Vgis macro the pigs and the emu lost decade

VANTAGE
GLOBAL INVESTMENT STRATEGIES

Wednesday, 10 February 2010 Macroeconomic Research & Global Investment Strategies

Is the European Monetary Union on the
brink of a lost decade?
The turmoil in which Greece has lately found itself has placed the entire Eurozone
into the spotlight, against all expectations. Long regarded as a safe and stable
harbour – though plagued with low below-average growth –, the ten-year old,
sixteen-member strong union is possibly undergoing its more severe test ever.
Chinks had arguably appeared in the credibility armour of several late joiners –
such as Spain, Portugal and Greece –, but the towering presence of the European
Central Bank and the assumed German support was deemed good enough to justify
a wide convergence of spread levels throughout the last decade. The credit crunch
and its consequences have completely reshuffled the deck: a new, far more
uncertain era may be about to open for the Eurozone.

Urgent intervention needed: The trouble with which Greece has been battling
recently could well be a first instalment of far more damaging action. We do believe
that leaving the problem alone will not suffice to solve it: an intervention (initiated
from the ECB, fellow EMU-members or the IMF, by decreasing order of cost
efficiency) is urgently needed. Recent talks about bilateral support from Germany are
welcomed in the short term, but won’t be enough in the longer term.

Double dip recession risk: This sovereign crisis could even be the spark that
lights the double-dip powder in Europe at least. If there is no immediate reaction
from the ECB, EMU members or the IMF, we regard this outcome as likely, and
Fahd Rachidy advocate cutting back on exposure to European stocks for some time.
Phone: +44 (0)20 3107 5373
Some options are not sustainable: Outright default won’t be permitted, fiscal
email: frachidy@vcmllp.com
and budgetary reforms won’t be sufficient to curb the debt crisis, and any economic
recovery won’t happen in the short term. Spain is more important than Greece in
Frederic Bonnevay the EMU: dealing with Athens without taking care of Madrid’s disease in the same
Phone: +44 (0)20 3107 5370 time will be a short-lived placebo.
email: fbonnevay@vcmllp.com
Two credible solutions left for a technical bailout?
• Explicit Sovereign Quantitative Easing from the ECB: the Central Bank could
directly buy government paper of Greece, Spain, Portugal or other members
of the Eurozone area. But this option is limited in time and quantity.

• Creation of a Eurozone Stabilisation Fund, as a means of mutual support
from ALL members, and - most importantly - as a way to provide liquidity
and buy time for euro sovereigns who need to make fiscal adjustments.

VANTAGE GLOBAL INVESTMENT STRATEGIES
Tuesday, 9 February 2010 Macroeconomic Research & Global Investment Strategies

Introduction

Inaction is not permitted, In every major crisis you don’t really have much choice. You cannot choose
decisions urgently needed between inaction and action, because ultimately you will be forced to act.
You do not really choose between bailout and no bailout, because very soon
you find that all the reasonable options involve some sort of bailout for some
people (and not for others). And, try as you might, there is no way to choose
to let your neighbors fail completely - because that failure has such awful
consequences for their citizens and, in all likelihood, for your banks, that you
finally come across with the money.

Only the form of assistance But you do have a choice on when to come to help your neighbors and your
leaves limited options friends, and you can definitely choose the form of this assistance. If you come
in earlier and in a more systematic fashion, the cost for everyone is lower
and the chances of a fast recovery are stronger.

And bailout is not one of The sensible decision might seem obvious from a distance or in retrospect, but
them… it’s this exact choice that the richer and more stable countries in Western
Europe are now struggling with. However, one should not forget that EMU
members have signed a Eurozone no-bailout’s clause with the Maastricht
Treaty…a German request at that time.

Much as it was necessary to let Lehman Brothers go down the pipe before
bailing out the remaining banks, will it be necessary to let a profligate
government default and ask for IMF assistance before punching a hole in the
no-bailout clause?

