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Sunday, January 17, 2010

The Debt Snowball Problem

OK, just for a change let's start with some math. The increase in a country’s sovereign debt stock to GDP ratio is given by the following formula:

where D is the total debt level, Y is nominal GDP, PD is the primary deficit, i is the average (nominal) interest paid on government debt, y is the nominal GDP growth rate and SF is the stock-flow adjustment.

Now, if like me, you don't especially love maths, you may want to ask "what the hell does this rigmarole mean?".

Well, in simple plain English the above equation - which in fact comes from the recent Danske Bank report on EU Sovereign Debt- means that movements in the critical debt to GDP level depend both on the level of the annual fiscal deficit (the primary deficit, on which so much attention is currently focused in the Greek case) and on changes in the ratio between the value of the stock of debt and the value GDP. The key term is the one in brackets, and it is often referred to as the “snow-ball” effect on debt - the self-reinforcing effect of debt accumulation (or de-cumulation) arising from the difference between the interest rate paid on public debt and the nominal growth rate of the national economy.

Nominal here means GDP values before adjustment for inflation (what is known as current price GDP). So what we can say is that the trajectory of (for example) Greek debt to GDP going forward (and thus the effectiveness of the adjustment programme) depends critically on only three main variables - the rate of deflation/inflation, the rate of GDP growth, and the interest spread charged on Greek bonds. Ideally, Greece needs solid GDP growth, inflation, and a low spread on Greek bonds vis-a-vis German ones. The problem is the Greek Stability Programme may achieve none of these.

In the first place, the attempt to reduce the primary deficit will involve withdrawing some 10% of GDP in government demand from the economy in the space of three years (to go from an annual fiscal deficit of 12.7% a year in 2009 to one of 2.8% in 2012). The Greek government plan projects the economy to shrink by 0.3 per cent this year before rebounding with growth of 1.5 per cent in 2011 and 1.9 per cent in 2012. Most analysts are very sceptical about this forecast, since sustaining any kind of GDP growth under the present circumstances will be hard, and I think the most realistic expectation is that the Greek economy will see some sort of annual contraction during each of the three relevant programme years.

Secondly, to keep the debt GDP level from snowballing Greece needs inflation. But to get GDP growth Greeec needs to restore competitiveness, and this means (given they have no currency of their own) price and wage reductions (ie the so called internal devaluation) so they will have deflation not inflation, or they will not "correct" and move towards GDP growth.

Thirdly, and this one is easier: Greece needs to reduce the bond spread to keep interest rates on the debt as low as possible. This is doable, should Greece be able to convince market participants a viable correction plan is being operated. The ECB could also play a role here. But Monsieur Trichet, in his wisdom, said two things which were relevant in the post-monthly-meeting press conference yesterday. In the first place he said, quite correctly "we are here to help" - which I read as meaning that he is saying to the Greek government that "you take the steps you need to take, and we will help with liquidity", but on the other hand he also said "we will make no exception for individual countries" in setting our collateral rule, which effectively means that (from 1 January 2011) should Greece lose it's A2 status from Moodys (by two notches), the ECB will not be able to accept Greek bonds.

The first statement clearly offers support to the Greek spread, but the second (which might lead people to think they should start to steadily remove Greek sovereign debt from their portfolio) obviously wasn't.

It was hardly surprising then that the yield on the 10-year Greek government bond remained above 6.1% this (Friday) morning, up around 0.2 percentage point from early Thursday. The yield stood some 2.79 percentage points above the yield on the comparable 10-year German bund, the euro-zone benchmark, up about 0.25 percentage point from early Thursday. The spread even widened as far as 2.9 percentage points at one point yesterday, following the ECB meeting, and details of the Greek government's budget plan.

So basically, to make Greek debt to GDP dynamics sustainable, and avoid the snowball effect, my guess is you need two things:

a) to convince investors that Moody's will not downgrade, or some that some other form of support will be offered to the country.

b) some solution to the restoration of competitiveness dilemma. Basically, at the moment the Greek government has no interest in carrying out an internal devaluation, since the deflation impact on the debt formula would simply precipitate the snowball. But if they don't carry it out the economy will not return to growth, and investors will lose confidence and the bond spreads widen again, effectively setting off the snowball via another route.

