Past the Sweet Spot: Impact of European Sovereign Debt Issues
May 26, 2010
By
Takehiro Sato & Takeshi Yamaguchi | Tokyo
1. Impact on Japan of Europe's Sovereign Debt Problems
Europe Has Avoided Intensive Care, but Faces a Long Period of Recuperation Which Could Have Repercussions for Japan
The arrangement by leading central banks on May 10 of a dollar fund swap agreement has contained the liquidity problem. This has averted disruption to trade from financing constraints, as occurred after the Lehman shock of 2008 when trade finance dried up. Japan was one of the countries most directly affected by the breakdown of global trade financing at that time, but swift action by the authorities now appears to have avoided the danger of a repeat. However, we cannot rule out the possibility that Japan will suffer indirect damage as Europe's economy slows further, with fiscal austerity across the region and lending attitudes becoming tighter as concern over the capital base of banks escalates.
Yet We Made Technical Upward Revisions to Our Outlook
Notwithstanding these concerns, the outlook for the economy in the very near term is actually in upward revision mode. For example, our US economics team has increased its GDP forecast from +3.2% to +3.4%. According to the team, US GDP is affected by only 0.2% even if growth in Europe slips by 1pp.
Japan's economy is already within range of real growth for calendar 2010 of 3.4%, on par with the US (2.7% for F3/11), based on the Jan-Mar GDP data from May 20. Among the G3, Japan's growth rate trails only the US and is founded on brisk external demand, chiefly exports to Asia. In this respect, the effect of stagnation in Europe on external demand is a risk.
For Jan-Mar alone, Japan achieved the highest rate of growth among the G3, and personal consumption was a key driver alongside external demand. However, most of this consumption demand was fed by durable goods benefiting from stimulus packages, and with eco-vehicle subsidies expiring at end-September and the eco-point program expiring at end-December, we are expecting retracement in consumer durables spending from the start of 2011.
In summary, while there may be technical GDP upside in the near term from a rise in the base effect, economic activity has now passed the sweet spot, and we may well see renewed stagnation as policy effects erode in future.
Impact on Trade: Europe's Share of Japan's Exports Is Not High, but...
Next let's consider the implication for trade. According to the MoF data for 2009, Europe's share of Japan's exports was 13%, compared to nearly 50% for Asia and below the 17% for the US. Growth momentum for export volumes to Europe was sluggish for some time anyway, and we believe that some further slowing should not cut far into the overall export momentum, which is backed by booming trade with Asia.
How should we view things from the perspective of Europe, the export destination? Total imports for the region excluding intra-regional trade (2008 data, 27 EU nations) were $2.2 trillion, or roughly 13% of global trade. These imports came from 1) China (source of 14% of Europe's imports), 2) the US (13%), 3) Japan (5%), and 4) East Asia (excluding Japan and China; 11%), but Europe's links with Eastern Europe (not part of the EU category above), the Middle East and Latin America are strong (about 60%). Exports from Japan routed via these regions, which are effectively exports to Europe, make up an estimated 20% or more of Japan's total exports. In considering the impact of further deceleration in the EU economy, we need to look at the indirect impact of a slowdown in exports into Europe from countries other than Japan. In this case, a 1% slowdown in EU growth could take 0.2% off Japan's GDP, which is similar to the impact of change in US growth.
Impact of Yen Appreciation: Change in Nominal Effective Rates Has Not Been Very Large So Far
Elga Bartsch, our European economist, is forecasting GDP growth for the EMU countries of +0.9% in the base case and -0.5% in the bear case for 2010, and +1.1% (base) and -1.5% (bear) for 2011. If her bear scenario were to play out, Japan's GDP would be lower than in the base case by approximately 0.3pp in 2010 and 0.5pp in 2011.
If we add in the factor of yen appreciation to the slowdown in the economies of trading partners above, the downside for Japan's economy becomes larger. The yen has been relatively stable against the dollar, but against the euro it has gained to JPY111-112, considerably beyond the assumed rate of JPY125-128 in the business plans of export firms. The effective yen rate has not strengthened dramatically, partly because the nominal share of exports to Europe is quite small. But an increase in the dollar/yen rate of 10% would have an impact on Japan's GDP of -0.3pp in the first year, and a larger -0.5pp in the second year. Likewise, an increase in the euro/yen rate of 10% would have a negligible impact on Japan's GDP in the first year, but -0.1pp in the second year. This means that the risks to growth from exchange rate movements could be greater in 2011 than 2010. There is already the danger that Japan's economy could level off in 1H11 as policy-induced demand fades, hurting consumption in particular as outlined, and the recent gains for the yen versus the euro are a new risk factor.