A remedy worse than the In a way, the current situation can be viewed as a neat illustration of the
disease? winner’s curse: costly unorthodox measures implemented by central banks
worldwide, forcefully throwing newly created money at then-fragmented
markets to curb yields, have successfully led investors to pile into sovereign
paper. Now that such « artificial » support is being removed – as was already
(or is bound to be) announced by monetary authorities – and as the ever rising
tide of capital inflow abates, debt holders suddenly realize just how badly
public finances have fared over the past two years, and feverishly question the
de facto solvency of the most fragile States. This sequence may look familiar
to any keen observer of sovereign debt history. There is, however, one crucial
difference between the current – admittedly still mounting – crisis and those
of 1994, 1997-98, and 2001-02: this time, industrialized countries, rather
than emerging markets, find themselves in the eye of the storm.

While far from being the only State to have suffered a credibility blow in
recent weeks, Greece is thus far facing the perfect storm. With spreads
between Greek paper and German Bunds skyrocketing by the day, abysmal
deficits – making a mockery of Maastricht’s Stability and Growth Pact-defined
criteria –, and fellow Eurozone members sending lukewarm signals when
asked about the possibility of a bail-out, the Papandreou administration has its
back against the wall. The choices that it is left with seem equally unpalatable:
a prolonged period of fiscal profligacy, along the lines initially advocated by
the ruling left-wing PASOK, would bring the country to ruin and precipitate the
much-feared default; on the other hand, too sharp a U-turn towards budget
austerity would choke domestic consumption and growth.

The debt crisis is rapidly Worse still, the Greek debt disease has started to propagate throughout the
spreading to other EMU EMU, as the financial health of Portugal, Spain, Ireland (and possibly Italy) is
members being challenged by nervous market participants. A widening rift is dividing

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the Eurozone into two groups – Germany, France and the Benelux, on the one
hand, the so-called « PIGS », on the other. Not only does this bode extremely
poorly for the ten-year old monetary union’s future, but this could also very
well prompt a second, generalized market collapse – putting an end to what
would have then been a short-lived, if powerful, technical rally.

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Exceptional measures for exceptional times: crisis and
response
The towering costs of public response
Financing heavily imbalanced budgets left debt as the only option on the
table: nearly USD 12,000bn were raised by OECD countries in 2009 compared
to just USD 10,000bn two years earlier, not only overburdening State with
new liabilities, but also jeopardizing the long-term equilibrium of capital
markets.

According to IMF projections (Source: World Economic Outlook, October
2009), the United States bears a (central government) public debt of 58.2% of
GDP, when Germany and France have already surpassed the 70% threshold,
some thirteen points above 2007 levels in Berlin’s case, not to mention Italy’s
113% and Greece’s ca. 170% (or EUR 300bn) levels.

Heavy debt is not the issue by The absolute level of debt may not, by itself, be a relevant indicator when it
itself… comes to measuring sustainability: a high debt stock, if easily refinanced and
combined with a manoeuvrable budget, a competitive economy as well as fast
growth rates, is clearly no cause for concern. In fact, the trouble is that none
of these conditions is satisfied.

• First, refinancing such vast pools of mostly short-dated paper will
not be easy. Deeper deficits in most debtor countries have translated
into higher, concomitant capital raising needs. Most issuers – both
public and private – have rushed to the market last year in the hope
of benefitting from extraordinarily favourable conditions: a record
USD 14,000bn of investment grade paper was issued in 2009. Public
…But short term paper auctioned by OECD countries consisted essentially of short-
refinancing, budget inertia dated securities: over 70% of total volume in the United States against
and countercyclical around 52% in the Eurozone. Hence, most governments will have to
measures are. come to the market again over the coming months: yet, without
continued QE support, there is no guarantee that the auctions will
proceed as smoothly as they have last year.

• Second, budgets are all but manoeuvrable. The extreme measures
taken by most governments carried the embedded cost of near-
permanence. Steep tax cuts, initiatives directed at the industrial
sector and stepped-up benefits cannot be removed just as briskly as
they were introduced, due to both political and economic realism. The
early winding down of ‘cash-for-clunkers’ programmes has already
taken a toll on growth – a warning sign that has not left governments
indifferent.

• Third, competitiveness and growth rates were probably hindered by
the crisis and the subsequent public stimuli. Not only has the huge
drop in orders stomached by companies until mid-2009 driven
capacity reductions, but countercyclical « backstops » will inevitably
translate into higher taxes and production costs – making growth
generally more tepid and less resilient than it was before.