So there needs to be a quid-pro-quo here, where the EU authorities undertake to restructure Greek debt in some way via the use of (eg) EU bonds (the famous bail-out) should Greece comply with a certain number of specified conditions first. Now many will scream at this point, "well they got themselves into this mess, now let them get themselves out of it". But matters are never that simple. Greek sovereign debt is in part a by-product of the eurosystem experiment, which made the accumulation of such debts at apparently cheap rates of interest possible (although none of those responsible for overseeing the system seem willing to recognise this). The Greek people have to accept their share of responsibility for the mess, and for the behaviour of their elected representatives. But there should be a limit to the "financial penalty" imposed. As Martin Wolf says in the Iceland context:
The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons. Asking a people to transfer as much as 50 per cent of GDP, plus interest, via a sustained current account surplus is extraordinarily onerous.
In fact, asked in a Reuters poll carried out between January 11-14 what they felt was the the probability of Greece actually seeking a bailout this year, the median response from around 30 analysts that they would was 20 percent, with the same likelihood being expressed that it would be necessary at some point in the next five years.

This is not a very high probability at this point, but then when the same sample of analysts was asked about future ratings decisions, some 16 of the 27 analysts involved said they thought Moody's Ratings Service would downgrade its rating from A2 to a below-A rating by the end of the year. This is a much more significant result.

As it happens, I personally don't agree with either verdict, since in the first place Moody's are concerned with long term sustainability, so I doubt they will change their view on that one this year if the Greek government follow an agreed EU programme, while I do think (for the reasons expressed above) that some sort of Greek "bail-out" will be necessary over the next five years (to stop the snowball) if the government does what it has to do.

But all of this only serves to highlight juest how precarious the Greek situation actually is, in particular since the government still haven't accepted the need for internal devaluation, which is the only policy which will really restore growth. With a majority of analysts thinking Moody's will move to a below-A rating by the end of the year, and Monsieur Trichet saying that as of 1 January 2011 the ECB will not accept such bonds as collateral for lending, something, somewhere is likely to give, which is why I think the Greek government should at this very moment be throwing itself into the welcoming arms of the IMF before matters reach the point of no return on the spreads and the debt snowball. To do otherwise would be to risk far greater problems in a future which will not be that far away.

The Italian Lion Sleeps Tonight, And Yet Awhile..........

“If we look at public-sector debt and interest payments, Greece isn’t doing particularly worse than Italy,” Peter Westaway,Chief Economist Europe at Nomura International
To everyone's relief, Italy's economy returned to growth in the third quarter of 2009, following five consecutive quarters of contraction. But that doesn't make the future look or feel any more secure than the recent past, and while an immediate return to a sharp recession isn't likely, it still isn't clear whether the Q3 performance was repeated over the last three months of last year, or whether output remained more or less flat. This does seem to be a more or less a touch and go call, and while the final result will hardly be a shocker one way or the other, my feeling is that we are looking at growth in the region of -0%. That is to say, slight contraction is marginally more likely than slight expansion. So Italy's economy is more or less dormant, but it's debt to GDP ratio is not, and is moving steadily upwards (see the last section of this post), so the lion sleeps tonight, and goes on sleeping, but what will happen tomorrow when she, or rather the financial markets, finally wake up, and discover seems evident, at least to me and Peter Westaway, that in the longer run Italy's sovereign debt problem is every bit a large as the Greek one, although given that most of the debt is in fact held by Italians, the threat to the good functioning of the eurosystem may well be proportionately less.

A "Weak" Recovery

If the most recent past is still clouded in uncertainty, what is a little less in doubt is the sort of rebound we might expect from the Italian economy, since any bounceback will surely be extremely muted to say the least. The Italian economy has been loosing steam for decades now, and only grew by something less than 0.5% per annum over the last - boom - decade. With the working age population declining and ageing, the outlook for the next decade is hardly improved.