Positives for the Global Economy: Stronger Dollar, Crude Oil Price, Long-Term Interest Rates
While rapid yen appreciation is a short-term negative for the Japanese economy, euro depreciation may work to ease deflationary pressures from fiscal restraints for the European economy. The EU27's trade volume is not insignificant, accounting for about 13% of global trade even excluding intra-regional trade. As the European economy is export-oriented, a cheaper euro could boost the regional economy.
Also, crude oil prices have abruptly corrected as the sovereign debt problems spread, pushing WTI now to below $70/barrel. During the previous economic slowdown, the global economy decelerated as the crude oil price shot up above $100. This time, however, as crude oil price started correcting even well before it reached $100 with the economic recovery still in process, we believe that recession risk from a sharp rise in resource prices would be limited.
Further, major central banks have pushed back their exit strategies as the sovereign issue spreads. Our US economic team now expects the fed funds rate target to be raised in Jan-Mar 2011, some six months later than Sep 2010 as previously predicted. US long-term interest rates have fallen to the lower 3% range as expectations for a rate hike have receded, and funds have shifted from risky assets to non-risky assets. A decline in long-term interest rates tends to prompt a fall in mortgage rates, lifting household discretionary income by boosting home loan refinancing. As we can expect such a built-in-stabilizer effect this time also, we see no need to factor for a risk of a significant economic slowdown in our forecast now, though we think Japan's economy will see a temporary lull in 2011.
2. Impact of Sovereign Debt Problems on Japan's Risk Assets
Sell into Rallies - If There Are Any
Swift conclusion of a dollar swap agreement among leading central banks on May 10 staved off dysfunction in the European short-term money markets, which serve as a hub for dollar fund settlement. For now, the likelihood of a panic comparing with the Lehman shock has been averted. However, our European economics team believes that the sovereign problems will ultimately conclude with debt reorganization (namely default) in peripheral nations, and views this EU/IMF and ECB funding assistance as a means of winning time.
Immediately after the bailout, risk asset markets saw a global short-covering rally, responding favorably to swift measures to tackle liquidity risk, but as is well recognized, solvency issues are tough to address even if the authorities respond to liquidity problems, with resolution of the former, requiring commitment to fiscal austerity over a long period. If sovereign risk escalates further, there is potential for impact on a broad range of risk assets. Indeed, the post-bailout optimism has now fizzled out, with risk assets now again correcting globally on concerns.
In this context, our global cross-asset strategist, Gregory Peters, recommends selling into any strength for risk assets in the near term. Put another way, there may be opportunities to profit from moral hazard-driven rallies in this period, and our Japan equity strategist, Alexander Kinmont, is actually somewhat more optimistic about Japanese equities than previously and has reduced the weight of cash in his model portfolio, and his existing domestic-value focus. Likewise, our China economist, Qing Wang, argues that the ongoing events provide the opportunity for a ‘Goldilocks' scenario for the Chinese economy. Furthermore, our European equity strategist, Teun Draaisma, has moved from an underweight to an overweight asset allocation for the European region.
Similarly, from a standpoint of global asset allocation, our global strategists, Jason Todd and Gerald Minack, are recommending selling Japanese export stocks and buying European exporters. Given the swings in exchange rates (euro losing ground, yen gaining) as the sovereign debt issues develop, we are comfortable with reducing exposure to Japanese exporters.
Downside Scenario: Widespread Impact on Multiple Asset Classes
More than the impact of trade contraction on the real economy, the point to be worried about is downward pressure on the economy from credit problems, such as a breakdown in the function of capital markets. Industrial production in Japan saw the largest plunge on record as trade financing shriveled after the Lehman shock, with risk assets in Japan suffering severer repercussions than in other markets.
