Central Europe
CE-3: Fiscal Check-Up
February 16, 2010

By Pasquale Diana | London

Fiscal concerns are in the spotlight: The current focus on Greece and its fiscal woes has renewed interest in fiscal fundamentals. We have already looked at why fiscal woes are nowhere near as serious in Central Europe as they are in Greece (see "Greece and CEE - Contagion and Hedges Against Tail Risk", CEEMEA Investor, February 9, 2010). In this piece, we take a deeper look at the underlying fiscal position in the CE-3, look at various metrics to assess their fiscal health and gauge possible rating action.

Anatomy of the fiscal position in CE-3: We look here at the main metrics of the fiscal position in Central Europe vis-à-vis their EU peers. Broadly speaking, their debt/GDP ratios are lower, their deficits have been rising steadily but not as fast as their EU partners, and both their expenditure and revenues as a percentage of GDP are lower than the EU average (Hungary is the exception, though expenditures are being curbed). The Czech Republic and Polish fiscal positions have worsened over the last few years due partly to cyclical and partly to structural reasons (fiscal easing); the Hungarian fiscal position has improved dramatically over the last few years, but, as we will see below, the coming elections introduce risks around the fiscal outlook.

Czech Republic: Expenditure Overruns Leave the Next Government Plenty of Work to Do

Fiscal reforms to cut the structural deficit did not take place during the boom years, and therefore the Czech Republic entered the credit crunch with a fundamentally weaker fiscal position than the headline numbers suggested. At first, the authorities let the automatic stabilisers work to cushion the impact of the crisis. Later on, they approved their own stimulus package, which included, among other things, a cut in social security contributions (0.5% of GDP) and public infrastructure spending (0.4% of GDP). Of course, the Czech Republic also enjoyed the spillover effects of the German auto incentives on the Czech car sector. At first, the 2009 budget targeted a 2009 deficit of CZK 38 billion. However, as the year unfolded, revenues collapsed and expenditures took off, and it became very clear that this target would be greatly overshot. Eventually, 2009 ended with a central government deficit of CZK 192 billion, equal to over 5% of GDP. In ESA-95 terms, this is likely equivalent to a number not far from 7% of GDP.

At under 40% of GDP in 2009, the Czech debt position still appears comfortable, but there is no room for complacency, taking into account the fact that the Czech Republic has not yet approved pension and healthcare reform, and age-related spending will rise by 6% of GDP over the next 50 years, according to the IMF. The government approved measures which seek to cap the 2010 deficit at CZK 163 billion, consistent with an overall ESA-95 deficit of 5.3%. The plan relies heavily on indirect tax increases, as well as some expenditure cuts that expire in 2011 (not structural). The issue is, of course, that this was the best compromise that caretaker PM Fischer could achieve, given the circumstances (lack of a stable majority and an aversion to expenditure cuts by significant parts of the current political establishment). The main event this year will be the elections in May, with more fiscal slippage possible until then, as the main parties jostle for victory. A CSSD (Social Democrats) win would likely intensify fears of more expenditure overruns.

Hungary: Impressive Adjustment, Medium-Term Growth Is the Issue

The Hungarian fiscal dynamics do not follow at all the trend in the rest of the region. This is because, at the time its neighbours were enjoying the fruits of easy money and strong growth and failing to adjust their structural deficits, Hungarian authorities were busy seeking to avert a sovereign debt crisis. Already in late 2006, the authorities were implementing fiscal cuts, to reduce a budget deficit headed to double-digit levels (as a percentage of GDP). Mostly as a result of budget tightening, Hungary emerged as a clear growth laggard in Central Europe in the subsequent years, with overall GDP growth averaging just under 1% in 2007-08 (compared to 4.3% in the Czech Republic and 6.0% in Poland). Then, when the crisis hit in 2008, the Hungarian fiscal position (especially its relatively high debt stock), combined with its high share of FX-denominated private sector debt, meant that investors focused on Hungary as one of the ‘weak spots' within CEE. As funding fears escalated, the IMF/EC stepped in with a €20 billion package, which practically ensured continued fiscal tightening to this date, even in the face of the crisis, as part of IMF package conditionality. The measures concentrated mostly on the expenditure side (less likely to be reversed), with a targeted reduction of primary spending to potential GDP equal to 9pp (from 49% to 40%) between 2006 and 2011, according to IMF calculations. Over recent years, the authorities have scaled back social transfers, shifted the burden of taxation from labour to consumption, attempted to shrink the informal economy (‘whitening'), and made significant changes to the pension system to reduce long-term liabilities. Finally, to ensure the durability of these reforms, they passed the Fiscal Responsibility Law, a rules-based framework which includes the creation of an independent Fiscal Council.

The April elections will be the key event this year. With a comfortable lead over the Socialists, centre-right Fidesz looks certain to win the upcoming elections in April. Fidesz has on paper an ambitious plan to radically reform public expenditure, which despite recent cuts still far outweighs neighbouring countries, and potentially move to a flat tax. However, the full extent of these plans will only become obvious after the elections. Provided that the election outcome is market-friendly, we see a good probability of a rating upgrade by year-end (S&P especially). Recently, senior Fidesz members have made headlines by stating that the ‘true' fiscal deficit in 2010 will be in the region of 7.5% of GDP. This is because the current government is keeping the losses made at some state-owned enterprises out of the official accounts. The companies include hospitals, the Budapest Transport Company (BKV), the railway company (MAV) and unmet obligations of the local government. Clearly, as the central bank also notes, not all of these need to be recognised in the same year: assuming that just over half of them are recognised, the impact on the 2010 deficit might be 1.5% of GDP. Even if all were recognised in 2010, provided such debts do not continue to be incurred every year, they would represent a one-off, and a way to start with a clean slate (though the headline number may well upset markets).

The Hungarian authorities want to take the deficit below 3% of GDP by 2011, though the Fund notes that this will require further tightening.  These targets are however highly uncertain, due to politics. Even if 2011 is an ambitious deadline, Hungary's progress on the deficit front is undeniable. As we highlighted in the past, its debt stock, the result of its previous fiscal profligacy, remains the key issue. At 80% of GDP, it far outstrips its peers. And assuming a nominal interest rate of around 5.5-6% in the medium-to-long term (plausible), the debt/GDP ratio will continue to expand unless: i) Hungary's real trend growth rebounds to at least 3%; and ii) Hungary continues to run a primary balance (i.e., fiscal policy stays as tight as it is today). While 3%+ growth does not look like an impossible task for a converging economy, we note that Hungary is in the midst of a secular downtrend in its potential growth rate, and may suffer from much weaker credit dynamics in the years ahead as FX lending is phased out.

Poland: Fiscal Adjustment Looks Back-Loaded

Poland enjoyed the fruits of previous fiscal discipline and low debt/GDP and, much like the Czech Republic, allowed its deficit to widen when the crisis hit. Back in September 2007, we stressed that pro-cyclical fiscal policy at a time of strong growth was inappropriate, and would lead to significant fiscal deterioration as well as C/A widening (see Poland: Complacency Leads to Trouble, September 27, 2007). In the event, the budget deterioration was much larger than we would have thought plausible at the time, with the budget balance heading to over 7% of GDP this year. The recently published convergence programme provides an adjustment path that will see the deficit drop below 3% of GDP by 2012. In terms of the announced measures, the authorities plan to introduce a fiscal rule to limit discretionary (25% of total) spending increases to inflation + 1%, starting in 2011. This is not particularly tight, given that it allows spending to grow in real terms. Of course, provided real GDP grows by more than 1%, the expenditure/GDP ratio should drop. The government keeps the ambitious PLN 25 billion privatisation target for 2010, but transfers more money from this to the budget (from PLN 9 billion to PLN 12.9 billion). The rest will still go to medium-term-focused funds such as the Demographic Fund. Unfortunately, the programme lacks detail on pension reform, most likely because it was an issue over which the current coalition is divided; also, the fiscal adjustment is very back-loaded, and the bulk of it takes place in 2012, when the deficit drops from 5.9% to 2.9% of GDP. True, the programme also shows a less favourable macro scenario, in which the deficit does not drop below the 3% threshold until 2013.

The real objective for the government this year will be to maintain the debt/GDP ratio below 55%, a level which would trigger automatic fiscal tightening. The privatisation programme is essential in order to avoid an overshoot this year: it is encouraging that, thus far, the Treasury has already exceeded the 1Q target of PLN 3.0 billion, collecting PLN 3.7 billion through the sale of 10% of KGHM, 16% of Enea and 10% of Lotos. The targets for the remaining quarters of the year are PLN 7.5 billion, 7 billion and 7.5 billion, respectively. This is doable, but clearly only if the equity environment is supportive. If markets turned sour, probably the debt ceiling would be breached. If that were the case, the government may choose to amend the national definition of public debt. For instance, it could clarify how much of the state debt is due to pension reform (and is therefore the consequence of a necessary transition to the new system) and how much is more traditional debt. On the lower definition, we note that Polish debt would not be that far from Czech debt (around 40%).

