Sluggish Recovery or
the dreaded Double Dip Recession
Global Economics Weekly Brief
We always knew that the UK’s recovery was going to be sluggish, but the Bank of England is warning that it may be even harder now for some years. -August 1, 2011- A slower global economy and nervousness about government debt in the major developed economic areas are keeping the markets on edge. `Big Problems` in the US and the Eurozone are still a big worry and not even the strongest economies are immune. The European Central Bank policy to buy up Italian and Spanish debt to reduce their borrowing costs is working so far but for how long, the roller coaster carried on as markets reacted to rumours that France may lose its AAA status very soon. This was refuted by all three of the rating agencies, but with austerity measures in place across the globe and markets still jittery, it’s no wonder that the road to recovery looks even more long and winding than before.
The UK’s economic outlook looks even more sluggish. The Bank of England’s August Inflation Report was very gloomy. Growth forecasts for 2011 and 2012 were revised down as the Bank warned that the pace of recovery had slowed and vulnerabilities (particularly within the Euro area) had increased. There is also the underlying concern that the loss of capacity from the recession may have affected the UK’s long term potential for growth. With inflation still expected to hit 5% this year, consumers will feel even more of a pinch too. The Monetary Policy Committee is not expected to tighten its policy stance for a while. The markets do not expect a change until early 2013 and the Governor even acknowledged that further rounds of quantitative easing could be used - but this would only be if the inflation outlook warranted it. Inflation will increase more!
US interest rates are expected to be on hold for at least two years. The US rate setting body, the Federal Open Market Committee, announced that it expects to keep its benchmark Federal Funds rate between 0%-0.25% until, "at least through mid-2013". Slower economic activity and recent turmoil in financial markets were the key factors behind the decision. While the Fed's statements often comment on how long interest rates are expected to remain on hold, previous guidance has been less transparent, coded in ‘Central Banker Speak’. The more direct approach is meant to give the market a clear steer that monetary policy will be kept very loose for as long as it takes. The Fed still has flexibility to raise rates before mid-2013 if the recovery gains momentum and inflation pressures re-emerge, but most forecasters now expect rates to stay put until late 2013, or perhaps even 2014. Still more big problems on the way!
UK and Eurozone industrial production stalled in June and the UK trade deficit widened. UK industrial production was flat in June after increasing 0.8%m/m in May. In the Eurozone it fell by 0.7%m/m in June from +0.2%m/m in May and even France and Germany suffered. The slowdown in production was faster than expected and the outlook isn’t great either. Weaker global demand means there’s going to be a struggle for the UK and European industrial sectors. This is already having implications for trade. The UK trade deficit for goods and services widened to £4.5bn in June - its highest since the end of 2010. Oil is the main culprit, single handily pushing the deficit up by c£1bn. But the recent performance of the export sector is a worry. A weaker US economy in Q2 has had a clear effect, as goods exports to our largest single trading partner fell 11%q/q. Fuel profiteering still continues!
The UK housing market is still flat, but mortgage arrears and possessions stay remarkably low and stable. Surveyors think UK house prices are still falling – except in London. But there is little to suggest that the market as a whole will be anything other than flat over the coming months. The sales-to-stock ratio, a good leading indicator of house price movements, is at its lowest since April 2009 when house prices were falling sharply. The remarkably low level of defaults has helped to support the UK market and this looks set to continue. Total UK mortgage arrears fell by 6%y/y in Q2, and possessions fell by 4%y/y. Ministry of Justice statistics on court orders shows a fall in claims and orders for possession too. This bodes well for the future. The first time buyers have disappeared and prefer to rent in these uncertainty times!
China's inflation rose to its fastest pace in over three years in July. The CPI rose to 6.5%y/y in July from 6.4% in June. This is the fastest pace of price rises since June 2008. Food prices continue to be the main driver, rising 14.8%y/y after a 14.4% rise in June. Other recent economic data has suggested a slowing in the Chinese economy, but with inflation so high there is little room to loosen policy just yet. There are signs that inflation may have reached a peak though. The pace of some food price rises have slowed and more encouragingly, the non-food price inflation reading fell in July. Yes, there will be more inflation in the coming years!
