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What’s next for the Eurozone Vanguard commentary November 2010 Executive summary. The Eurozone continues to work through its sovereign debt issues, but a great deal of concern remains regarding the long-term economic health of the bloc. In this commentary, we review the current situation, present possible scenarios for the peripheral European economies, and weigh in on the much-discussed idea of a euro breakup. In our view, the most likely outcome is one in which the European currency union “muddles through” its problems without coming apart. A restructuring of Greece’s sovereign debt is still quite possible, given the country’s unsustainable debt dynamics. Abbreviations: ECB = European Central Bank. EMU = Economic and Currency Union. EU = European Union. GDP = Gross domestic product. Connect with Vanguard > vanguard.com > global.vanguard.com (non-U.S. investors) IMF = International Monetary Fund. bp = basis point (1/100 percentage point). Authors Jonathan Lemco, Ph.D. Roger Aliaga-Díaz, Ph.D. Charles J. Thomas Since the beginning of 2010, much of the global financial system has experienced tremendous uncertainty regarding the outlook for the economies and government debt of peripheral Eurozone members, notably Greece, Portugal, Ireland, and, to a lesser extent, Spain and Italy. The global recession of 2008–2009 exacerbated long-term structural issues in these countries: public sectors that were excessively large in relation to the overall economy, unsustainable social entitlement programs, and fundamental misalignments in wage and price levels relative to more competitive members of the currency union. Things came to a head in late April and early May with a global retreat from the debt of the peripheral countries, causing spreads on sovereign yields and credit default swaps (CDS) to soar (see Figure 1). Since then, supranational authorities and policymakers in the Eurozone and elsewhere have engineered major responses. Figure 2 summarizes the various bailouts, standby programs, and policy actions addressing the crises. Figure 1. Short-term outlook: Deep fiscal cuts with implications for growth The governments of the peripheral economies have also shown notable commitment to solving their fiscal imbalances. Fiscal austerity programs have been announced and implemented across the Eurozone. However, the timing of these events has serious near-term implications for the ongoing European economic recovery. Instead of spending and engaging in fiscal stimulus to support economic activity, governments across the Eurozone are being forced to reduce spending and cut stimulus programs, creating negative shocks to spending and growth. In our view, the combined impact of these simultaneous austerity measures is likely to reverberate across the entire euro area in the short run. As shown in Figure 3, the overall fiscal adjustment is large, even if austerity measures are spread out over four years. The consensus growth The Eurozone sovereign debt crisis: Rising costs of default insurance The credit default swap spread can be viewed as the relative cost of insuring a debt security against a default or restructuring event. This chart shows CDS spreads for the five peripheral countries versus Germany, considered one of the soundest issuers in the region. The wide spread for Greece illustrates rapidly eroding confidence in the country’s ability to repay bondholders. Spreads of 5-year sovereign CDS relative to Germany: January 1, 2009–October 29, 2010 1,200 1,000 Basis points 800 600 400 200 0 Jan. 2009 April 2009 Greece July 2009 Portugal Source: Thomson Reuters via Thomson Datastream. 2 Oct. 2009 Ireland Jan. 2010 Spain Italy April 2010 July 2010 Oct. 2010 Figure 2. Key responses to the Eurozone debt crisis Response Amount Description Bailout of Greece’s government € 110 billion € 80 billion from Eurozone members and € 30 billion from IMF. Extension of EU balance-of-payment facility € 60 billion Originally € 50 billion, extended to € 110 billion in May 2010; the loan program is now available to more EU members. European Financial Stability Facility (EFSF) € 440 billion EFSF can make loans funded by floating debt that is guaranteed by Eurozone member states. IMF standby funding € 250 billion Applicant states must agree to IMF conditions. ECB bond purchases Approximately € 60 billion The bank makes secondary-market purchases of sovereign debt issued by peripheral Eurozone nations. Bank stress tests and recapitalization Not known. Banks were stress-tested for a worst-case scenario. Those failing to pass were given access to government funding, in addition to potential funding from the EFSF if needed. Source: Vanguard. Figure 3. Fiscal retrenchment in the Eurozone These key figures show the need for fiscal adjustment in the Eurozone. The deficit reduction targets are listed in each country’s Growth and Stability Program, a document that EU members must submit annually. The targets are based on