My best-guess estimate is that the Italian economy contracted by something like 4.8% in 2009 (just a little less than the 5% German contraction), following a 1% drop in output in 2008. Consenus opinion is mildly optimistic for the year to come, but expectations are modest with the Bank of Italy arguing that what is still the euro region’s third-biggest economy will experience a “weak recovery” this year and a 0.7 percent expansion in 2011. Of course, as with forecasting the weather, the further into the future you move, the greater the level of uncertainty which is attached to any growth estimate, and in current global conditions this is even more the case. The Italian central bank forecast compares with a November projection from the Organization for Economic Cooperation and Development of 1.1 percent growth this year and 1.5 percent in 2011, while the IMF projects 0.25% growth for 2010 and 0.75% for 2011, and the EU Commission currently project 0.7% for this year and 1.4% for 2011.

Certainly all parties project that internal consumption will remain weak, and what growth they are expecting should be driven by external demand, which, of course, is itself subject to considerable uncertainty as government stimulus after government stimulus is steadily withdrawn. Almost all EU economies are now looking to live from surplus demand in other countries, and like the British working classes in the nineteenth century they can't all surely hope to live from "taking-in each others washing".

More than talking about growth, what we are really talking about is getting back to where we were, since if we look at the level of Italian GDP, it is clear that there has been a sharp drop in output since the start of 2008, and at current rates of growth it will be many years before we get back up to 2007 levels.

Mario Draghi, Governor of the Bank of Italy suggested at the end of last year that it would take four years for the Italian economy to return to its 2007 size. If the recovery is slower than anticipated these four years could easily turn into five or six with fairly serious implications for the Italian sovereign debt dynamic. Indeed, there already appear to be more downside risks emerging than the above forecasts contemplated and I'm inclined to agree with that doyen of Italian economy bank analysts - Unicredit's Marco Valli - when he argues for a likely upper limit to growth this year at around 0.5%, with plenty of scope for it to come in even lower.

Touch and Go In Q4

" We doubt that the pace of growth seen in the third quarter will be maintained in the fourth one: given the weak momentum with which industrial production closed the third quarter (-5.3% monthly in September after +5.8% in August), a substantial deceleration in industrial activity and GDP is likely in the final quarter. However, given that manufacturing surveys keep pointing north, car registrations remain firm and there are increasing signs that services activity is starting to re-gain some traction, we have penciled in flat GDP for the fourth quarter"
Unicredit's Italy Economist, Marco Valli, 23 November 2009

In line with most analyst expectation expectations, the Italian economy expanded by 0.6% between the second and third quarters of 2009, an improvement which was largely driven by a 4.3% quarter on quarter (qoq) rise in industrial output. GDP also benefited from a rebound in exports (+2.5% qoq) and machinery/equipment investment (+4.2%), some growth in private consumption (+0.4%, on strong car registrations) and a moderately positive contribution from inventories (+0.1pp). The evident weakness was construction investment, which continued to fall sharply (-2.1%).

Industrial production has been steadily losing momentum in the fourth quarter, and was up only 0.2% in November, on the back of a revised 0.7% increase in October. These rises follow a sharp 4.9% drop in September which means, assuming the upward December output rise is close to that indicated in the last PMI, industrial production in the last three months will be more or less flat in the final quarter when compared with the third, and could even be slightly down.

On the other hand, Italian consumer activity - normally the weak spot in Italian GDP - does seem to have recovered rather during the quarter. Consumer confidence has imporved considerably of late.

And while retail sales have long since stopped their upward trend ...

the retail PMI showed growth in both November and December following 32 consecutive months of decline.

Also services activity has been stronger, with the services PMI registering growth during the fourth the quarter for the first time in many months.

In fact private consumption has been looking up in the last two quarters, and this trend may continue.