The future of the euro – Getting it right this time
Global Economic Outlook, 3rd quarter 2011
The story of European integration is a long one, but solving its first serious debt crisis should not have been. The second quarter 2010 edition of the Global Economic Outlook featured an article called “The future of the euro,” describing the pros and cons of different options for dealing with the emerging debt crisis of fringe nations. Unfortunately, instead of fundamental reform, the year that followed introduced more stopgap measures while the crisis deepened.
The story of European integration is a long one, but solving its first serious debt crisis should not have been. The second quarter 2010 edition of the Global Economic Outlook featured an article called “The future of the euro,” describing the pros and cons of different options for dealing with the emerging debt crisis of fringe nations. Unfortunately, instead of fundamental reform, the year that followed introduced more stopgap measures while the crisis deepened. Finally, on July 21, European leaders agreed on far-reaching measures that will change the structure of the monetary union. As an immediate effect, the rescue of Greece will help calm nerves and ease the pressure which has been building in the European bond market. But the real test will be in the execution of the agreements reached on economic alignment and fiscal discipline. If it succeeds, it will lift European integration to the next level.
A short review
When the euro was created, the 11 founding nations agreed under the Growth and Stability Pact that government debt may not exceed 60 percent of GDP and government spending may not be above 3 percent of GDP. The Maastricht treaty also set “convergence” criteria, such as low and stable inflation and long-term interest rates, to check whether countries were economically fit enough to join the single currency. One problem was that even Germany and France were in violation of treaty and ran "excessive" deficits under the pact’s definition for some years – so the rules were eased in 2005. There was no agreement on consistent criteria to govern the reporting by member countries, and the Economic and Monetary Union (EMU) did not include an enforcement mechanism. A monetary union without fiscal integration relies on individual governments to take the actions necessary to comply with the rules of the union.
With global growth flourishing and the financial system awash with liquidity, none of this mattered during the first few years of the monetary union. While growth in Germany was still sluggish for most of the past decade, fringe nations benefitted from low interest rates and ample credit availability due to the elimination of exchange-rate risks. Credit markets overlooked large current account deficits, rising real estate prices and the public finance practices of peripheral nations.
Structural and financial problems exposed
Weaknesses were exposed when the crisis struck. What determines the success of an economy in a monetary union is its flexibility in both labour and product markets, since it can no longer rely on currency depreciation to realign its costs. High levels of liquidity obscured the fact that the peripheral economies had declined steadily after the introduction of the euro. While core nations stuck to a strict reform process of holding labour costs in check, wages in countries like Spain, Italy and Portugal rose faster than productivity, thereby eroding competitiveness. Greek unit labour costs rose 37 percent over the last 10 years against an increase of just 5 percent in Germany (see figure 1).
For Greece in particular, this impact on competitiveness aggravated its starting point relative to the rest of the group. With the lowest exports-to-GDP ratio in the Euro area, membership to the Euro zone presented more advantages in terms of access to inexpensive imports rather than a path to higher productivity. Trying to focus on exports to get the economy back on a sustainable growth track would require a prolonged and challenging reduction in Greek wages.
A public-debt-to-GDP ratio of 127 percent and a budget deficit of 15.4 percent of GDP were factors which led to markets raising questions about the risk associated with Greece’s sovereign debt. Ireland had low public debt going into the crisis, but the state was hit by declining tax revenues and the cost of its banking sector bailout after the housing bubble burst. As of May, the European Commission predicted public debt above 100 percent of GDP for both Ireland and Portugal by the end of this year. Greece will likely cross the 160 percent threshold soon (see figure 2).
Sluggish Recovery? Or a Double Dip Recession?
What to do
As declining confidence led to rising risk premiums in the European government bond market in May 2010, country leaders came together and constructed a €750 billion rescue package. It consisted of the European Financial Stability Facility (EFSF) plus additional guarantees by the International Monetary Fund (IMF). Greece received a bail-out worth €110 billion ($158 billion), which was supposed to put the nation back to borrowing from the private capital market within three years. That expectation has not held. Furthermore, Portugal and Ireland also had to receive rescue funds and it became clear that Greece will be in need of a second rescue package of roughly the same magnitude as the first, and soon.
How would the rescue package be paid for? The answer hinged on how far private creditors would “participate” – something Germany in particular had been pushing for as the negotiations dragged on. The ECB was at first opposed to any form of “reprofiling” of debt amid worries about the impact on its own portfolio if the restructuring was deemed a “credit event” by rating agencies.
