David Karsbøl, Chief Economist
We have now reached the outcome that almost every bank in the world is trading on how strong the public finances are in the country that back-stops the bank’s liabilities. That means that everyone should focus on public finances… which they are.
No doubt we have some problems in the PIIGS countries and some of the 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 would still be okay if the majority of the G10 countries would have sustainable finances. The problem is that they don’t.
The lack of political understanding of the problems and the fact that most politicians that been contaminated with The Keynesian Drunken Sailor Spending Disease virtually guarantees that budget deficits will continue at least over the next 3-5 years – and probably a lot longer.
With debt markets already now about to vomit, this should be a major concern because the market is beginning to choke-off the Spanish banks completely from the non-Spanish interbank market. The extend and pretend game has continued for too long and the total leverage of the Western economies has increased during the crisis. Exactly nothing has been solved:
- Consumers have only moderately reduced their spending. The consumption/GDP ratio of the US economy is still hovering around 70%. That is way too much to ensure long-term growth.
- Banks are still lying about their balance sheets and we have to suspect that the majority are still insolvent. US banks are insolvent due to the massive defaults on mortgages and European banks are insolvent partly due to the same reason and partly because of their irresponsible exposure to Southern Europe. And banks are not going to start the securitization/lending machine in the next decade.
- Government spending continues almost unabated with very little attempt to actually reduce it. The extremely lavish entitlement programs are left untouched in most European countries.
In BIS Working Paper # 300, Cecchetti, Mohanty & Zampolli attempt to forecast the government debt / GDP ratios of several of the developed economies under three different scenarios. The ratios are predicted on a 30-year horizon and in most cases we end up in a completely impossible scenario. In the baseline scenario (no change on government entitlement programs and age-related spending), 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 the “middle-scenario” (#2) and use this to predict the government debt / GDP ratio and assume that household and corporate debt to GDP remains constant at the 2010 level, we reach the situation in below graph.
Source: BIS, Eurostat, Bloomberg, Saxo Bank Research own estimates
Total Debt / GDP is set to surpass 500 percent in eight out of the economies in question, including the US, the UK, Japan, Spain and France. From 1997 to 2040 the ratios will on average increase by 66% or more than 200 percentage points of GDP. In short, everybody will look like Japan in 30 years. We better learn how to cook rice and get the 75-year-olds to take care of the 100-year-olds in nursing homes.
BUT THIS WILL NOT HAPPEN. The only reason Japan manages to stay afloat until now is that their household savings were so big. Guess what? That 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 roll the ever-greater debt forever at ever-lower yields forever.
But none of the other countries in question have domestic savings sufficient to finance such public sector profligacy. Even assuming that governments will make “small and gradual changes” is a harsh assumption and we have only got very few examples in history where hell-bent administrations actually achieved to cut government spending. Margaret Thatcher is about the only politician who achieved a significant adjustment of government spending to GDP through her rule.
Not much in the political landscape of Europe indicates that we have a bunch of Thatcherites on their way in the immediate future and just achieving the “middle-scenario” for the BIS debt / GDP projections requires a tough and ongoing stance on deficits. This might, however, change as interest rates move higher across the board and the Tea Party movement is already having a lot of success in the US.
European voters and policy makers are seemingly still ignorant of the size of the problem and so far focus 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 vs. Germany will move higher and fiscal sustainability will be center-stage for the bond market. Germany, Denmark, Norway and Sweden will continue to benefit from their safe haven status and strong public finances. Our “outrageous call” for German 10-year rates at 2.25% in 2010 (see our Yearly Outlook) looks more and more realistic by the day (currently at 2.55%). At the same time, PIIGS spreads vs. Northern Europe will continue to edge higher as they have been doing lately
This development sends and important message: Let’s assume that the inflation/deflation outlook for Europe is roughly the same. With spread on 2-year notes (PIIGS-Germany) moving higher and with Germany et al verbally committing to a bail-out of the PIIGS that 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. One should in other words count on a restructuring and rumour has it that such restructuring would be happening over the coming weekend. Please don’t yell at me if I am wrong – this is only a rumour. But it would make a lot of sense and in my opinion it is the only way out of the debt trap Greece is caught in.
Look East…
We believe that the focus of the market will continue to gradually move to the east (began in the US in 2008 with subprime, then the UK with the big financial sector) and now Europe with the PIIGS debt problem. Next move will be toward the EE countries and we are already seeing concerns about Romania and Hungary. With the IMF being cash-strapped, the market will increasingly be expecting EE restructuring. Since IMF is the determining factor, one should also worry about the Baltic countries (again). We expect this to go on over the summer. Don’t get caught long HUF and RON.
Next phase in “focus-shifting” will be China: The global growth juggernaut that 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 once the unsustainable Über-Stimulus of China fades. We expect Chinese growth to moderate to 5-6% from 2011 and onwards. Therefore, the CRB Index will re-test the 2009 low of 200 (20% from current levels).
We are also considering (but not yet calling) the case for a head and shoulders formation in stocks (in 2010), which would lead to the creation of the right shoulder due to a strong earnings induced bounce from these levels to around 1150 and then 880 due to the coming Chinese slowdown and much bigger European (and US) austerity programs.
What it takes
Policy makers are moving painfully slow 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 “bombed back” to 2001 levels or so, but 2001 was not a social mass grave. 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 are only two 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. 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 the fact that no political leader has yet provided the vision and guts to demand it (and more).
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