Conclusion

Nowhere in Central Europe are fiscal fundamentals as weak as in the euro area periphery (see also CEEMEA: Greece and CEE - Contagion). Even in Hungary, the evidence speaks to an impressive fiscal adjustment that took place over the last few years. In the Czech Republic and Poland, the starting point is much better and, likely as a result, the authorities have been more complacent. Despite its superior fiscal fundamentals, sovereign risk is on the rise and, should long-term yields come under pressure in core markets, Central Europe would not escape. In an extreme scenario, we think that both the EC and the IMF would again get involved (as they did in Hungary, Latvia and Romania), though this is a tail risk so far. Election risk in Hungary and the Czech Republic is high this year, whereas equity market outlook is crucial to the success of the privatisation programme in Poland. We think that the odds are tilted towards positive rating action in Hungary (outlook change) and negative in the Czech Republic. The authorities maintain a realistic attitude towards EMU, as a combination of existing trouble within the euro area, uncertainty about the macro outlook and high budget deficits suggest that EMU could still be several years ahead. It is noteworthy that even in Poland, the country which had adopted an ambitious 2012 EMU target as recently as in late 2008, the latest convergence programme is consistent with EMU in 2014-15 at the earliest.

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CEEMEA
CEEMEA: Greece and CEE - Contagion
February 16, 2010

By CEEMEA Economics Team | London, Johannesburg & Dubai

Looking at spillovers, again: We briefly discuss here potential spillovers from current tensions in Greece to the CEE region. To reiterate, our euro area economists believe that, while extreme events cannot be ruled out, the ‘tough love' the EU is administering to Greece will ultimately result in an improvement in local finances (see Whither Greece? January 25, 2010). That said, continued tensions in Greece mean that we need to look at potential spillovers elsewhere. Concerns about sovereign debt have already triggered worries about Spain and Portugal's debt situation. In this piece, we look at what an escalation of the situation in Greece may mean for the economies of Central and Eastern Europe. We identify four main channels of contagion:

The banks - watch Bulgaria and Romania: Greek banks have invested heavily in Emerging Europe over recent years. In Bulgaria and Romania for instance, the largest four Greek banks account for 40% and 25% of total loans in the country, respectively. The business model for these banks is that they are partly funded with loans from Athens rather than local deposits. The extreme tail risk is that Greek banks retrench on a large scale, choose to focus on their core business and decide not to roll over the existing loans to their CEE subsidiaries (which mature every few months). This extreme case, however, is very unlikely to happen, according to our equity analysts, due to reputational risk associated with withdrawing from these markets. Also, they note that Greek banks' loans to Emerging Europe are just over 10% of the total loan book, so the costs of pulling out would probably outweigh the benefits. Finally, we note that this risk of large-scale withdrawal from the region has been grossly over-emphasised in the past: Austrian and Italian banks have rolled over the lion's share of their loans to their subsidiaries in CEE, and the mass-scale withdrawal from the region that some were predicting just did not happen. The exposure of the banking system in Turkey to volatility in Greece is even less of an issue, with the total size of the loans from the country representing less than 5% of GDP and less than 10% of the total private sector loans. 

So, is Emerging Europe immune? No. Our equity analysts believe that Greek banks will seek to move away from the external funding model for their Emerging Europe subsidiaries, and try to grow the local deposit base faster than loans, to reduce leverage; in the extreme, they may refrain from making fresh loans for a while. As a result, CEE economies which are under-leveraged already may suffer from a severe shortage of credit, which derails the recovery. Bulgaria (and to a lesser extent Romania) look most at risk here.

Fiscal concerns - Hungary concerns understandable, but likely overblown: By far the most frequent question we get these days is which country in CEE is most at risk from a fiscal standpoint. A superficial look at fiscal metrics would place Hungary at the extreme end, with a debt/GDP ratio of just under 80% of GDP, significantly higher than its peers (Poland: 52%; Romania: 22%; Czech Republic: 38%, all end-2009). While this is true, we would highlight that a more careful examination of the fiscal position highlights that Hungary has actually the lowest budget deficit in Central Europe, and one of the lowest in the whole EU, as a result of previous fiscal adjustment as well as the strictures imposed by the IMF package. So, while the stock picture may be gloomy, the flow one is more favourable. In addition, the comparison with Greece looks far-fetched to us, even in Hungary's case: according to Eurostat numbers, Greek debt/GDP could climb to 125% of GDP this year, while Hungarian debt may be around 80%. What's more, the debt dynamics are totally different: the primary balance (i.e., before interest payments on existing debt) is around flat in Hungary, and around 7% of GDP in Greece. While contagion fears are entirely rational, the actual numbers suggest that the underlying fiscal situation in CEE (even Hungary) is nowhere near as serious as in Greece. In addition, the main issue for markets at the moment is a liquidity crunch for sovereign borrowers, rather than long-term solvency per se. And Greece's government borrowing needs for this year exceed those of Hungary, with €20 billion worth of redemptions coming due in April and May, and total (gross) borrowing needs for the year of €55 billion. In Hungary, gross borrowing needs for 2010 are around €25 billion (57% are maturing T-bills, which should be rolled easily), and the recent US$2 billion bond deal has covered FX funding needs for the entire year already. Regarding any contagion concerns towards Turkey, we believe that the impact would be only indirect via an overall risk-aversion rather than specific concerns towards the country's fundamentals. With an improved fiscal outlook (deficit heading to 5% of GDP or lower) and a debt to GDP ratio below 50%, we think that Turkey is not in the higher echelons of risky credits.

The real economy - who does Greece do business with? Considering further channels of contagion from the real economy, we looked at trade, remittances and FDI flows within the region. Trade relations with Greece are most important for Macedonia, Bulgaria and Albania. Trade is surprisingly small with Serbia, but the evidence shows that most trade is with Montenegro (separated from Serbia in 2006).

We looked at the migration situation in Greece to assess the danger of remittances flows drying up. The available statistics suggest that Albania would be most affected, as 65% of Greece immigrants are from this country (2004 Greek Ministry of Interior data). Total workers' remittances were around 12% GDP in 2009 (World Bank estimates) in Albania, of which we estimate that at least US$900 million (8% of GDP) came from Greece. After Albania, the next biggest immigration sources are Bulgaria and Romania (less than 10% of total each) but relative to their GDP, remittances flows won't play as significant a role, so should be a smaller source of contagion. Looking at FDI data available, we conclude that Macedonia, Serbia and Bulgaria are most vulnerable. Greece is the largest foreign investor in Macedonia (15% of the total FDI stock, 7% of GDP), followed by Holland and Hungary. It is present in all major sectors: banking (28% of Greece's total investment in the country), energy (25%), telecommunications (17%), industry (15%) and food (10%). In Serbia, Greece is the second-largest source of investment (14% of the total FDI stock), including banking, telecommunications and tourism. In Bulgaria 8% of total FDI stock (8% of GDP) is of Greek origin, and Greek FDI flows to Bulgaria had already plummeted in 2009. The data for Albania are not available, but we expect Greek FDI to play an important role there as well.

The political economy argument and EMU membership - risks of delay: The unfolding Greek situation risks having ramifications for longer-term CEE euro adoption prospects. This, as Elga Bartsch puts it, is the first real test for the euro's institutional framework. Even though we think the test will be passed, this episode will likely act for years as a reminder that it is not enough to meet the nominal Maastricht criteria to prove ability to live in EMU. For countries poorer than the EU average, the lower level of rates allowed by EMU increases the risks of excessive borrowing, wide current account deficits, lack of fiscal control and loss of competitiveness. The current crisis experienced by Greece and others suggests that, aside from insistence on the Maastricht criteria, the EC/ECB may start putting far more emphasis on factors such as external imbalances, budget positions, proven ability to implement counter-cyclical fiscal policy and overall policy credibility. In this scenario, investors may think about re-pricing CEE convergence, and companies which invest in the region may want to prepare about planning for FX volatility for a decade or more, rather than just four or five years.