cyclically adjusted GDP, meaning that the economic recovery is already built into assumptions about government revenue. Germany and France, the largest members of the Eurozone economy, also have fiscal retrenchment targets to meet, meaning that the overall adjustment for the region is substantial. Germany Country’s share of European Union GDP 2009 budget deficit (% of GDP) 26.8% 3.3% Debt-to-GDP ratio (debt as % of GDP) Deficit reduction target through 2013 (% of GDP) 73% 3.3% France 21.4 7.9 78 5.0 Italy 16.9 5.3 116 2.6 Spain 11.7 11.4 53 8.4 2.6 12.9 115 10.7 Greece Portugal 1.8 9.3 76 5.5 Ireland 1.8 11.5 65 9.0 — 6.6 Weighted average 81% 4.7% Sources: Vanguard calculations, based on data from the World Economic Outlook Database, the International Monetary Fund, and EU members’ Growth and Stability Programs for 2010. estimates for the euro area are 1.7% for 2010 and 1.5%1 for 2011; however, with a fiscal shock of such magnitude the downside risks to that forecast are high. A serious slowdown in the region in the first half of 2011 is highly likely and could even include a GDP contraction (see Figure 4, on page 4, for a summary of alternative short-term scenarios). Reinforcing this view is the fact that Eurozone members are highly dependent on one another for trade, extending the potential impact of any fiscal retrenchment across Europe. The leading economy in the area, Germany, depends on other EMU members to consume roughly 40% of its exports. If such a slowdown occurs, investors should expect a lax monetary policy and ECB quantitative support lasting longer than in the United States. Inflation may stay subdued, as deflation pressures in the peripheral countries pull the Eurozone inflation average downward. 1 Official IMF projections for real GDP growth, as of October 2010. This forecast partially reflects the impact of expected fiscal adjustments. 3 Short-term horizon (2011) Figure 4. Alternative short- and long-term scenarios for the Eurozone Probability Scenario Market implications High 1. Fiscal austerity and economic slowdown. Simultaneous fiscal austerity programs create a drag on growth across the euro area, likely with some divergence between strong members such as Germany and the weaker peripheral economies. • Elevated market volatility; investors should expect to see some divergence in the equity markets, as stronger Eurozone members may escape recession. 2. Fiscal austerity with an export boom. A strong global economy and a weak euro pull up Germany’s export sector, with spillover effects in growth over the rest of the Eurozone. For the spillover effects to be meaningful, Germany would need to rebalance its current account and stimulate domestic spending. • Upside surprise causes equity markets to boom ahead of the export-led recovery. 1. Muddling through. EMU members recognize that breaking up the currency union would not serve their best interests. The peripheral economies manage their fiscal troubles, enduring several years of restrained growth, and the Eurozone emerges as a stronger market with more structural balance among its members. • Subdued inflation, moderate growth, and fiscal austerity prevent a sharp rise in bond yields. 2. Muddling through, with a Greek restructuring. Greece, starting with a much higher level of debt than the other peripheral countries, restructures its debt within three years, most likely applying haircuts to bondholders. EU regulators will play a significant role in determining the likelihood of this outcome. • Markets distinguish between Greece and the other countries, and remain convinced that the latter will stay solvent over the long term. 3. A break-up of the Eurozone. The global economic outlook worsens considerably, and renewed pressures on the governments of the other peripheral economies result in one or more members leaving the currency union. For this to happen, conditions must have deteriorated so far that the transition costs of leaving the euro (financial market turmoil, banking system stress, etc.) are already being realized. • Necessary conditions for this scenario include a global double-dip recession, probably accompanied by a spike in global equity market correlations, a retreat from risk, and the kind of massive flight to quality we saw in 2008 and early 2009. Medium to low Medium- and long-term horizon (2012 and beyond) High Medium to high Low Source: Vanguard. 