All in all, what seems most problematic arose not so much from deeper
deficits and increased debt levels, strictly speaking, but far more their near-
permanent nature and for the tensions that the short-dated claim refinancing
effort will continue to generate. The Greek episode is probably a mere omen
of a far deeper crisis.

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Fig. 1: 2009 Gross Marketable Debt Issuance

Source: OECD Projections

Table 1: Short Term Issuance Projection (USD bn)

ST Issuance Projection % of Short Term
2009 (USD bn) Issuance
North America 5350 70.4%
Euro zone 802 52.2%
Other Europe 156 28.5%
Asia - Pacific OECD 267 20.3%
EM OECD 73 35.9%
TOTAL OECD 6648 59.4%

Table 2: Change in Borrowing

Change in Gross Change in Gross Change in Gross Change in Net
Borrowing Borrowing Borrowing Borrowing
2007-2008 2007-2009 2008-2009 2008-2009
North
America 47.6% 59.7% 8.2% 46.1%
Euro zone 26.8% 56.5% 23.4% 84.9%
Other Europe 83.6% 116.2% 17.8% 75.7%
Asia - Pacific
OECD 5.1% 8.6% 3.3% 197.1%
EM OECD -4.4% 3.8% 8.5% 71.2%
TOTAL OECD 37.1% 51.5% 10.5% 61.5%

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A Pyrrhic victory over the credit crisis
Countercyclical measures Strange as it may seem, the remedy could well have been worse than the
swiftly implemented by disease. The standalone impact of the credit crisis has undeniably drained
most OECD members only fiscal revenues, as corporate profits waned, income tax receipts crashed, and
aggravated the trend VAT-derived payments fell due to consumption weakening. But the
countercyclical measures swiftly implemented by most OECD members only
aggravated this trend: stabilizing measures, first aimed at reassuring tense
investors and restoring financial market to a normalized trading regime, at
kick-starting banking credit, and at supporting private demand, surely did not
come free. Huge public deficits, dwarfing any of those witnessed over the past
decades, soon followed.

Germany’s 5% budget imbalance last year – corresponding to a shortfall of
over EUR 85.8bn to which a belated EUR 14.5bn had to be added as a
consequence of last-minute fiscal stimulus enacted by the first Merkel
government – compares poorly to 2007’s near-equilibrium. France’s 8.1%
deficit (or around EUR 150bn) leaves little hope of narrowing swiftly over the
next few years, in spite of the administration’s spending cut rhetoric.

Greece, this quarter’s worst offender by far, announced an even more
startling 12.7% deficit – over four times the floor imposed by the Stability and
Growth Pact –, and admitted to having cooked its books for gaining Eurozone
admission. Other members of the now infamous ‘PIGS’ group, though not in a
comparable state of despair, shared a common and alarming trait: their
domestic growth engine, fuelled by consumption and foreign direct
investment (notably in real estate, in the case of Spain), had come to an
abrupt halt. In other words, the extent of the damage inflicted by the credit
crisis had by and large been frozen by emergency measures taken at the turn
of 2009 – but the real test remained ahead. The Portuguese budget deficit
rose from 2.7 per cent of gross domestic product in 2008 to a record 9.3 per
cent last year. Public debt is expected to hit a 20-year high of 85.4 per cent
this year. Spain's deficit rose to 11.4 per cent of GDP last year, and its public
debt, although low by Eurozone standards, is rising. In addition, Spain has
been running a trade deficit for the last decade.

Are PIGS bonds junk bonds? Greek strike prospects helped send the 10yr Greek/German spread up 10bps
to 360, and Portugal edged up to a new 10-month high of 163; and Spain
settled just over the 100bps mark. The latter occurred even as Spain
announced that its net bond issuance this year would be 34% less than last
year and promised to cut spending as necessary. For the latter two markets, it
seems the pressure will remain for spread widening (despite offering adequate
risk premiums in our view) until there is solid progress on either the fiscal
front or an EU pledge to provide emergency relief/ guarantees if called for.

In the meantime, uncertainty prevails, as does the risk that the Iberian
peninsula spreads could break to new post-EMU highs. After all, while
Greece has widened by 220bps since the end of October, Portugal has
widened by half that and Spain by just 45bps.

