the losses they incur are limited. Furthermore, the banks can slowly offload parts of their sovereign debt via the ECB's bond buying and as the EU/IMF refinance the maturing GGBs. Finally, the rising private sector defaults in SGIP will occur over a number of years and the sums involved appear manageable for the Eurozone financial sector.
What remains for the rest of the Eurozone are the economic effects from reduced demand by SGIP. I hear frequently that given Germany is such a big exporter and given SGIP are in a longer-lasting recession, Germany cant grow amid lack of export demand. However, it seems that no one looked at the data as this is just not true.
The table below shows the share of exports going into a particular region relative to total exports for various Eurozone countries. Due to data availability it covers only export of goods but not services (services account for about 20% of all exports). It highlights that the share of exports going to SGIP relative to overall exports is low for most Eurozone countries. In 2008 Germany exported only 6.6% of all exports to SGIP. This has come down further in 2009 to below 6% (EUR48bn vs. total exports of EUR808bn). According to Bundesbank data for services, the picture is the same. Germany exported 6.2% of all exports in services to SGIP in 2008 and 5.6% in 2009 (EUR 9.3bn vs. a total of EUR165.5bn). Except Portugal, due to the high export share going to Spain, only France and Italy have a share of more than 10%. As a side note, the UK – even though not being a Eurozone member - has a share of more than 12% of exports going into SGIP. Overall, demand weakness emanating from SGIP should not have a dramatic effect on the rest of the Eurozone.
Furthermore, exports of goods in the magnitude of more than 20% compared to GDP go outside the Eurozone for Germany, Austria, Finland, Belgium and the Netherlands. Together these countries account for 42% of Eurozone GDP vs. only 18% for SGIP. Furthermore, these exporters have relatively low fiscal deficits and in turn only a limited need for fiscal tightening. France and Italy face a less positive environment as they have a lower share of exports going outside of the Eurozone but will be impacted relatively more by the loss in demand emanating from SGIP and have higher fiscal deficits.
Euro has been weakening especially vs. competitors

Source: Bloomberg

Moreover, the Euro has weakened considerably on a trade-weighted basis which should give a significant boost to the exporters within the Eurozone and therefore for more than 40% of Eurozone GDP. Besides the weakening of the trade-weighted Euro which is based on trade relationships, the Euro has weakened even more vs. the currencies of key competitors. For example the direct trade relationships between the Eurozone and Japan are limited (accounting for 2% of all exports in goods and 3.5% of imports), but Japan is a key competitor in important industries such as cars and machinery. The fall by roughly 30% in the EURJPY cross rate over the past two years means that Eurozone exporters have become significantly more competitive in a short time-period. In turn, Eurozone exports should profit not only from Eurozone goods & services having become cheaper for its trade partners (or alternatively Eurozone corporates being able to increase their margins), but also that Eurozone goods have become much cheaper vs. close substitute products. Both factors should act to boost demand for Eurozone exports.
Consequently, we are likely to face a Eurozone economy where 18% (SGIP) will remain in a longer-lasting recession, 42% (the exporters) face strong external demand and Italy/France (accounting for 38% of GDP) will be able to muddle through. So far, the Eurozone’s current account has been close to zero amid very high deficits in Spain, Portugal, Greece and to a lesser extent France counterbalanced by substantial surpluses in Germany and the Netherlands. Going forward, the Eurozone current account promises to move into a significant surplus amid significantly lower deficits in Portugal, Spain and Greece and very high surpluses in Germany, the Netherlands and to a lesser extent, Finland, Austria and Belgium.

Monday, June 14, 2010

Intra-Eurozone competitiveness: A solvable task

Much has been written about the unsolvable problems for Spain, Greece, Ireland and Portugal which ultimately can only be dealt with via default. Additionally, the enacted austerity measures have been condemned as hurting growth and therefore increasing the debt burden, raising indebtedness even further. However, one should not forget that these countries essentially face two challenges: Over-indebtedness (mostly of the sovereign in Greece and mostly of the private sectors in Spain and Ireland with a mixture in the case of Portugal) as well as low competitivity. Yes, austerity measures depress near-term nominal growth and in turn raise indebtdedness further, however, they help to restore competitiveness.While the road ahead for Greece appears particularly challenging, there is a high probability that Spain, Ireland and Portugal will manage to solve most of their problems over a 3-5 year time period.
It is frequently stated that SGIP need an internal devaluation in the magnitude of 20-30%. However, this estimate appears wrong on several counts. They are usually derived by comparing the development of nominal unit labour costs (ULC) in Germany with those in SGIP. For example, nominal unit labour costs increased by approx. 8% in Germany since 1999 whereas they increased by approx. 36% in Greece. This suggests that Greece has lost 28% in competitiveness vs. Germany and hence needs an internal devaluation of the same magnitude.
However, one should not forget that Germany joined the Eurozone at an uncompetitive exchange rate. It took Germany several years to restore competitiveness vs. the other monetary union members which was one factor for its weak economic performance early last decade. Assuming that Germany had re-established competitiveness by the end of 2003, reduces the gap in nominal ULC between Greece and Germany to 15% (and 14% for Spain and Ireland and 13% for Portugal). Finally, SGIP need not restore competitiveness vs. Germany but rather vs. the average of the Eurozone. Nominal unit labour costs in SGIP since 1999 increased by 34% whereas ULC in the rest of the Eurozone increased by approx. 21% (see chart below). The difference between these two developments is substantial but not insurmountable. SGIP either need a reduction in nominal unit labour costs of 10% or the rest of the Eurozone needs an increase in nominal ULC of 11% to restore competitiveness in SGIP. More likely though is that we will get a mixture of the two, falling ULC in SGIP and rising ULC in non-SGIP.

Nominal Unit Labour Costs in SGIP vs. the rest of the Eurozone
Source: Research Ahead, Eurostat

The development of Eurozone country inflation rates suggests that the re-adjustment process has already begun. As the chart below shows, inflation in Spain, Portugal and Ireland (grouped together according to their GDP-weight) dropped into negative territory. More importantly, inflation rates are significantly below those in the rest of the Eurozone. Only Greek inflation is headed in the wrong direction. Greece has clearly more work to do and its outlook remains uncertain even beyond the 3-year lifeline provided. However, Spain, Ireland and Portugal have the ability to restore most of the competitiveness lost within the next 3 years. At the same time the announced austerity measures go a long way in bringing fiscal deficits to much lower levels and in turn restore debt sustainability. The price these economies will pay is negative nominal growth as well as a higher sovereign debt to GDP ratio (which will prove sustainable once fiscal deficits have been reduced and given the relatively low starting point especially in Spain and Ireland).
Inflation developments: SIP have already started to restore competitiveness
Source: Bloomberg, Research Ahead

In turn, we will face a divided Eurozone, a longer-lasting recession with negative nominal growth in SGIP and an export-led growth rebound in the North-East which should take both their real growth and inflation rates into the 2-3% range. Current account deficits in Spain, Portugal and Greece should shrink whereas surpluses in the North-East will rise, leading the overall Eurozone into a significant surplus. In turn, the burden of the necessary adjustment to restore competitiveness and debt sustainability in SGIP will not only fall on the SGIP themselves (via deflation) but also on the north-eastern Eurozone economies (via a somewhat higher inflation in the medium term).