The Baltics and Ukraine - Far Easier to Bail Out

Looking further afield to north-eastern Europe, direct trade or banking links with Greece are minimal.  Clearly, the main risk is more that countries with highly fragile fiscal positions are caught up in the general consensus about avoiding exposure to weak sovereigns.  The crucial difference we think is that these countries are far easier to bail out.  Turning to the IMF is far from painless, but involves few of the constitutional and structural obstacles it would for a euro member.  For EU members outside EMU, the EU also has a support fund currently at €50 billion, already in use for Latvia, Hungary and Romania, and allowing some very generously funded programmes. 

In the Baltics, we continue to see a wide differentiation of risks.  For Estonia, the primary risk is that Greek concerns could drive a rejection of its EMU application this year.  We still think this is highly unlikely, if - as we assume - 4Q09 data confirm that Estonia met the fiscal criterion in 2009.  A rejection would have wide repercussions on EMU hopes for Eastern Europe, and we think would bring serious political fallout.  We think that Estonia will no doubt loosen fiscal policy significantly in 2011, as other members have done once membership is confirmed.  But government debt is still negligible (7% of GDP) and spreads still look wide to us. 

In Lithuania, the fiscal position is more serious, a deficit of 9.5% of GDP, but the debt position (33% of GDP) is still such that we think EMU membership is achievable within five years, before debt reaches 60% of GDP.  The government can currently fund the deficit in both external and local markets, though we think that this effectively reflects implicit IMF and EU support.  We are confident that both will step in quite quickly if needed, given the government's willingness to make spending cuts.  In Latvia too we no longer see a significant risk of devaluation this year, in this case because of actual massive support from the EU and IMF.  The government's Treasury balance at the National Bank stands at the equivalent of €1.8 billion, already enough to cover the 2010 deficit.  That the 2010 budget has been passed leaves Latvia on track to receive a further €2.5 billion this year, in what is a very generously funded programme. 

Investment in Ukraine remains a moral hazard story, effectively dependent on the return of the IMF.  Sovereign debt levels are manageable, and we do not expect sovereign restructuring, despite this week's comments by incoming President Yanukovich.  However, the current fiscal position is very serious.  We expect the Fund to come back, but a drawn-out process of government formation clearly brings risks of delay.  With no access to the external market for several years already, Greek contagion is likely to be a much less significant driver of risk perception than domestic politics. 

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Euroland
Portugal and the EMU Periphery
February 16, 2010

By Daniele Antonucci | London

Summary and Conclusions

In this report, we focus on the fiscal situation in Portugal and compare it with that of other EMU peripherals. We reach six main conclusions:

•           Current market concerns have more to do with short-term liquidity risk than long-term solvency risk. Volatility is likely to remain high, though it might not truly reflect the fiscal fundamentals.

•          Core and peripheral  EMU countries are deeply intertwined. Contagion risk, should it materialise more visibly, might have euro area-wide implications.

•           Greece is in a unique situation in Europe, we think. Although the other EMU peripherals are superficially similar to Greece in some respects, none of them scores poorly on so many fronts.

•           Portugal's fiscal fundamentals are not too different from the ‘typical' euro area country, though it has high private sector debt and a wide current account deficit relative to the size of its economy.

•           There is considerable scope for Portugal to boost GDP growth through structural reforms. In particular, product market liberalisation and allowing for market competition are key, in our view.

•           Although the 2010 budget has not yet been approved, we think that the solid social cohesion in Portugal bodes well for these reforms taking place.

Liquidity Risk versus Solvency Risk

What's in the Price?

Sovereign risk analysis is back in vogue in Europe. Markets are increasingly concerned about the fiscal positions of several European countries, mainly at the EMU periphery. For example, the cost of insuring against default in the credit default swaps (CDS) market has risen (and bond spreads have widened).

In Portugal too - and even more so in Greece - the 5-year CDS spread, which measures the cost of insuring against a government violating the conditions of a debt contract, has increased notably. At over 200bp, the spread indicates that a buyer of such protection would need to pay two cents every year for $1 of protection against the Portuguese government defaulting.

This implies that the markets are pricing in slightly less than a one in five chance of the government defaulting over the next five years, under the assumption that 40% of the principal is recovered in the event of a default. We disagree with this, and think that current market concerns have more to do with short-term liquidity risk than long-term solvency risk.

To assess the short-term risks around the EMU peripherals, our interest rate strategists have put together an estimate of the funding-related cash flows for these countries (see European Interest Rate Strategist - Sovereign Risk in Context, February 5, 2010). Of course, the coupons and redemption amounts are known. But the future supply numbers are unknown. Our strategists have projected them according to the historical supply patterns and the borrowing requirements announced by the individual countries. The starting point of this exercise is the government cash balance at the central bank. Then, the cumulative cash balance is projected according to the funding-related inflows and outflows.

The schedule of coupons and redemptions shows the pressure points for the individual countries. For Portugal, May is the big payout month. Spain paid almost €27 billion of redemptions in January, but faces another €30 billion in July. For Greece, the pressure points are April and May, when the government will need to pay €20 billion of coupons and redemptions. From this perspective, event risk and volatility remain high, though they are not necessarily a true reflection of the long-term sustainability of the Portuguese public finances, for example, as we will see in the next section.

Gauging the Contagion Risk

This is not to say that short-term liquidity risk should be dismissed. We believe that it is important. What's more, like all developed countries, the EMU peripherals need to tap the market for their funding needs. So, a hypothetical situation in which one or more of them faces difficulties in refinancing the debt might quickly result in widespread contagion.

Thus, understanding the potential repercussions is key. This fits with our global theme #5: sovereign and inflation risks on the rise (see Global Forecast Snapshots - 2010 Outlook: From Exit to Exit, December 9, 2009).

Three quarters of the Portuguese and Irish government debt is held abroad, probably in other euro area countries. This compares with two-thirds for Greece, 42% for Italy and 60% for Spain. In case of adverse news, which could potentially push interest rates higher, foreign holders might hold on to the debt to a lesser degree than domestic holders (the so-called ‘home bias' effect). Another option to gauge the potential repercussions is the BIS cross-border bank lending database. French banks have the highest exposure to EMU peripherals - particularly to Italy and Spain - amounting to 32% of GDP.

What's more, Swiss banks have the highest exposure to Greece, amounting to roughly 12% of Swiss GDP. In turn, the various peripheral countries are highly intertwined too. Perhaps unsurprisingly, Spain is exposed to Portugal, for example. Of course, this reflects foreign subsidiaries, but the bottom line is that - regardless of the fundamentals - a short-term funding problem in one of the EMU peripherals, at least theoretically, might result in more widespread funding problems (though an eventual rescue package in one country would benefit all the others).

Portugal versus Other EMU Peripherals

The Basics

Portugal's public debt, relative to the size of its economy, is roughly in line with that of the euro area. At the onset of the financial crisis in 2007, it stood at 63.6% of GDP, against an average of 66% in the euro area as a whole. And we expect it to have risen to around 75.6% in Portugal last year, still below the euro area average of 81.2%, and significantly lower than in Italy (115%) and Greece (112.1%). Among the EMU peripherals, only Spain does better than Portugal on this measure, with a debt-to-GDP ratio of 64.9%.

What's more, the estimated change in the debt-to-GDP ratio between 2007 and 2010 is slightly smaller in Portugal than in the euro area as a whole (20.5ppt to 84.1% in the former versus 21.2ppt to 87.4% in the latter) - a smaller ‘delta' relative to Greece (26%), Spain (29%) and Ireland (53%, though this is ‘high-quality' debt, as the assets that the government acquired could be sold at a later stage). Among the EMU peripherals, only Italy does better than Portugal on this measure, with a change in the debt-to-GDP ratio of about 14%.

The cost of debt too is roughly in line with the euro area average in Portugal. Indeed, interest expenditure amounted to around 3% of GDP in both economies last year. Of course, the cost of debt looks set to increase over the next two years, but this trend is common to virtually all euro area countries. What matters is that interest expenditure - as a percentage of GDP - is likely to remain lower in Portugal than in other EMU peripherals with the exception of Spain.

Of course, this does not mean that Portugal has no homework to do from a fiscal standpoint. Indeed, the government now estimates last year's budget deficit at 9.3% of GDP compared to a previous estimate of 8.3%. This means that fiscal consolidation - clearly one of the key economic themes in Portugal over the next few years - is starting from a deeper hole. On this measure of fiscal vulnerability, Portugal does considerably worse than the euro area average.

Debt Affordability - Who's at Risk?

There is no universal definition of debt affordability. For us, debt affordability is the ability of a country to contract a large amount of debt at an affordable cost. Debt affordability has hardly deteriorated in Portugal from 2007 - and we expect it to worsen only by a small degree over the next two years despite rising public debt. What's more, the slope of the debt trajectory in Portugal is similar to that of the euro area as a whole, reflecting a solid ability to contract a large amount of debt at an affordable cost. Apart from Italy - which has historically carried a high debt load - the other EMU peripherals exhibit a steeper debt trajectory.