4 • The ECB keeps interest rates low for some time, as both inflation and growth remain subdued in the near term. • Expectation of currency appreciation may draw more capital inflow, adding momentum to the rally. • Spreads of sovereign debt of peripheral members over German bunds narrow from current levels, but remain permanently wider than before the crisis. • CDS spreads for Greece rise above 1,100 bps while they remain low for other peripheral economies. • The break-up of the Eurozone sends shock waves to the rest of the global financial system owing to banking system interconnectedness and generalized investor panic. Why is a breakup highly unlikely? Unless global economic conditions worsen significantly, EMU members are not likely to pull the currency union apart. The trade-offs would be too painful for both the stronger members, such as Germany, and the peripheral economies. For Germany, a move back to a national currency would hurt its main engine of economic growth. After the EMU breakup, Germany’s fundamentals (high productivity and low inflation) would drive appreciation of its currency, hurting the nation’s export sector. More importantly, by abandoning the euro Germany would wreak havoc on its own financial system. German bank assets in peripheral euro countries (both private and sovereign debt) amount to 6% of the total assets in the system and to 150% of its Tier 1 capital (a core measure of banks’ strength). The initial sharp appreciation of the local currency In our view, recent price drops in European equities mean that Europe’s markets have for the most part priced in this short-term scenario. Going forward, we might see some divergence in the Eurozone equity markets, as the EMU’s stronger members may escape recession while the bloc as a whole experiences anemic growth on average. A welldiversified approach within the EMU may prove valuable to investors. Long-term outlook: Muddling through Given the gloomy near-term prospects for the Eurozone as well as the long-term structural challenges, talk about the “inevitable” breakup of the EMU has persisted throughout the sovereign debt crisis. That the currency union itself is partly to blame for the crisis contributes to this view. The introduction of the euro allowed for inexpensive capital to flow to the less competitive members of the currency bloc; this amounted to a “free ride” on Germany’s credibility. Access to cheap credit caused construction booms, property bubbles, and excessive government spending in the peripheral countries. that would likely follow a breakup would create massive dislocation in the balance sheets of German banks. Their foreign portfolios would drop in value (in local terms) and the losses could render many banks insolvent, which in turn could trigger a bank panic. Alternatively, some of the weaker EMU members might be tempted to leave the union to cause a competitive devaluation of their currency. However, here too the financial fallout would be devastating, as the move would likely throw these countries’ own banking systems into chaos. Upon the announcement, the local currency would immediately depreciate. Banks in the peripheral Eurozone countries are typically funded externally (in euros) and lend to local businesses in local currency, so the prospects of a sharp currency depreciation would trigger an instant bank run and financial panic. Our view is that a breakup of the EMU would not be in any member nation’s best interest (see the sidebar above for details on the immediate costs to members that abandon the union). A more likely scenario is that the fiscal commitments and bailout measures will persuade financial markets that the peripheral euro governments are on a long-term path to solvency. Thus, the fiscal reforms will be painful in the short term, but in the end will prove beneficial for the EMU. For the peripheral countries, the pain will be especially great, but the likely reward of enduring the current economic slowdown and expected deflation is that they will become more competitive through lower labor costs and lower prices (this is the so-called “internal devaluation”). Figure 5, on page 6, shows the potential deflation adjustment needed in each of the peripheral economies to get back to parity with Germany. Some countries, such as Portugal and Ireland, have already started to deflate; others, like Greece, still have a long way to go. For Greece, the fiscal austerity and deflation adjustments may prove overwhelming to the economy. As tax revenues fall with economic activity, 5 Figure 5. Cumulative inflation gap, 1999–2010 Prices and labor costs have risen much faster in the five peripheral countries than in Germany. This chart indicates the extent of deflation needed to restore their competitiveness relative to the German marketplace. The need for deflation: Price and labor costs in peripheral countries relative to Germany 25% 20 15 10 5 0 1999 2000 Greece 2001 2002 Portugal 2003 Ireland 2004 2005 Spain 2006 2007 2008 2009 2010 Italy Sources: Eurostat and various national sources via Thomson Datastream. Figure 6. Implied probabilities of default priced in by the sovereign CDS market Expectations of a debt restructuring reflected in 5-year CDS premiums, January 1, 2010–October 29, 2010 Probability of a 25% haircut within 5 years 1,200 90% 1,000 88% 74% Did not opt out 85% 18% Partial opt-out 82% 8% Full opt-out 77% Basis points 800 600 72% 65% 400 57% Europe 10-year excess returns: 10-year excess returns: 47% U.S. 10-year excess returns: Global 34% 1-year excess returns: Europe 19% U.S. 1-year excess returns: 1-year excess returns: Global Oct. 2010 200 0 Jan. 2010 April 2010 July 2010 0.25 Greece Portugal Ireland Spain Italy 0.20 Note: The chart shows implied default probabilities that are consistent with levels of sovereign CDS premiums based on a 5-year probability valuation model. Probabilities are calculated as the break-even rate, for each level of CDS spread, at which investors are indifferent between two options—investing in the euro risk-free rate and investing in a Greek 5-year bond plus a sovereign CDS on that security, assuming a 25% haircut on the sovereign bond within 5 years. 