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Eurozone’s structural weaknesses revealed
Latent imbalances
Were PIGS enjoying an EMU Indeed, lack of fiscal discipline in Greece – and in other ‘PIGS’ countries – is
free ride? hardly news. For the best of the past ten years, the government has posted
deficits far larger than was allowed by Maastricht’s SGP, while also largely
letting its sovereign debt rise steadfastly. The « low accuracy » of Greek
statistical releases, furthermore, was a secret to no one, including when the
country was first admitted to the union. Spain’s own statistics, on the other
hand, were probably less unreliable, but possibly no less deceitful, as the
budget surpluses amassed over the last decade where chiefly the result of
powerful investment inflows – leaving the Spanish economy in a very frail
position.

German and ECB’s Dropping the drachma and the peseta, though, was a mixed blessing. The
protection is not enough advantages were, self-evidently, numerous: far cheaper borrowing
anymore. conditions, thanks to converging debt spreads, a stable currency, protective of
investment flows, reinforced commercial ties to other member countries –
and, not least though stunningly for the naive, a license for fiscal carelessness.
The existence of a Stability and Growth Pact was enough to convince investors
that nothing could ever happen to Greek or Spanish solvency, protected as it
was by the joint shield of Frankfurt and Berlin, and a relatively stable capital
market environment proved them almost continuously right: they merely
enjoyed the relative premium paid by Madrid or Athens-issued paper.

This equilibrium, however, was altogether – though not completely
obviously – very frail, dependent as it was on German means and goodwill.
The imposing FRG-GDR reunification bill had apparently been footed without
harm, so providing a modest financial lifeline to a fellow Eurozone member did
not seem as too great a cost against the likely adverse currency movements
that the mere possibility of a sovereign default would necessarily cause.

From free ride to free lunch to free fall
Peripheral countries thought that they could therefore safely play this « free-
riding » game forever. 2008’s credit crisis came as an unwelcome reminder of
the extremely hypothetical foundations on which convergence relied. The
financial tremor hit Germany badly enough to justify a political repositioning
of the Merkel administration, focused on bailing out its breathless and toxic
asset-ridden Landesbanken, while also pulling its vital exporting sector out of
recession.

Leading to a complete risk As Germany licked its wounds and announced unflattering, dark red deficit
reassessment figures, investors started to worry about the exact worth of their erstwhile
assumptions, shortly thereafter coming to a complete risk reassessment of
sovereign paper – and sending Greek (later Spanish and Portuguese)
government bond yields through the roof – validating the downgrades
inflicted by rating agencies (now standing at BBB+ and A2 with S&P and
Moody’s, respectively, still eligible for ECB monetary policy operations, where
the minimum rating is BBB- since October 2008 and until further notice).

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Fig. 3: 10yr Sovereign Curve Yields (%) – Greece, Spain, Germany and Portugal

Source: Bloomberg

The vicious nature of this situation is made clear by the late consequences it
has had on Iberian debt, and on the euro – hitting the former paper by classic
credit contagion mechanics (much like those that applied in 1997 in Indonesia
and South Korea, prey to Thai speculative bouts of fever), and deteriorating
further the trend of EURUSD appreciation.

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Three scenarios
This nascent debt crisis could have dire consequences. The magnitude of the
recent action seems excessively violent. It could still cause grim decisions to
be taken on the domestic, European or international front. The evolution of
the Spanish and Greek issue will likely determine the outcome of the entire
process, provided that fast initiative is taken to restore credibility. We study
three possible scenarios before turning to our probabilistic assessment and
corresponding investment recommendations.

1/ Outright default
An outright default, while technically possible, is unlikely.

The consequences of the Greek turmoil have thus far been limited to some
EURUSD easing (beneficial to the exporting members of the EMU – chiefly to
Germany) and to some flight-to-quality action on the government bond
market (again, beneficial to Bunds). An outright default would send the
Eurozone into a legal void widely perceived as much too detrimental and
harmful not to be avoided by all means. It would also greatly hurt German
and French banks – with a respective EUR 43bn and EUR 75bn exposure to
Greek government debt (of all kinds) in Q3 2009, according to the BIS – far too
hard to be tolerable. The same reasoning applies to Spain and Portugal,
where German banks held claims of over EUR 240bn compared to French
banks’ EUR 195bn and Dutch institutions’ EUR 127bn.