Another way of approaching the question of debt affordability is by looking at the trend of interest payments as a percentage of GDP over time. The picture that emerges is that, historically, EMU peripherals have been able to cope with higher interest rate burdens than today. For example, interest payments peaked at around 12% of GDP in Italy and Greece in the early 1990s. At the end of last year, they stood at around 5% of GDP in both countries. Clearly, there is still considerable scope for the cost of debt to rise further without putting public finances under considerable stress. Furthermore, Portugal's interest expenditure-to-GDP ratio is currently roughly in line with that of Germany and France.

Thinking Long Term, Very Long Term

So Portugal's fiscal position compares favourably to that of other EMU peripherals - at least from a short-term perspective. What about the long term? The main concern here is that ageing-related expenditure might contribute to an increase in the debt-to-GDP ratio over the next decades. Recent European Commission's projections (see the Sustainability Report, October 23, 2009) show that, on unchanged policies, by 2060 the debt-to-GDP ratio would be 389.9% of GDP in Portugal.

As alarming as this might sound, however, Portugal's long-term fiscal sustainability seems less at risk relative to most other euro area countries. Indeed, the projections show a debt-to-GDP ratio of 884% in Greece, 848.5% in Ireland, 766.6% in Spain and 431.3% in France. Indeed, only Germany (318.9%) and Italy (205.9%) would have a lower ratio in 2060 according to this (admittedly very uncertain) simulation exercise.

Naturally, these projections - based on the assumption of no government policy change - are unrealistic, and in the above-mentioned report the Commission clarified that the simulation exercise is not a forecasting exercise. Of course, it is unlikely that bond markets would keep financing government debts amounting to a multiple of the GDP of the respective countries - or that governments would maintain their policies unchanged in the presence of ever-increasing debts. Still, these simulations are useful, we think, because they rank all the European countries on the same metrics, thus highlighting the risks faced and the need for deep structural reforms to bring potentially exploding public finances under control.

Indeed, the Commission's assessment shows that the long-term sustainability risk to Portugal's public finances is medium - together with Germany, France and Italy. Conversely, the long-term sustainability risk to the Greek, Spanish, Irish and Dutch public finances is high. Outside of the euro area, the UK is another country at high long-term sustainability risk, based on these projections.

What's more, the size of the structural primary balance, i.e., the budget balance excluding interest payments, required at the beginning of the simulation exercise to ensure a sustainable budgetary position in the light of the cost of ageing and the cost of debt seems manageable in Portugal. In contrast, the structural balance that would be required at the beginning of the simulation horizon to close the sustainability gap appears remarkably high - and well above any primary surplus ever recorded in any European country - in Greece. To a lesser extent, Spain and Ireland too need to run a sizeable primary surplus, while Italy's required fiscal effort seems smaller and in line with its historical achievements.

Starting to Defuse the Demographic Time Bomb

Why is the adjustment in the primary balance required to ensure fiscal sustainability in the long term smaller in Portugal than in most other European countries? After all, as birth rates have fallen, working-age population is already declining in several European countries. And this trend looks set to worsen.

Indeed, the pace of the decline in the working age population is likely to be faster in Portugal and in Greece, for example, than in other EMU peripherals, namely Italy and Spain, according to projections of several international organisations - such as the UN.

The favourable position of Portugal stems from a much lower projected cost of ageing - relative to other EMU peripherals and to the euro area as a whole. The European Commission expects an increase in ageing-related expenditure of 2.8% of GDP between 2009 and 2060 in Portugal and of 4.8% in the euro area.

Furthermore, the situation seems to have improved in Portugal, courtesy of the effects of the social security reform back in 2006 (which included an increase in the pension age and an alignment of private and public pensions). Indeed, in its previous assessment three years ago, the Commission projected the cost of ageing for the Portuguese economy at 9.7% of GDP between 2009 and 2050 - some 7ppt higher than the current projection.

Conversely, the situation seems to have deteriorated in the euro area as a whole - where some countries still have to start addressing their long-term fiscal challenges. The Commission projected the cost of ageing for the euro area economy at 4.4% of GDP between 2009 and 2050 - slightly lower than the current projection.

Based on current policies, ageing-related expenditure is projected to increase across the board in developed Europe, but to a very different degree. Three groups of countries are easily identifiable:

1.         Greece, Spain, Ireland and the Netherlands, where the increase in the cost of ageing over the next 50 years is likely to be very high (above 7ppt of GDP) - though their starting level is currently below the euro area average.

2.         Germany, Belgium, Finland and the UK, where the increase in ageing-related expenditure between 2010 and 2060 is likely to be more limited, but still high (4-7ppt of GDP) - closer to the lower end for the UK and to the higher end for Belgium.

3.         France, Italy, Portugal, Austria, Sweden and Denmark, where the increase in the cost of ageing is more moderate (below 4ppt of GDP) - courtesy of recent pension reforms, in some cases involving a partial switch to privately funded pension schemes.

The upshot is that while a number of EMU core and peripheral countries still have to start addressing the pension and healthcare issues that might weigh on the long-term sustainability of their public finances, Portugal has already begun to implement structural reforms in various areas. In our view, Portugal compares favourably with the other EMU peripherals - and with some core countries as well - at least strictly from a long-term fiscal sustainability perspective.

How about Private Sector Debt?

We have so far discussed fiscal sustainability by looking at the public sector in isolation. However, the private sector is important too for an overall sustainability assessment. Indeed, to the extent that overly indebted households and firms need to tighten their belts, fiscal policy may need to be more expansionary than otherwise - in order to make up for the resulting shortfall in private demand.

The bottom line is that the attempt to prompt the deleveraging of the private sector often results in a more risky public sector. This is not a criticism of policymakers' actions. Rather, it is an observation that nothing comes without a cost or side effect. Indeed, policymaking often implies trade-offs between one scenario and another - after all, there is no such thing as a free lunch.

The private sector is highly indebted in Portugal, along with Spain and Ireland. In particular, the sum of household and corporate debt amounts to 229% of GDP in Portugal, much higher than the 164% euro area average. This makes the Portuguese public sector riskier than by looking solely at the public debt. Private sector debt is particularly low in Greece, Germany and Italy, by European standards, while it is higher in France.

Financing the Current Account in the EMU

The high private sector debt in Portugal is one reason behind the deterioration of its international investment position (i.e., what a country owns versus what it owes). Hence, looking at the financing of the current account is another key aspect.

Does it Matter?

In a world of large international current account imbalances, the euro area is a fairly balanced economy. Indeed, its current account deficit was just 0.6% last year, on our estimate, and we expect a surplus of around 0.5% this year. But the aggregate picture conceals remarkable cross-country differences: while the sustainability of the current account is not an issue for the euro area as whole, some high-deficit countries might experience medium-term financing constraints.

Persistent current account deficits might make it difficult to finance the shortfalls, as investors find themselves with increasing amounts of that country's debt in their portfolios. To compensate for the rising exposure, they might require a higher risk premium through a lower exchange rate or higher interest rates. The former does not apply within the EMU. But the latter is still relevant even if the base rate is set for the euro area as a whole (i.e., the adjustment happens via asset prices).

How Is it Financed?

Last year, the countries with the highest current account deficit-to-GDP ratio were Portugal (-9.7%), Greece (-7.1%) and Spain (-4.1%), on our estimates. In contrast, the countries with the highest current account surplus-to-GDP ratio were the Netherlands (+6.6%), Germany (+4.2%) and Finland (+2.1%). France (-2.6%) and Italy (-2.5%) ranked in between.

Of course, an economy with a persistent current account surplus, being a creditor country, does not raise sustainability worries - exporting capital is easy. But the issue for a debtor country is where the financing will come from next. The deficit reflects financing needs that cannot be met by domestic savings. In other words, these financing needs represent the difference between domestic investment and savings reported in the financial account of the balance of payments.

Broadly speaking, a current account deficit that is financed by a steady flow of long-run - and hence slow-moving - capital flows tends to cause less anxiety than one financed by short-run financing flows (‘hot money'). Examples of the former are foreign direct investments (FDI) such as purchases of companies or large equity stakes, or purchases of real estate, which are difficult to liquidate in the short term. Examples of the latter are portfolio investments in stocks and bonds, or short-term lending from the financial sectors of the rest of the world, which tend to expose the economy to more shocks - through fluctuations in sentiment and movements in exchange and/or interest rates. Therefore, if a country relies heavily on short-term capital flows, it may face more risk in terms of financing its current account deficit in adverse economic climates.