However, at some point there will be a deceleration in momentum, since consumption will undoubtedly be negatively affected by the expiration of the car scrapping premium. As Marco Valli puts it: "the extent of the correction in durable goods spending crucially depends on whether the government decides to quit the premium outright (which we regard as unlikely) or opts for a gradual phasing out of the incentive scheme (more likely)". It is worth bearing in mind, however, that even if the current premium scheme were to be fully confirmed for the whole of 2010, the effect on car registrations would be much more restrained than in 2009, due to the fact that most of the earlier pent-up demand has already been met.

Is Italy Export Dependent?

Even if this seems strange to many people, the Italian economy is, in fact, highly export-driven. In this sense Italy is heavily reliant upon the recovery of German demand, and it just thios demand which now seems to be faltering. In Q1 2009, German imports fell 5.4% over the previous quarter, after dropping in Q4 2008, driving Italy's economy further and further down.

Exports amounted to some 28.8% of Italian GDP in 2008. In the third quarter of last year Italian exports grew by 2.5% on the quarter following a 2.5% drop in the previous one, while imports were only up 1.5% following a 2.5% drop in the second quarter. Thus the trade factor was positive for GDP growth. This situation seems set to change in the last quarter. Seasonally adjusted October exports were down, while imports fell less than exports, and if this trend is continued in November and December net trade will in fact be a drag on GDP. To my insufficiently well trained eyes it looks very much like the German car stimulus gave a big boost to Italian industry in August, and that this effect is now waning, even if the domestic Italian stimulus counterbalances to some extent.

Fixed Capital Investment Stimulated By Tax Incentives

Capital spending decisions look little better. Spending on machinery and equipment was up 4.2% quarter over quarter in Q3, but was still down 16.1% on the year, and the relatively strong recent performance is partly due to a tax incentive provided by the Italian government.

Again, Marco Valli points out that investment decisions are likely to remain conservative next year, since levels of corporate indebtedness are still high in an environment where profitability is notably weak. Moreover, extremely depressed capacity utilization rates will unavoidably put a ceiling on business investment. However, Valli suggests that firms will undoubtedly continue to take advantage of the tax bonus on machinery investment to replace old machinery during the first half of the year. When the bonus finally expires in July 2010, it is likely there will be a sizeable capex correction. As a result Unicredit expect machinery investment to drop 0.9% in 2010 following a likely -16% in 2009.

Official Figures Underestimate Unemployment

In November 2009 the Italian unemployment rate reached 8.3% in Novemember, as compared to 7.0% a year earlier. The European Commission expects the annual unemployment rate to rise to 7.8%in 2009 and 8.7% in 2010. The OECD's November 2009 economic outlook also expects Italian joblessness to peak in 2011 at 8.7%.

But the EU harmonised method of calculating unemployemnt rather underestimates the situation in the Italian case, and Italy’s real unemployment rate is significantly higher (around 10.7% according to Bloomberg calculations) once you add-in those workers paid by a fund known as cassa integrazione, or CIG. The CIG pays laid off employees about 80 percent of their salaries for up to two years.

Again Bloomberg calculate that use made by Italian companies’ of the CIG fund quadrupled to almost 1.5 billion euros in 2009 from 365 million euros in 2008. The official cost of the CIG in 2009 will be published in the annual report of INPS (the Rome-based agency that handles the welfare payments) later this year. Under Italian law, businesses suffering from a downturn can lay off permanent employees for as long as two years and take them back when conditions improve. In fact CIG aid can be extended to five years if the government decides that circumstances are “exceptional.”

Difficult Years Ahead If Italy Wants To Consolidate Its Fiscal Position

The overnment's response to the present crisis has been - at least formally - rather moderate due to the need to avoid a substantial deterioration in public finances, given the very high level of already existing government debt in a context of increased global risk aversion. Evidently the Italian government didn't want to draw attention to itself in the way the Greek one has. As a result measures taken to support low-income groups and key industrial sectors have been largely financed by reallocating existing funds, and this is even largely true of the additional stimulus package of 4.5 billion euros, in an effort to "intensify actions against the crisis," according to Minister of the Interior Claudio Scajola in a statement at the time.