Now that panic in financial markets has been contained by liquidity provisions, the latter risk need not be overemphasized. But our team's view is that debt reorganization (default) for peripheral European nations will be unavoidable. As the authorities have bought time until that point is reached, if credit events occur at a stage when debt reorganization has already been priced in, we believe that it should be possible to avoid the discontinuous changes in the market that followed the Lehman shock. Even so, if it turns out that risk has been more broadly dispersed than is apparent, for example via the repackaging of government bonds of the peripheral countries into securitized products, we could see debt restructuring having a compounded effect in multiple asset classes, affecting unexpected areas in much the same way that the Lehman shock battered money markets. We need to keep this risk in mind.
Upside Scenario: Debt Reorganization Marks the End of Negative News
The upside scenario is that debt reorganization for peripheral nations in the Europe region comes at a point when the implications have been fully priced in, and risk assets then rally on the end of bad news. For debt reorganization to take place smoothly without triggering similar upheavals of the Lehman shock, creditors would need to have made preparations such as ensuring that sufficient reserves were in place for the relevant bonds. This would necessarily take a fair amount of time, and so we think that a smooth and early debt reorganization process is after all a low probability.
Tracking the credit conditions in the borrowing country by lenders such as the IMF, as below, would be a useful way of keeping tabs on the possibility of debt reorganization. The markets are likely to swing one way or the other in response to the fulfillment of conditionalities and potential for debt restructuring.
Overview of the IMF/EU's Package
On May 9, the IMF's board approved a three-year Stand-By Arrangement (€30 billion) for the country at issue. This, along with the funds (€80 billion) earlier approved by eurozone member states, made a total of €110 billion officially available to the nation in need of assistance. The first tranche of €20 billion (€5.5 billion from the IMF, €14.5 billion from the EU) has already been disbursed, easing short-term liquidity problems for the time being.
But whether loan disbursements will be smoothly made during this three-year period depends on meeting conditionalities every quarter. Specifically, they include numerical fiscal targets (‘performance criteria' such as upper limit for the general government fiscal deficit) and structural measures laid out in detail each quarter. If governments fail to meet the targets, the probability rises that the program will slide off-track and funding from the IMF and eurozone countries be suspended.
Our European economists, Daniele Antonucci and Elga Bartsch, point out that a restructuring can still happen within the three-year loan period. Their first reason is that the country might not deliver on this program, and so the money flow might stop. Second, though a low probability in the near term, the country might refuse to tighten sufficiently at some point because policymakers think it excessive. The program would go off-track in this case too. Third, Daniele and Elga point out that there might still be some kind of voluntary restructuring further down the line.
The question of whether conditionality can be observed looks like a technical one at first, but its roots go deeper. Ordinarily, when a country undertakes fiscal adjustments, the best prescription is to employ accommodative monetary and forex policy and avoid abrupt contraction in aggregate demand. But countries with a common currency cannot pursue independent monetary and exchange rate policies without leaving the currency zone, so their economies are vulnerable to severe deflationary pressure if extensive fiscal adjustment is undertaken. In other words, they would likely face negative GDP growth, falling wages and prices, and rising unemployment. In the case of the country at issue currently, the IMF is forecasting negative growth for three successive years to 2011, but our European team is expecting wider margins of the negative growth than the IMF. Even the IMF, with more optimistic forecasts, is assuming the unemployment rate will soar to 14.8% in 2012. As the cases of several countries including Japan show, politically there is only a narrow path for implementing structural reforms at a time of economic contraction.
This gives critical importance to upcoming quarterly reviews of progress towards meeting loan conditions conducted by the IMF. If the program review goes smoothly, the likelihood of debt restructuring would diminish, while if conditions are not being met, the market would factor for a higher probability of debt restructuring. We would naturally expect risk assets in Japan to reflect these trends.
Rebound in Exchange Rates
Another risk scenario is a snapback in yen exchange rates. If sovereign debt problems were to recur in Europe on a larger scale, we think the yen could well provide a haven for buyers, as the currency of a country with current account surplus. This is no more than a risk scenario, but when the New York stock market sold off sharply on May 7, the yen was temporarily bid up to a level of JPY88 to the dollar.
Furthermore, with the ECB following the Fed among the G3 central banks in transitioning to quantitative easing, the soundness of the BoJ's balance sheet is likely to take on greater prominence. In our view, the size and capital ratio of a central bank's balance sheet have little to do with the institution's credibility, and the ECB's credibility should not necessarily be hurt by its moves to buy government bonds. Instead, it is the cumulative policy track record which earns credibility for a central bank. However, the consensus market view is that the ECB's credibility has been dented, and our European economics team does have concerns on that score. In these circumstances, if the BoJ is unable to move flexibly to quash deflation, we must assume that conditions would become conducive to buying of the yen generally - not just at the expense of the euro - as the markets focus only on the superficial health of the BoJ's balance sheet.