‘Hot Money' Playing a Big Role in High-Deficit Countries

The sizes of the current account deficits in Portugal, Greece and Spain raise the question of whether they could be sustained in the future.

Clearly, the deficits are narrowing, courtesy of weak imports - not booming exports. Still, they remain wide. From this perspective, how the deficits are financed becomes relevant:

•           ‘Hot money' constituted a large part of financing in Portugal, Spain and Greece in recent years. This suggests that - all else being equal - these countries are more exposed to changes in market sentiment and movements in interest rates compared with their euro area neighbours, when it comes to financing their current account deficits.

•           Indeed, short-term financing has dominated over long-term financing, with net inflows of portfolio investments and currency/deposits, and net outflows of FDI over the years, particularly in Spain. What's more, Portugal has relied more on the ‘other investment' category over the years, which refers to short-term lending in the form of deposits.

•           ‘Middling' countries, such as Italy (and France), have seen their current account balances deteriorate in recent years. However, the size of their deficits is more manageable and considerably smaller than that in Portugal, Spain and Greece. Recently, portfolio investment has been the primary contributor to the inflow of financing in both countries.

•           From a current account financing perspective, Ireland's position looks sound. After a relatively small current account deficit last year, we expect it to run a surplus this year and the next. Clearly, one reason for this improvement is that import growth will likely remain subdued and exports should benefit from a weaker euro and stronger foreign demand.

Putting it All Together ...

Bringing together all the factors that we analysed separately in the previous sections, the main takeaway is that the EMU periphery is a very heterogeneous bunch. More specifically, one question that seems to be on many an investor's mind is ‘after Greece, who's next?' (see European Economics Chartbook: Expanding at a Pedestrian Pace - Ripples at the Periphery, February 1, 2010). From a fiscal standpoint, we think that Greece is in a unique situation in Europe at this stage (see Whither Greece? January 25, 2010), for two reasons:

•           First, Greece has a high debt-to-GDP ratio, as well as wide public and current account deficits. While Italy, Spain, Portugal and Ireland all score next to Greece on some of these metrics, none of these countries is comparable to Greece on all of these indicators.

•           Second, Greece's tax collection mechanism and statistical reporting need to be improved, by the government's own admission. Although there is scope for improvement in many EMU countries, the picture looks better in most of them on both fronts.

However, there are two caveats:

•           First, what matters, from a long-term sustainability standpoint, is the ability to service the debt. Although Greece's debt-to-GDP ratio is slightly higher than Italy's - and the deficit-to-GDP ratio considerably wider - interest payments represent approximately the same share of GDP in both countries.

•           Second, the above-mentioned factors (public debt, budget balance and current account balance) are very important; but they are just some of the drivers behind a country's overall fiscal picture. Indeed, private sector indebtedness, especially at this juncture, is crucial too.

We captured the above-mentioned factors (namely current account balance, budget balance, public debt, interest payments and private sector debt) in a ‘radar' chart, which compares the EMU peripherals and the euro area. The main takeaway is that Portugal looks more vulnerable on its current account deficit and private sector debt.

What's more, Spain and Ireland score poorly on the private sector debt measure too. Finally, except for its high public debt, the other ratios are close to the euro area average in the case of Italy.

Economic Growth and the ‘Debt Trap'

So the fiscal position of Portugal is not particularly critical. But sluggish economic growth prospects have implications for the sustainability of public finances too. As an illustrative example, we focus on the evolution of one key variable: the debt-to-GDP ratio. The behaviour of this ratio is driven by the dynamics of the numerator (the stock of public debt) and the denominator (nominal GDP). The time path of the stock of debt D is given by the standard debt equation:

D(t) = -[T(t) - G(t)] + [1+i(t)] x D(t-1) + a(t)     [1]

where D(t) is the stock of debt at time t, i(t) is the interest rate paid on this debt, T(t) - G(t) is the primary surplus - defined as government/tax receipts T minus government spending (excluding interest payments) G - and a captures one-off factors, e.g., privatisations and asset sales. Similarly, the dynamic of nominal GDP (NGDP) could be modelled using the following equation:

NGDP(t) = [1+n(t)] x NGDP(t-1)     [2]

where n is the rate of nominal GDP growth (the sum of real GDP growth and the GDP deflator growth).

In the absence of any contribution from the primary balance (i.e., T(t) - G(t) = 0) and one-off factors (i.e. a(t)=0), we can see from equations [1] and [2] that the debt over GDP ratio would be driven by the difference between the rate of (nominal) GDP growth n and the implied interest rate paid on the public debt i. In this stylised case, if n is larger than i, then the ratio of debt over GDP will fall over time, and vice versa when i is larger than n.

The interest rate i(t) that the government pays on its debt is close to 4%. Hence, one way to ensure a downward path in the debt over GDP ratio - all else being equal - would be to maintain the growth rate of nominal GDP above 4% in the long term. With GDP deflator growth averaging 2.8% since 1999, the rate of growth of real GDP would need to remain above 1.2% so that n remains larger than i. Reassuringly, Portugal's economic growth has been adequate - though barely so.

This matters, because the fiscal challenges of the years ahead - coupled with slow economic growth - might result in a ‘debt trap'. For example, let's assume that annual nominal GDP growth is 5% and interest rates are two percentage points higher. In this example, a government with debts equal to 25% of GDP would need to run a primary surplus of just 0.5% of GDP each year to ensure that the debt-to-GDP ratio remained unchanged.

But this would rise to 1.0% of GDP if interest rates were four percentage points higher than GDP. And, if the government's debts were equal to 150% of GDP, then it would need to run a primary surplus of around 2.9% to prevent the debt-to-GDP ratio from rising, even if nominal interest rates were only 2% higher than nominal GDP growth. The upshot is that boosting economic growth is almost a necessity in the context of the fiscal challenges ahead.

Boosting Economic Growth - Will Portugal Make it?

Against this background, the pace of growth of the Portuguese economy has been far from impressive: since the inception of the EMU, Portugal has expanded by a mere 1.2% on average, far slower than the euro area average of 2.0% and than its own post-war norm. Indeed, GDP growth has steadily declined from approximately 3% in the 1970s and in the 1980s. The economy stagnated in 2008, and contracted sharply last year. The outlook for 2010-11 remains very fragile.

Will fiscal consolidation result in slower GDP growth? Not necessarily: it might result in a strengthened economy, if structural reforms are part of the package. From this perspective, the European Commission highlighted that about half of the fiscal consolidations in Europe over the past 30 years or so had non-traditional, counterintuitive, effects (see part IV of Public Finances in the EMU, 2003).

In a nutshell, as consumers/firms are forward-looking, they base their spending decisions on their expected long-term income/return, not just their current income/return. Changes in expectations can offset the initial impact of fiscal policy. What's more, if healthier public finances positively affect long-term expectations, perhaps because of hopes of future tax cuts, the detrimental effect of the tightening will diminish. The bottom line is that some reforms are needed to enhance competitiveness. Indeed, unit labour costs have been on an upward trend for at least a decade in Portugal and in the other EMU peripherals, unlike in Germany and in France.

It is sometimes said that it is difficult to improve price competitiveness in a country in a monetary union because no unilateral currency devaluation is possible. But even in a monetary union so-called ‘good deflation' can be generated by deregulating product markets and allowing for market competition (EU funds, for example, could be used for the necessary reforms).

Examples of countries improving their competitiveness within the EMU go beyond Germany; Finland, Austria and the Netherlands have done it too. Another way to improve a country's terms of trade within a monetary union would be through a VAT rate hike. This would affect only the price of domestic goods and services (making them more expensive) - but not exports (which don't carry VAT).

The government seems to be moving in this direction, we think. Indeed, while the new stability programme will be submitted to the European Commission in the coming weeks (and feedback will be provided after some time), the 2010 draft budget focuses on the following broad guidelines, in addition to reiterating the commitment to correct the excessive deficit situation by 2013:

1.         Restraint in public spending, with particular emphasis on wage policy and the complete phasing-out of the anti-crisis measures this year.

2.         Maintenance of fiscal stability (including controlling fraud and evasion) and measures to reduce primary expenditure and the public debt.

3.         Public investment focused on increasing competitiveness and employment, and reducing dependence on non-renewable energy.

The government's thinking in terms of solving Portugal's main structural deficiencies is sound, in our view, and almost unanimously shared (more domestic competition, especially in the services sector, additional investments in research and development, improvements in material and immaterial infrastructures, increased efficiency in the public administration, bigger and more internationalised firms).