We do not think that neither the ECB nor the EMU will let Athens, or Madrid,
or Lisbon, fail to pay its creditors. Both economical and political costs would
be catastrophic for European countries. For the same reason, opting out from
the Eurozone does not appear as a credible scenario, and therefore
devaluation will not happen, unless EMU members suddenly decide to kill
forever the 50 years old European construction.

2/ Normalisation and new sources of tax revenue

We do not think that fiscal and budgetary reforms will be sufficient to curb
the debt crisis, and any economic normalisation will not happen in the short
term.

Greek’s plan failed to George Papandreou, the Greek Prime Minister, has already presented an
convince… incredible reform plan to Brussels – and to the market – that draws a roadmap
to deficit reduction and debt stabilization. This plan, which targets an
appalling 9.7% budget balance improvement « by 2012, » all too logically
failed to convince: either this pledge amounts to a promise of dismantling the
Greek State over twenty-four months, or it is a thinly disguised wisecrack to
please investors. In both cases, anyhow, the result does not sound very
satisfactory – hence the renewed tensions on Athens’ paper. Yesterday,
Greece says it will cut public sector wages by as much as 5.5%. This comes
after a variety of other revenue-raising plans such as raising the income tax
rate for incomes between EUR60k and 75k.

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Fig. 2: 5yr CDS for Greece, Spain and Germany

Source: Bloomberg

…and so did the Spanish Spain’s repeated stimulus effort and bleak growth outlook (due to dried up
one investment) might justify some risk revaluation (as does, to a much lesser
extent, Portugal):

Spanish economic Minister Elena Salgado, in a London this week, has
announced a new tax reform bill. Among the key elements, we highlight the:

• introduction of a unified progressive tax scale for income from all
sources
• abolition of autonomous taxation and tax exemptions in personal
income and corporate earnings
• treatment of distributed earnings as personal income
• reintroduction of a progressive tax on large property
• effective taxation of off-shore companies

Markets are notoriously moody, and hypersensitivity simply cannot last
forever. Credible fiscal and budgetary disciplines are urgently needed,
though they would initially have a countercyclical effect. Cutting spending
and raising taxes will help refinancing, but the short term effect won’t be
sufficient and Spain and Greece currently lack political credibility, and will
have to face social unrest. In addition, both countries (and other Euro
members) are facing scary demographic challenges that will further pressure
their political ability to push for reforms.

Better-than-expected unemployment numbers, an upturn in consumption, a
resurgence of bank credit or solid corporate earnings could curb the current
pressure. In other words, the situation could normalize by itself, letting
Greece, Spain and Portugal escape the turmoil more or less unscathed. This
solution, unfortunately, does not look ready to materialise just yet, and we
believe that any form of easing tensions will necessarily have to be prompted
by an external intervention.

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3/ Bail-out
A bail-out is an alternative. This can come into two forms, of two kinds each:
actual (funded) or promissory, EMU- or IMF-initiated.

Clearly, a Dubai-alike solution would scare markets to death and would also be
very costly – directly and indirectly. So there is a good chance that, unless
Athens is on the brink of financial implosion (which we think it is not,
independently of its longer-run solvency), someone will come to reassure
investors by guaranteeing, one way or another, that help will be provided if
needed.

An IMF intervention would be a political blow to the Eurozone’s ambitions: it
remains, nonetheless, very possible. Much more likely though is a Berlin- or
a Frankfurt-driven intervention.

Germany’s Chancellorship (or Ministry of Finance) is now trying to publicly and
unambiguously moot some form of EMU-solidarity: this would certainly be
effective immediately, but remains remote, due to the political cost thereby
transferred to Berlin and the lack of any credibility improvement on Athens’
the beneficiary State’s part. (It should be added that this move would, strictly
speaking, not be compliant with European law: verbal support may well be
useful, but an effective bail-out would be far more problematic, due to the
non bailout clause.)

An ECB solution, on the other hand, is perfectly feasible and far less costly.
Enabling PIGS debtor countries to refinance their budget and protecting
them against adverse yield shocks can be done:

(i) by publicly promising banks to accept Greek they considered
sovereign paper as collateral irrespective of ratings (while also
restricting other private securities so as to prompt a net increase in
demand for Athens’ those bonds). The problem in this case is that the
institution’s President, Jean-Claude Trichet, has already voiced the
board’s intention not to « change [its] collateral policy for the sake of
any particular country »: any U-turn dictated by recent events would
harm the ECB’s standing.