The above is presented as a risk scenario, and is not the house view of our currency strategy team. That said, our US economics team has revised its US interest rate outlook to no longer envision a rate hike by the end of the year, and since we do not expect the gap between US and Japan interest rates to widen by much within this year, we think that this risk is becoming all the more pronounced.
3. Possibility of Credit Concerns Spreading to Japanese Debt
Japan Is Not at High Risk of Contagion
Contagion for Japan is an aspect of Europe's sovereign debt problems that needs to be considered. Comparing fiscal indicators for Japan and Greece, and Japan and the US and UK, for example, shows that Japan has by far the highest level of government debt.
Yet, as major countries including Japan have pursued fiscal expansion since the Lehman shock, Japan's fiscal deficit exposure no longer looks conspicuously worrying. Indeed, the current account surplus and real long-term interest rate levels throw Japan's strengths into relief. As a result, though the jury is still out on whether the contagion will spread to Japan, we do not see the possibility as high.
One factor that militates against it is the health of Japan's macro balance that we have referred to in our December report. We believe that overseas investors also now generally recognize that funding of government debt looks increasingly sustainable, thanks to a current account surplus backed by a stable income surplus, a rich domestic savings and investment balance and the strong home bias of domestic investors.
European Sovereign Debt Issue as a Spur to a Japanese Consumption Tax Hike
Another more recent positive development is the rising sense of urgency among politicians to restore fiscal health in the wake of Europe's problems.
For example, in a press conference on May 11, Finance Minister Naoto Kan declared that the issuance amount of new financial resource bonds in F3/12 would be held level with the JPY44.3 trillion of F3/11. Given the expenditure items in the DPJ's campaign manifesto and the outlook for tax revenue, this declaration must be viewed with some degree of skepticism, and may simply be a marker to emphasize that the government is committed to a path of fiscal retrenchment. Even so, regardless of the outcome of July's Upper House election, we think the policy debate is likely to focus increasingly on fiscal soundness, and more specifically the consumption tax.
Moreover, in its discussions at a subcommittee meeting on May 18, the Fiscal System Council, a MoF advisory body, expressed a majority view that the consumption tax hike of April 1997 did not do major damage to the economy, with many attendees referring to the impact of bad debt disposal and the Asian currency crisis on lowering the growth rate.
At the meeting, University of Tokyo professor Toshihiro Ihori said with regard to the economic impact of the April 1997 consumption tax hike (from 3% to 5%) that 1) in terms of the net impact on the economy, the effects of bad debt disposal and the Asian currency crisis were greater than the consumption tax increase, 2) a tax hike should be neutral for the economy if it matched future tax cuts, and 3) how increased tax is used is also a key consideration (as reported by Reuters). MoF Kan has already said that as long as the money is used properly, the economy will still improve even if taxes are raised, and the view of the Fiscal System Council essentially rubber-stamps this thinking. All of this gives the impression that the government is gradually leveling the ground for a hike in the consumption tax rate.
As JGB market participants are already discounting the possibility of fiscal rehabilitation measures, we do not expect major disruption in the markets despite recent deterioration in Japan's fiscal indicators. On the other side of the coin, any backsliding on the rehabilitation agenda could raise the potential for European sovereign debt problems to emerge in Japan as well, in our view.
What if, for Example, the ‘Medium-Term Fiscal Framework' Fails to Hit the Mark?
One event to watch will be publication of the ‘medium-term fiscal framework', expected in June, for whether it contains credible targets and measures for fiscal rehabilitation. For example, the market consensus appears to be that if the framework contains a clear roadmap (schedule) for achieving a surplus in the primary balance, the JGB market should stay calm, whereas if it does not, the market faces a rise in long-term interest rates.
Yet, with publication of the mid-term framework expected in mid/late June, just before the Upper House election, and the prospect of support for the DPJ dwindling further in the approach to the election, there is much uncertainty as to whether the government and ruling party will name specific numerical targets, and a hike in the consumption tax as a means of achieving them. Indeed, DPJ Secretary General Ichiro Ozawa, for example, indicated his opposition to an election commitment to raise the consumption tax rate after the next Lower House election at a press conference on May 17.