Clearly, Portugal has a lot to gain. For example, in its latest country assessment (the so-called Article IV Consultation), the IMF estimates that, in the long run, a cut in government consumption would free up resources for private consumption and investment. The Fund's simulations suggest that output would be 2% higher than in the baseline. And a permanent reduction in the wage markup would result in large gains in terms of GDP, employment and consumption. In the long run, output would be 3% higher than in the baseline - courtesy of higher employment and higher capital stock. Indeed, a lower price for labour relative to capital is likely to encourage firms to adopt more labour-intensive technologies and to increase their labour demand.

Whether these broad guidelines will actually be implemented, and in what form, remains to be seen. The government no longer has absolute majority; it has until March 12 to debate and vote the budget - and another month will then be needed for the budget to be published in the official bulletin, thus coming into effect. Encouragingly, the opposition seems inclined not to vote against the budget. And, perhaps more importantly, the Portuguese society does not appear to be hostile to change. For example, social unrest and various forms of industrial conflict are relatively rare in Portugal - indeed, the number of workdays lost due to strikes is almost the lowest in Europe. This bodes well for fiscal consolidation.

Conclusions

In all, there are six main takeaways for financial markets:

•           First, current market concerns have more to do with short-term liquidity risk than long-term solvency risk. Volatility is likely to remain high, though it might not truly reflect the fiscal fundamentals.

•           Second, core and peripheral EMU countries are deeply intertwined. Contagion risk, should it materialise more visibly, might have euro area-wide implications. Germany, France, the UK and Switzerland are highly exposed to EMU peripherals.

•           Third, Greece is in a unique situation in Europe, we think, as it scores poorly on virtually all the fiscal indicators. Although the fiscal position of all the EMU peripherals is similar to Greece's in some respect, none of these countries scores poorly on so many fronts.

•           Fourth, Portugal's fundamentals are not too different from the ‘typical' euro area country. From a long-term sustainability standpoint, Portugal scores better than most other EMU countries, but it has a high private sector debt and a wide current account deficit.

•           Fifth, there is considerable scope for Portugal to boost GDP growth through structural reforms in order to regain competitiveness. In particular, product market liberalisation and allowing for market competition are key, in our view.

•           Sixth, although the 2010 budget has not yet been approved, we think that the solid social cohesion in Portugal bodes well for these reforms taking place, but it will take time to see results.

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United States
Review and Preview
February 16, 2010

By Ted Wieseman | New York

The Treasury market saw significant long-end-led losses over the past week that sent the yield curve to new record highs as global market attention was mostly on developments in Europe through the week until China came with another surprise required reserve ratio hike on Friday that allowed Treasuries to make back ground after a run of four days of losses through Thursday when attention was on Greece.  Domestically, a lot of Treasury market focus was on the refunding auctions, all three of which were on the soft side, which we haven't seen in a run of auctions in a while.  Big adjustments in mortgage market valuations and positioning also were substantial rates markets movers after Fannie Mae and Freddie Mac boosted efforts to buy delinquent mortgages out of their guaranteed MBS pools, with a significant late week underperformance by higher-coupon MBS but a strong relative showing by lower coupons.  Domestic economic data were generally positive but had limited market impact.  We boosted our forecast for the 4Q GDP revision to +5.9% from +5.8% but lowered our 1Q tracking estimate to +2.5% from +3.0% as exports and imports both continued surging in December, but the latter more so.  Upside in retail inventories pointed to stronger growth in 4Q at the expense of 1Q, while final domestic demand is showing a bit of acceleration as retail sales showed a solid gain in January and a big gain in December capital goods imports added to recent data pointing to a decent pick-up in business investment. 

Domestic developments were certainly of limited market interest, however, as attention was instead largely on Europe through most of the week and then China Friday.  The decision by the EU to announce support not just for Greece but potentially for all fiscally troubled EMU members (in a vague initial statement that is expected to be fleshed out into more concrete proposals as soon as the upcoming week) supported a big tightening in spreads of Greek government bonds versus benchmark German bunds.  After initially moving to new highs Monday, the Greece/Germany 2-year spread hugely reversed course and tightened about 125bp on the week to near 415bp.  Moves not quite as dramatic but still very large (particularly relative to much lower rate levels) were seen in 2-year government spreads over Germany for Spain, Portugal, Ireland and Italy, with moves on the week near 50bp, 95bp, 60bp and 30bp, respectively.  Against this lowered perceived risk in these countries versus Germany and France, however, was a growing realization later in the week that having Germany and France perhaps effectively backstop the financing of Greece and other fiscally strained EMU members clearly greatly reduces risk of an imminent crisis but really just diffuses the problems in the periphery more broadly through the Eurozone.  If we've now discovered that Germany is the ultimate backstop for Greek government debt, then Germany's fiscal position and sovereign risk is potentially worse than previously perceived.  Wednesday and Thursday this was starting to be reflected in a small way in spread narrowing coming not just from rallies in the recently more troubled EMU countries, but also by a bit of softness in bunds.  Friday's EMU GDP data brought more into focus, however, some softening in the underlying economic picture in Europe that was developing even before the sharp fiscal tightening that the EU is calling for in coming years from Greece and other countries.  Still substantial, if now less acute and more diffuse, fiscal concerns in a weak economic backdrop weighed heavily on the euro Thursday and Friday after an initial bounce on optimism about EU fiscal support.  With focus on Greece, holidays coming and a benign CPI print, China had become a much lesser market concern until Friday when a second surprise required reserve ratio hike in a month was implemented.  The heightened global growth concerns from fears that China could move behind mopping up excess liquidity into a more aggressive tightening campaign added to the more negative view on Europe to support decent Treasury market gains Friday.  Fiscal concerns remain high globally, however, and real rates continue to see upward pressure at the long end of the TIPS market, while the ECB now could on hold longer than previously expected and the Fed shows few signs of imminent action even after Fed Chairman Bernanke at least made clear that the Fed has an exit strategy sequencing excess reserve draining and rate hikes when they do eventually decide it's time to move.  Slower global growth from Europe's problems and potential fallout from China tightening and ‘lower for longer' short rates in the developed world combined with mounting fiscal concerns across many major developed economies were a recipe for a steeper yield curve, and that's certainly what we've continued to get. 

At the early Friday afternoon time of writing, benchmark Treasury yields were 7-15bp higher on the week and the curve significantly steeper and at all-time highs.  With the 2-year yield up 7bp 0.82% and 30-year 15bp to 4.64%, 2s-30s was sitting at a new high of 382bp, moving above the prior peak of 380bp hit January 11 ahead of the first of China's now two surprise reserve ratio hikes.  With the 10-year up 13bp at 3.67%, 2s-10s was 5bp steeper at 285bp, not quite through the all-time high of 289bp hit January 11.  Given the size of the losses in the nominal market, relative TIPS performance was quite weak, with almost all of the losses at the longer end of the curve coming in a real rate adjustment.  The benchmark 10-year inflation breakeven was only up about 1bp on the week at 2.25% Friday as the 10-year TIPS sold off almost as hard as the 10-year nominal.  While substantial late week downside in commodity prices - on both the weaker euro/stronger dollar and also China's tightening move - added to pressure on TIPS, at the longer end of the TIPS market there has been persistent pressure over the past week-and-a-half or so regardless of day-to-day moves in commodity prices.  We expect fiscal strains domestically to contribute to a substantial real rate adjustment at the longer end continuing throughout this year.  Mortgages were thrown into some disarray late in the week after Freddie and Fannie's moves to step up repurchases of delinquent mortgages shook up estimates of MBS prepayments and duration.  For the lower coupons, this provided a lot of relative support, and current coupon mortgage yields rose a lot less on the week than Treasuries, extending a period of comparative yield stability.  Current coupon MBS yields have been in a narrow range of 4.3-4.4% for most of the past month and were trading not far from the middle of that range Friday afternoon.  This has kept average 30-year conventional mortgages rates very close to 5% the past month. 