(ii) by engaging into explicit quantitative easing, whereby the ECB
would simply grow its balance sheet by purchasing the targeted
government paper on the open market, sending a clear signal to all
investors and easing yield tensions.

This is, nonetheless, not a one-size-fits-all solution: the individual situations
of Athens and Madrid require different remedies. The ultimate decision
taken by public authorities will rely on a comparative cost-to-benefit analysis
on both political and economic grounds.

The economic gain of bailing out Greece is small: Greek economy’s limited
importance to the EMU’s GDP does not, we believe, justify a breach to EMU
rules or even a credibility loss for the ECB. The political gain of not letting an
EMU country default or be rescued by a third-party may be much larger:
whether or not Greece is abandoned to its fate and to the goodwill of the IMF
thus depends largely on purely political considerations.

Spain’s situation is far more intractable: the country’s weight inside the
Eurozone and its key position in the union’s political arena would make an
outside intervention (let alone a default) intolerably – perhaps terminally –
costly. Madrid’s debt may not yet be as closely watched (and volatile) as that

Page 11


of Athens, but runs unmistakably much deeper. Neither a « credit event » nor
an IMF bail-out are credible options: should Spain’s situation continue to
worsen, there is little doubt that the ECB and the members of the Eurozone
will be ready to risk their stature to stave off a fatal accident.

Conclusion – Investment recommendations
The EMU’s decade-old financial stability and subsequent government bond
yield convergence has relied on the myth of solidarity. Berlin’s light-heartedly
prognosticated support miraculously turned leaden deficits and debt burdens
into political gold within Mediterranean new joiners. This misunderstanding
could simply not last forever: the credit crisis has aggravated every debtor
country’s own problems, and led to a resurgence of idiosyncratic risk. Greece
has pledged fiscal frugality. Ireland’s government faces a rocky road as it
pushes to cut wages. Spain’s deficit has also exploded, and Italy’s public sector
debt as a share of gross domestic product is around Greek levels

QE removal and increased (as well as synchronous) short term refinancing
needs should weigh on the least solvent issuers’ yields over the coming years.

The trouble with which Greece has been battling recently could well be a first
instalment of far more damaging action. We do believe that leaving the
problem alone will not suffice to solve it: an intervention (initiated from the
ECB, fellow EMU-members or the IMF, by decreasing order of cost efficiency)
is needed.

While the euro is not immediately threatened, we still anticipate further EUR-
USD weakening over the coming months – at least for as long as the EMU
sovereign paper issue remains an ongoing concern. Flight-to-quality effects
should benefit Bunds and OATs, both of which should see their front-end
yields tighten. (Relatively speaking, though, the Bund should still fare better.)
Further widening on Spanish Bonos is likely, while Greek government bonds
will stay highly volatile, jumping on each rumour and fresh piece of news.

Such uncertainty will inevitably damage the sustainability of the wider
rebound. In the worst-case scenario, this sovereign debt crisis could even be
the spark that lights the double-dip (or, at least, the momentum-abating)
powder.

If there is no immediate reaction from the ECB, EMU members or the IMF, we
regard this outcome as likely, and advocate cutting back on exposure to
European stocks for some time.

One solution (apart from ECB sovereign QE) could be the creation of a
Eurozone stabilization fund, as a means of mutual support and - most
importantly - as a way to provide liquidity and buy time for euro sovereigns
who need to make fiscal adjustments. Creating a European Stability Fund with
at least €2tn of credit lines guaranteed by all Eurozone member nations and
potentially other European countries with large financial systems such as
Switzerland, Sweden and the UK could provide alternative financing to
member countries in case market rates on their government debt become too
high. This would prevent a self-fulfilling cycle of rising interest rates. The fund
should be large enough to have credibility; countries could access the fund
automatically, but should then adopt a 5-year program for ensuring financial
stability, subject to peer review within the Eurozone.

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Copyright 2009 Vantage Capital Markets LLP http://www.vcmllp.com THIS RESEARCH BROCHURE IS A MARKETING COMMUNICATION:
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