However, even given this evident restraint, the EU Commission sill forecast that the government deficit probably widened to 5.3% of GDP in 2009 (from 2.7% in 2008) and remain at around that level in both 2010 and 2011. In comparison to other EU country deficits this is not big beer, but it does need to be situated within the context of the long history of public indebtedness in Italy.

Primary expenditure looks likely to have risen by more than 4.5% in 2009, significantly faster than planned in the stability programme update submitted to the EU Commission in February 2009. In particular, public sector wage growth is continuing to outpace inflation. In addition, government financed consumption via social transfers grew considerably in 2009 due to a combination of pensions being indexed to the previous-year's inflation, one-off transfers to poor households and the extended coverage of the wage supplementation fund. Capital spending also rose by an estimated 13%, as a result of recovery measures that bring forward some previously agreed investment plans. The only significant item expected to decrease is interest expenditure, which is benefitting from historically low short-term interest rates.

While the strength of the 2009 downturn understandably derailed the three-year budgetary consolidation plan adopted in summer 2008, a marked slowdown in expenditure dynamics is likely in 2010 and 2011, as the government attempts a return to the planned consolidation path. Capital expenditure is set to decrease in both years, while modest increases are projected for current primary expenditure. Interest expenditure is also expected to rise, due to monetary policy decisions at the ECB and the expanding size of the debt itself.

The EU Commission estimate that the gross government debt-to-GDP ratio climbed by almost 9 percentage points in 2009, to around 114.5%, and forecast that it will continue rising to around 118% in 2011. The 2009 increase is overwhelmingly due to the sharp fall in nominal GDP. Looking forward, the EU Commission emphasise that ongoing interaction between high debt-service requirements and Italy's low potential GDP growth rate underlines the importance of raising the primary balance so as to put the very high debt ratio on a declining path once again.

In this context, one of the concerns about Italy's government debt trajectory is the extent of recourse to one-off and make-and-mend measures to keep the state finances afloat. One good example of such a measure are the tax amnesties, a technique which Italian Finance Minister Guilgio Tremonti has had considerable experience with, since in both 2001 and 2003, as part of an earlier Berlusconi government, he enacted similar measures that brought some 20 billion euros back to Italy, with a further 15 billion euros being declared by Italian clients of Lugano banks, though it remained in Switzerland. But the yield the first time round has been dwarfed by the rich harvest this time. Mr. Tremonti recently announced that Italians had declared 95 billion euros in assets under the plan, with some 98% of the money being brought into Italy from offshore sources. The harvest should have added something like 5 billion euros to 2009 Italian tax revenue, and although the plan formally expired on December 15, a further ammnesty period is not ruled out.

In fact the Italian Finance Minister has often come under attack from those who want to see the government taking more decisive action against the economic crisis, but his insistence on fiscal prudence appears to have been justified, given the difficulties currently facing Greece. For once an Italian government can be congratulated for its prudence, and the risk premium on Italian government bond yields was just overcompared with benchmark German bunds is running somewhere around 80 basis points as compared with Greece, where the spread is now over 250 basis points.

Resources are also being acquired from the Trattamento di fine rapporto (TFR), a fund containing contributions paid by employers for employees' severance pay when they retire, leave their jobs or are made redundant. Although there is little doubt that the government will eventually reimburse the money, it is likely that it will have to resort to increased taxation or cuts in expenditure to do so.

So the issue is, that far from using the crisis as a justification for implementing the much needed deep-seated reform, it has instead and once more been used as an excuse for postponing it. I leave you with the words of The Italian economist Francesco Davieri, writing last June in the economics portal VOX EU:
If Italy’s government does not push reform more aggressively – issues like pension reform, the schooling and university system, and the labour market – the most likely scenario is that the Italian economy will return to its usual...[lacklustre]....annual growth after the crisis. This is why postponing reforms in today’s Italy is like consuming a luxury good when you are close to starvation. Today’s Italy just can’t afford it, if it wants to resume faster long-run growth.