A quiet economic calendar the past week (fortunately so given the major weather disruptions in Washington) was generally positive, though stronger-than-expected imports relative to also surging exports pointed to slightly lower domestic output over 4Q and 1Q.  Imports and exports both continue to strongly recovery from the collapse seen from mid-2008 into the spring of 2009, clearly a very positive indicator for the global economy.  Domestically, however, the rebound in imports has been outpacing the recovery in exports, providing a bit more of a short-term drag on GDP growth than we previously expected.  Incorporating a wider-than-expected December trade gap, we see net exports being 0.2pp more negative in 4Q and 1Q.  Meanwhile, the already huge add to 4Q GDP growth looks to have actually been even bigger after an upside surprise in retail ex auto inventories in December relative to BEA's assumption following an upside surprise to non-durable manufacturing inventories reported the prior week.  We now see inventories adding 3.9pp to 4Q GDP growth instead of the initially reported +3.4pp, but with an offset to 1Q.  We now expect inventories to be neutral for 1Q GDP instead of adding a few more tenths.  With demand continuing to grow modestly, over the medium term inventories will still need to see further upside to stabilize inventory/sales ratios that have moved back down to lean levels as of the end of 2009 after a major inventory correction over the course of the year.  A solid retail sales report continued to support expectations for a moderately positive trend in final domestic demand.  We see real consumption gaining 2.5% in 1Q after rising 2.8% in 3Q and 2.0% in 4Q, with some volatility in 2H09 caused by cash for clunkers.  Netting this all together, we now expect 4Q GDP growth to be revised up to +5.9% from +5.7%, slightly better than the +5.8% revision we expected coming into the week, and we now see 1Q GDP growth tracking at +2.5% with final sales (GDP ex inventories) also at +2.5% but final domestic demand (GDP ex inventories and net exports) accelerating to +3.1%.  These adjustments around the margin haven't prompted any shifts in our outlook for a moderate but sustainable recovery in 2010, and we still see real GDP growing +3.2% in 2010 (on a 4Q/4Q basis).

Retail sales rose 0.5% overall in January and 0.6% excluding a flat result for autos, boosted by solid gains across a number of discretionary categories, including general merchandise (+1.5%), electronics and appliances (+1.2%), and sports, books and music (+1.0%).  Non-store retailers (+1.6%), which includes dedicated internet retailers, also extended a strong recent trend, and the heavily weighted grocery store category (+0.8%) reversed an unusually big drop seen in December, possibly as a result of weather disruptions.  On the softer side, the most housing-centered components - building materials (-1.2%) and furniture (-1.4%) - remained weak.  Gas stations (+0.4%) also saw a smaller rise than we expected, based on the upside in gas prices, and drug stores were flat.  Without the drag from building materials, the key retail control grouping (sales ex autos, gas stations and building materials) was a strong +0.8% in January.  Since bottoming in July, retail control has now risen at a solid 5.7% annual rate.  Along with a bit less than 4% annualized growth in services spending, this has left overall nominal consumption trending at close to +5% and real spending near +2.5%, which is right where we see 1Q tracking after some mild volatility around this level in 3Q (+2.8%) and 4Q (+2.0%) caused by cash for clunkers. 

The trade deficit widened to US$40.2 billion in December from US$36.4 billion in November, as a 3.3% surge in exports trailed a 4.8% spike in imports.  Imports fell harder during the near collapse in world trade in the nine months through April, but have since rebounded more sharply - exports fell 26% in the nine months through April and are up 17% since, while imports dropped 35% and have rebounded 22%.  As a result, there has been a bit of a drag on US growth since mid-2009 from trade after it helped to cushion somewhat the plunge in output in late 2008 and 1H09.  In the three quarters ending in 2Q09, net exports added 1.6pp annualized to GDP.  This turned to a 0.8pp drag in 3Q, what we expect will be a downwardly revised 0.3pp add in 4Q, and a projected 0.7pp negative in 1Q for an annualized -0.4pp contribution from 3Q09 to 1Q10.  With developing world growth accelerating sharply this year and expected to well outpace US domestic demand growth, we continue to expect that stronger net exports will return to being a meaningful net positive for US growth over the rest of 2010. 

The economic calendar is a lot busier in the upcoming holiday-shortened week.  While we wait for Congress to schedule Fed Chairman Bernanke's semi-annual monetary policy testimony, the minutes from the January FOMC meeting will be released on Wednesday.  While the dissent against the prediction of "exceptionally low levels of the federal funds rate for an extended period" by Kansas City Fed President Hoenig moved the markets significantly when the last FOMC statement was released, the minutes will probably show (as in December) that the internal argument was more two-sided, with dovish members supporting an extension of Fed mortgage purchases.  The next wave of supply will be announced Thursday - 2s, 5s, 7s and the return of the 30-year TIPS in place of the current 20-year benchmark.  On the data calendar, it will be time to start setting expectations for the upcoming employment and ISM reports after claims on Thursday, Empire State Tuesday and Philly Fed Thursday.  Initial claims in the latest report, which covered the survey period for the February employment report, showed a sharp drop and finally appear to have normalized after a month of upside centered in unusually high readings in California.  California apparently has finally cleared a big backlog of unprocessed claims, while it seems that the rest of the country might have seen some small worsening from early January to early February, though nothing too notable compared to the big improving trend still in place since late last summer.  We want to see the state-by-state data for the February survey week that will be released in the upcoming report before setting our initial forecast for February payrolls, but it appears that the underlying trend at this point is probably slightly positive.  Note, however, that the past calendar week was the reference week for the February employment survey, and clearly there were some major disruptions from the blizzards.  Our initial best guess is that the bad weather might lower February job growth by about 100,000.  Adding to potential distortions on the other side, however, census hiring should be starting to ramp up after a small amount of hiring in January.  Other key data releases due out in the coming week include housing starts and industrial production Wednesday, PPI and leading indicators Thursday and CPI Friday:

* We expect January housing starts to fall to a 540,000 unit annual rate.  Construction jobs in the residential sector fell 15,000 in January - the worst performance since September.  And home sales have pulled back in recent months following a tax break-driven surge in the fall.  So, we look for about a 3% dip in overall starts in January.  In particular, we look for a pullback in the volatile multi-family category, which has been surprisingly strong lately.

 

* We look for a 1.1% gain in January IP.  The employment report pointed to a sharp rise in factory output during the month of January.  In fact, headline IP is expected to post its best gain since August, with a solid rise expected in the key manufacturing category accompanied by another weather-related jump in the utility sector.  By industry, the strongest performers are expected to include electrical equipment, machinery, motor vehicles, petroleum and chemicals.  Finally, the utilization rate should continue to recover from the extremely depressed readings seen in 2009 and is expected to hit a new 14-month high in January.

* We expect the producer price index to surge 0.8% overall in January but only 0.1% ex food and energy.  Rising quotes for wholesale gasoline and natural gas are expected to help push up the headline PPI in January.  Also, the food category is likely to show some further upside following a sharp 1.4% jump in December.  Assuming some stabilization in motor vehicle prices, the core should register a reading that is right in line with the underlying trend.

* The index of leading economic indicators should rise 0.3% in January, its tenth straight gain to extend the strongest run since 1983.  The main positive contributors this month should be the yield curve, supplier deliveries and the manufacturing workweek.  The real money supply will be a significant offsetting negative, in our view.

* We look for the consumer price index to rise 0.3% overall in January and 0.1% ex food and energy.  A rise in gasoline prices and a weather-related jump in quotes for fruits and vegetables are expected to lead to some modest elevation in the headline CPI. Meanwhile, the core is likely to remain well contained, with continued softness in the key shelter category offsetting slight price gains elsewhere.  On a year-on-year basis, the core is expected to slip a tick to 1.7% - and base effects are likely to lead to some further moderation in this measure over the next few months.

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United States
Updating Our Themes: Fed Exit and Sustainable Growth
February 16, 2010

By David Greenlaw | New York

Bernanke More Specific on Exit Strategy

Fed Chairman Ben Bernanke's congressional testimony on Wednesday, February 10 reinforced the notion that progress towards an eventual Fed exit is underway.  Yet Bernanke did not provide much insight with regard to the timing of the exit, and it's clear that the Fed is still engaged in internal debate on the specific strategies that will be employed. 

We continue to believe that the exit process will unfold fairly quickly during 2H10, spurred by market-based indications of rising inflation expectations as the economic recovery takes hold.  The time lag between actions aimed at draining a significant volume of excess reserves and the hiking of policy rates is likely to be relatively brief, putting the IOR (Interest on Reserves) program to the test (note: the current volume of excess reserves is US$1.063 trillion versus a ‘normal' level of US$1.5 billion).

We have three key takeaways:

Discount rate: The Fed is getting closer to hiking the discount rate.  This would be a technical adjustment aimed at restoring the normal 100bp spread between the discount rate and fed funds rate that was originally established as part of some broader adjustments to the discount window program in 2004.  The fact that Bernanke is now highlighting such a change means it is likely to occur sooner rather than later, but it should not be viewed as a policy signal.

Sequencing: The Fed will begin testing the term deposit program sometime in the spring, and Bernanke noted that "hundreds of billions of dollars" could be drained from the banking system "quite quickly" using term deposits and reverse repos.  While the sequencing remains somewhat unclear, the bottom line is that it appears to be data-dependent. 