Our basic view is that even if the mid-term fiscal framework fails to deliver, the JGB market is unlikely to succumb to panic or become destabilized. First, as noted above, market participants view a consumption tax hike as likely to occur in any case in the not-too-distant future, and second, among the populace too there has been some progress towards a consensus for building the foundations of social security by raising the consumption tax rate. In this sense, regardless of the shape of the administration after the Upper House election, we expect the policy agenda to lean toward fiscal rehabilitation, and we believe the markets have factored for this.
In terms of the schedule ahead, before simultaneous Upper and Lower House elections in 2013, the domestic political diary is empty for 2011-12 as regards major national votes. 2012 in particular is a blank political slate in this sense, with not even any regional elections of note on the timetable. Thus, the government/ruling party should view this as a good opportunity to proceed with fiscal restructuring.
A risk factor for the above scenario would be the DPJ falling far short of a majority in this July's Upper House election, making way for stronger representation by the left in a coalition government. If such a coalition included the Komeito in particular, fiscal policy could become more expansionary.
A Touch of Uncertainty about Where Japan's Macro Balance Is Going
The LDP, the ruling party at the time of the Lehman shock, responded to the sharp drop in economic activity that followed with a package of economic measures of historical magnitude, a line of fiscal expansion that it initially passed on to the incoming DJP. Like other leading nations, two secondary supplementary budgets pushed the fiscal deficit into double-digit territory as a percent of nominal GDP. Moreover, around Sep-Oct 2009, immediately after the start of DPJ rule, as it became clear that there would be a large shortfall in tax revenue, investors became increasingly concerned about the sustainability of the government's finances. Then, as concerns about fiscal sustainability subsided, JGB yields turned downward from a peak of just under 1.5% in early November, and the bear trading of Japan that spread chiefly among overseas investors is currently burning low.
From a macro perspective, in terms of judging the sustainability of government debt, it is important to establish whether the domestic private sector savings/investment gap has improved in a way proportionate to the sharp widening of the fiscal deficit (the income/expenditures gap) during F3/10. Throughout F3/10, the current account balance - the difference between the two - remained stably in surplus. In other words, while the income/expenditures gap was about 10% of nominal GDP, the proportion of the current account surplus was about 3%, causing the private-sector savings/investment gap to widen to 13% of nominal GDP. We think that this dramatic widening of the gap was achieved by the shrinking of investment in the corporate sector, not the household sector. Indeed, private-sector corporate capex recorded a steep fall of about 20% in F3/10, and corporate balance sheet restructuring also continued to progress, with the exception of the rise in provisional demand for funds in the immediate wake of the Lehman shock.
Where now? Based on the current DPJ manifesto, the fiscal deficit looks set to stay in the teens as a percentage of GDP. At the same time, private-sector capex has stopped falling in F3/11. Though the tone of capex does not suggest an immediate surge, now that this component has stopped falling, we expect the balance of corporate savings and investment to worsen compared to F3/10 unless there is an increase in gross savings.
If so, assuming that the current account balance remains in surplus, it will be necessary to offset the decline in net savings in the corporate sector with a net savings rise in the household sector, or alternatively, if net household sector savings do not rise, to improve net corporate savings through a rise in gross savings.
Otherwise, as long as the government sector deficit failed to shrink, the recurring account balance would turn into a deficit. If we assume a stable income balance, it seems unrealistic that the current account would turn into a deficit in the near term. We expect the actual outcome to be increased deleveraging in the corporate sector, resulting in an improvement in corporate net savings.
Even so, with capex no longer falling, sustainability of a fund surplus in the corporate sector most likely holds the key to continuing to finance the fiscal deficit ahead. In other words, against a backdrop of what we expect to remain a high fiscal deficit, the structure of deficit financing has become that much more fragile.
The spread of the European sovereign debt concerns has created a certain sense of concern among Japanese politicians, but without untiring efforts to translate that concern into actual policy, the JGB market is likely to be more vulnerable than in 2009 to investor concerns about fiscal collapse, if such concern were to intensify.
We think that the Japanese government will have no choice other than to stay more disciplined, regardless of the shape of coalition after the elections in July, especially when fiscal consolidation is on track on a global basis. Otherwise, the bad shape of Japan's fiscal deficit is likely to become prominent again, if European governments are successful in their fiscal rehabilitation.
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