0.15 Sources: Vanguard, based on Thomson Reuters via Thomson Datastream. 0.10 6 0.05 the debt burden becomes heavier and approaches unsustainable levels. Greece is in much worse shape than any of the other peripheral countries, because it is starting from much higher debt levels (a 115% debtto-GDP ratio) and needs a considerably larger deflation adjustment. To date, Greece is the only EMU member that has required a rescue to avoid default. Currently, market consensus expectations imply that Greece is highly likely to restructure its debt within the next five years. Figure 6 displays the probabilities of default priced in by Greece’s sovereign CDS market since the beginning of 2010. Currently, CDS spreads of nearly 800 basis points imply roughly an 80% probability that Greece’s creditors will take a 25% “haircut” (creditors receive 75 cents on the euro). Going forward, spreads above 1,100 bps are something to watch for, as this would imply that investors are almost certain of a default event. Although market-based forecasts are often inaccurate, current CDS market expectations are not unreasonable, given the information available today. Greece’s bailout funding is estimated to cover scheduled repayment obligations through about 2012. After that, the Greek government will need to return to the debt markets for additional funding. The bailout last May did not materially change the unsustainable longterm trajectory of Greece’s debt relative to its GDP. Thus, under current economic growth projections, the country will still look insolvent to the markets two years from now. With projections showing that interest rates on Greece’s outstanding debt will be well above its economic growth rate for years to come, even the deep cuts in budget deficits will not be enough to stop government debt from swelling to more than 150% of GDP. At those levels, interest service will take about 10% of the Greek national income, with 80% of that interest going to foreign creditors. Given the country’s weak economy and uncertain growth prospects, it may be too late for Greece to rely solely on belt-tightening as a way out. To be fair, the Greek government has delivered key reforms in its pension system and in its highly regulated labor market; however, the growth dividends of structural reforms like these usually arrive only in the long term. Thus, there is fundamentally a mismatch between the long-term payoff of the reforms and the medium-term funding that Greece will need after bailout funding runs out. The IMF and the European Commission are studying the possibility of extending the current bailout programs to help address this gap.2 The odds of a Greek restructuring event depend on whether relief arrives from the IMF, other Eurozone members, or both. Regardless of the eventual outcome, the bailout last May has likely bought time for the markets to distinguish the rest of the peripheral economies from Greece as contagion fears subside (see the related sidebar on page 8). If it were to happen, a restructuring of Greece’s sovereign debt would most likely entail a swap of bonds for new ones with maturity extensions, and very possibly the imposition of haircuts on bondholders, as the CDS market is forecasting. As noted earlier, current CDS valuation suggests a high probability of a 25% haircut within the next few years. Figure 8, on page 9, compares that rate with recent examples of sovereign debt restructurings,3 and shows that a 25% Greek haircut would be roughly in line with that of Belize in 2006 and less than half of what bondholders experienced in Argentina, the Ivory Coast, and Russia in the 1990s and early 2000s. As of this commentary’s publication, Ireland was facing increasing pressure from its bond markets due to continuing problems in its largely concentrated banking system. Unlike the response to the crisis in Greece, this time around the euro area has preexisting mechanisms for short-term response (i.e., the EU-IMF financial stabilization programs). However, the longterm implications of these developments for Ireland are still unclear. 2 As of the publication date of this commentary, EU regulators had tentatively agreed to a proposal backed by Germany and France to amend the Treaty of Lisbon. The current proposal would establish a permanent fund to aid member states facing financing difficulties, with access to the fund potentially involving penalties such as forced restructuring and a loss of voting rights in the EU. Passage of the proposed amendment is not certain and will likely involve significant debate among member states, as the entire EU will be involved in negotiations, pulling non-euro member states such as the United Kingdom into the process. 