Interest on reserves (IOR): Bernanke indicated that the stance of policy might be best communicated using the IOR rate rather than the fed funds target - at least during the initial stage of the exit process.  The announcement of changes in the IOR rate could be accompanied by the specification of quantity targets for excess reserves. 

In our view, the potential reliance on the IOR rate during the early stages of the exit process reflects the fact the Fed cannot be certain that IOR will work as intended.  The IOR program was introduced in autumn 2008 in order to help prevent the effective fed funds rate from falling too far below the official target rate as the Fed balance sheet ballooned.  However, for a variety of reasons, the funds rate traded well below target for an extended period of time.  The majority of Fed officials seem to believe that the program will work more effectively going forward, but they have publicly admitted that they cannot be certain.  As a result, until markets normalize, the Fed will look to other money-market rates - e.g., UST repo - to gauge money-market conditions. 

When the system returns to normal, the Fed, like other central banks, will have a corridor system for rates.  IOR will be the floor, the discount rate will be the ceiling, and the funds rate will lie between them. 

‘Cleaner' Jobless Claims Data Support Optimism on Labor Market

The jobless claims report released on Thursday, February 11 showed that filings plunged 43,000 in the latest week to 440,000, the lowest reading since the week ended January 2.  A Labor Department official indicated that the plunge reflected "the end of an administrative backlog" rather than any significant change in economic conditions.  Moreover, the state-by-state breakdown, which is released with a one-week lag, showed that filings remained quite elevated in the state of California during the week of January 30.  As we've noted over the past few weeks, almost all of the recent volatility in claims has been tied to swings in California.  It appears likely that California claims plummeted in the latest week as the state's backlog was finally resolved (last week, a local press report indicated that state legislators were pressuring government employees to speed the processing of claims).  Moreover, even assuming a return to the November/December trend in California, it looks like claims posted a meaningful decline across the rest of the US in early February.  So, while we still have some unanswered questions regarding the recent gyrations in claims, it appears that underlying conditions may have improved a bit over the course of recent months.

In all, the latest claims data reinforce our optimism regarding the progress towards recovery in labor market conditions.  As we've been noting for some time, the recent surge in productivity growth appears unsustainable, and if the turnaround in economic output is going to be sustained, companies will need to begin to add some labor.  The claims data, layoff survey info, rising temporary help jobs, and consumer sentiment gauges are all supportive of this gradual progress toward recovery in the labor market.  (As we have noted in the past, the continuing claims and emergency claims data are not sending a clear signal in one direction or the other and should be ignored.)  Also, despite our survey results to the contrary, we still think that reduced uncertainty regarding the potential for a significant new cost burden being imposed on businesses as part of the healthcare reform initiative could help to unleash some hiring.

Our major concern related to employment over the near term is the impact of severe winter storms.  The latest storm hit the East Coast during the survey period for the February labor market report.  On a preliminary basis, we are assuming about a -100,000 impact on February payrolls tied to unusually severe weather (this is the estimated weather impact, not a payroll forecast).  Our estimate is based on the experience with the blizzards of 1996 and 2003.  We will receive more information in coming days that might be helpful in refining these estimates, and we will release a more comprehensive February employment forecast next week.

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United States
A European Slowdown Would Only Nick the US
February 16, 2010

By Richard Berner | New York

Limited spillover to the US.  The European sovereign debt crisis may net to slower European growth from an already-tepid starting point.  Although the European Council of government leaders has pledged "to take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole", that backstop is unlikely to immunize the euro-zone economies completely.  The crisis likely will tighten financial conditions and promote fiscal austerity, consisting of increased taxes and lower public sector demand.  And the crisis hits a still-tender euro area economy, which we have expected to advance just 1.2% in 2010.  Incoming data showing that growth rose just 0.1% in 4Q09 and a poor start to 1Q10 underscore the downside risks (see Whither Greece? January 25, 2010; and European Economics Chartbook: Expanding at a Pedestrian Pace - Ripples at the Periphery, February 1, 2010).

The impact of even dramatically slower growth in Europe would only trim US growth fractionally; Asia is far more important for the US outlook (see Global Economics: Asian Amplification, February 4, 2010).  However, the European sovereign crisis does create a tail risk for US growth and markets: If the crisis spills over into broader risk-aversion and a drying up of liquidity - the functional equivalent of the US subprime crisis - the consequences could be more dire.  At the least, these unknown risks make us more cautious about risky assets (see Sovereign Crisis Roadmap, February 11, 2010).

Challenge to sustainable growth.  Strong growth abroad is one of four pillars for our view that the US economy is at the start of sustainable growth through 2011 (the other three: improving financial conditions, persistent impact from fiscal stimulus, and the elimination of excesses (see Outlook 2010: Higher Rates, Fed Exit and Sustainable Growth, January 4, 2010).  Thus, a slowdown in Europe's economies would at least challenge that thesis.

Indeed, from a short-to-medium-term cyclical perspective, the crisis seems likely to slow European growth through three channels: 1) rising risk premiums on the region's sovereign debt will tighten financial conditions; 2) higher funding costs and constraints on market access will limit the supply of bank credit; and 3) fiscal tightening - both spending cuts and tax increases - will weigh on growth in peripheral economies.  In turn, the willingness of core EU countries to backstop the periphery, perhaps with an emergency lending facility sponsored by Germany, seems likely to cause the contagion to spread to the core.  As a result, we now expect 10-year Bund yields, which have begun to rise despite soft incoming European data, to rise to 4.5% this year.  A weaker euro will be a partial offset by helping boost the region's export competitiveness; we expect the euro to decline to 1.24 EUR/USD. 

Quantifying the fallout for the US.  We estimate that a one-percentage-point slowdown in European growth might shave 0.2% from that in the US.  Three channels matter: exports, earnings and financial linkages. 

Exports: Big share, but slow growth. Exports of goods and services to the European Union account for 29% of the US total, but given our outlook for tepid EU growth, the contribution to US growth from European demand is small.  Nonetheless, a dramatic slowdown in European demand would dent US export growth.  In contrast, Asia ex Japan is growing eight times faster than the EU, and Canada and Latin America are growing four times faster.  The share of US exports of goods and services to Asia (27%) is comparable to the EU, while Canada and Latin America account for 37%.  We see upside risks to both those sources of export vigor.

Earnings/Income: An important, overlooked channel.  US income from direct investment is much more closely coupled to Europe, because Europe accounts for 57% of the US$3.1 trillion in overseas facilities owned by US companies.  So, a slowdown in European growth will affect results at US affiliates in the region, which contribute roughly one-sixth of US earnings.  Slower growth in Europe would slice 200-300bp from the likely rise in US earnings this year.  Fortunately, the growth differentials matter; while Asia accounts for only 20% of direct investment income, its rapid growth is contributing a like amount to US earnings growth. 

Financial linkages to Europe: More diffuse and hard to calibrate, but could be noticeable.  A rise in core European sovereign yields could intensify concerns about the sustainability of US fiscal policy among global investors and push up US Treasury yields.  Uncertainty about the slowdown in Europe might weigh on US credit and equity prices.  Slower growth in Europe would depress results at US global financial services firms and could make them more hesitant to lend.  US financial exposure to Europe is relatively low: For example, US banks' claims on residents of the European periphery were a miniscule 0.3% of total assets as of 3Q09, and claims on all European residents amounted to only to 4.6% of total assets (see Betsy Graseck's Quick Comment: International Exposure a Low Risk for US Banks, February 10, 2010).  As we learned in the financial crisis, however, such linkages could be the most important of all if idiosyncratic risk morphs into something systemic.  Indeed, while the retreat in risky assets in the past few weeks is not yet a headwind for growth, it is hardly a plus (for credit implications, see Problematic Relatives - Downgrading € IG Credit, February 12, 2010).

Cross checking.  To cross-check these results, we estimated a Vector Auto Regression among three variables: Growth in US GDP, US domestic demand, and overseas GDP.  Shocking the system with an impulse response shows that a 1pp change in the growth of foreign GDP will move US GDP growth by 60% of that, which is consistent with our back-of-the-envelope calculation of a 0.2% impact from a similar change in Europe alone.

Contagion tail risk.  Our base case is that peripheral Europe will muddle through with assistance from the core.  Yet the crisis will surely slow European growth somewhat.  Contagion spreading from the European banking system is the biggest tail risk.  If the crisis spills over into broader risk-aversion, a drying up of liquidity, and deleveraging - the functional equivalent of the US subprime crisis - the consequences could be more dire.  That scenario is far from investors' minds, and we think it is highly unlikely, given that EU officials have made it clear that conditional assistance for Greece is coming.  But that's what makes it important to think about.

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