3 See Moody’s Sovereign Default and Recovery Rates 1983–2006, June 2007. http://ksuweb.kennesaw.edu/~dtang/CRM/Moodys_SovereignDefault.pdf 7 Figure 7. Latin American sovereign debt crisis, 1998–2002 Yield spreads relative to U.S. Treasury securities 5,000 Period of Russia/Asia debt crises IMF bailout, conditional on austerity measures Basis points 4,000 IMF ceases funding; Argentina defaults 3,000 2,000 1,000 0 1998 1999 Argentina Mexico 2000 Brazil 2001 2002 Chile Note: Spreads display the yields of each country’s corresponding JPMorgan Emerging Market Bond Country Index relative to the yields of U.S. Treasuries of similar maturity. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: JPMorgan via Thomson Datastream, Vanguard. Can contagion fears subside while Greece restructures? Given that Greece is much worse off than the other peripheral Eurozone states, can we expect spreads for other countries’ debt to diverge from Greece (and tighten) as the Greek government approaches the end of the bailout funding? Based on the experience of Latin America in the late 1990s and early 2000s, this expectation appears reasonable. Figure 7 displays sovereign spreads relative to U.S. Treasuries in the years leading up to Argentina’s default on its debt. While the initial shock in 1998 from the Russian ruble crisis (and the other financial crises in Emerging Asia) caused spreads for several Latin American issuers to spike, the IMF bailout of Argentina gave the markets time to distinguish the varying degrees of credit quality within the region: Mexico, Chile, and even Brazil proved to be on a more solvent path versus Argentina, which was clearly headed to insolvency. As a result, when Argentina did default on its debt in late 2001, spreads on the other countries actually tightened. 74% Did not opt out 18% Partial opt-out We think a similar situation would probably arise in 8% Full opt-out the event of a Greek restructuring, with markets distinguishing Greece from Ireland, Italy, Portugal, and Spain. If this is the case, any default event from 10-year excess returns: Euro Greece should be met with modest (not significant) 10-year excess returns: U.S. volatility in the spreads of the other countries’ debt. 10-year excess returns: Glob 1-year excess returns: Euro 1-year excess returns: U.S. 1-year excess returns: Glob Chile Mexico Brazil Argentina 5000 4000 3000 Chile Mexico Brazil Argentin 2000 8 1000 Figure 8. Haircuts during past sovereign restructuring events Estimated reduction in par value for bondholders (%) 0 Russia (1998) Ecuador (1999) Pakistan Ivory Coast (1999) (2000) Ukraine (2000) Argentina (2001) Moldova (2002) Uruguay (2003) Grenada (2004) Dominican Republic (2005) Belize (2006) Greece (?) estimated −20 −40 −60 Value-weighted average: –45% −80 −100% Note: The estimate for Greece is based on analysis similar to that described in Figure 6, using CDS premiums as of October 2010. The implied probability of a 25% Greek haircut within five years is about 80%. Sources: Moody’s Investors Service, Vanguard. Toward a more balanced Eurozone Despite the reaction of financial markets and the widespread fears of contagion, the most likely outcome is one in which the EMU muddles through its fiscal issues, with the peripheral members undergoing several years of constrained growth due to fiscal retrenchment and deflationary rebalancing. Because Greece is starting with far worse conditions than the other economies, a scenario involving either additional bailout funding or a restructuring event appears probable. The short-term economic outlook is bleak, and the long-term rebalancing needed within the bloc is challenging. However, in our view, there would be little benefit in ending the currency union, given the trade efficiencies that a single currency provides and the financial disruption that would result from returning to a system of national currencies. In addition, member nations may have much to gain from working through the current problems. In the long term, the painful reforms will likely prove beneficial, with the European currency union 74% Did not opt out emerging as a more balanced, competitive economy. 18% Partial opt-out 8% Full opt-out 10-year excess returns: Europe 10-year excess returns: U.S. 10-year excess returns: Global 1-year excess returns: Europe 1-year excess returns: U.S. 1-year excess returns: Global Notes on risk: All investments are subject to risk. Investments in bonds are subject to interest rate, credit, 0 and inflation risk. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in -20 developed countries. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Haircut -40 -60 9 -80 P.O. 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