Meanwhile, reforms set out by European leaders in March 2011 fell short of a comprehensive long-term solution. The “Pact for the euro” aimed to strengthen cohesion in the single-currency area through economic measures – for example, greater wage flexibility – and the introduction of binding fiscal rules to fix public finances. The temporary rescue fund will be turned into a permanent “European Stability Mechanism” (ESM) with an effective lending capacity of €500 billion by 2013.
Markets were not convinced of the long-term success of these measures (or worried their implementation will take too long to avoid an imminent default of Greece). Credit rating agency Standard & Poor’s has downgraded Greek government debt to CCC in June, making it the lowest-rated sovereign debt in the world. The insurance premiums for Greece and other affected nations – including the ones rescued – were higher in May 2011 than they were in May 2010. The level of interest rates on Greek debt meant that the government would have had to make interest payments equivalent to around 12 percent of GDP this year.
So what were the options for stabilizing fringe nations of the monetary union, first and foremost Greece? European leaders seemed to have recognized that another short-term stop-gap measure will not be good enough for markets (and more importantly, the electorates). Another rescue package without a long-term plan is just prolonging the uncertainty. Breaking up the monetary union would not have been a workable solution. The expulsion of Greece (or any other member state) whether from the EU or from EMU would be so challenging on multiple levels that its likelihood is close to zero (see Global Economic Outlook Q2 2010).
A voluntary exit of a Eurozone member might be possible – but what would be gained? A return to the nation’s old legal tender would severely hurt confidence; interest rates would rise even higher, increasing the fiscal deficit even further and making solvency even less likely. In addition, forcing one country of the common currency out would have serious contagion effects. Markets would immediately price in similar scenarios for other endangered nations. Forming a “strong euro” area would in addition hurt core nations’ growth prospects. Germany, for example, is sending over 60 percent of exports to Eurozone neighbours – with suddenly depreciated currencies, they won’t be able to afford as much of them.
The new deal
Finding a long-term solution meant tackling two issues (1) providing immediate relief for indebted fringe nations and convincing markets that a working system is in place to deal with any emerging debt crisis and (2) agreeing on a common understanding of fiscal discipline and creating the structures for enforcing it. At a crucial summit on July 21, heads of the state of the euro area and European Union institutions, together with the IMF, agreed on measures to deal with both points:
(A) Immediate relief for Greece, private sector involvement and stabilization tools restructuring: The total official financing will amount to an estimated €109 billion, with the refinancing profile of Greece improved through lower interest rates (reduced in the Eurozone’s portion from about 5.5 percent to 3.5 percent) and extended maturities (from 7.5 years to a minimum of 15 years and up to 30 years with a grace period of 10 years). The IMF will continue to contribute to the financing and the EFSF will be used as a financing vehicle. Recapitalization of Greek banks will be provided if needed.
The restructuring of Greece debt – both in terms of interest to be paid as well as maturities – is not much different in nature from a Brady bond-style rescue operation, in which Greek government bonds would have been swapped for debt issued jointly by euro-region members (ideally EFSF bonds). (Brady bonds, named after then-U.S. Treasury Secretary Nicholas Brady, enabled 17 countries in Latin America, Africa, Asia and Eastern Europe to swap bad loans for new debt starting in 1989, some of which was backed by zero-coupon U.S. Treasuries.)
Private Sector Involvement (“PSI”): About a third of the €109 billion cost of the package (€37 billion) will be absorbed by the private sector through write-downs between now and 2014. In addition, a debt buyback program is expected contribute another €12.6 billion, bringing the total to €50 billion. For the period 2011-2019, the total net contribution of the private sector has been communicated at €106 billion – but there is still some uncertainty surrounding that figure. Importantly, the statement stresses that “As far as our general approach to private sector involvement in the Euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.” The EFSF lending rates and maturities agreed upon for Greece, however, will also be applied to Portugal and Ireland.
Stabilization Tools: To improve the effectiveness of the EFSF and of the ESM and address contagion in the long-term, the leaders decided that the new financial stability facility would be made more flexible to intervene in secondary markets and provide recapitalization of financial institutions if necessary. And the agreement states that the community is “determined to continue to provide support to countries under programs until they have regained market access, provided they successfully implement those programs.” Combined, these announcements are intended to address the markets most immediate fears and lead to easing pressure in Eurozone bond markets.
(B) Fiscal integration of the monetary union and economic governance For the longer term, a commitment has finally been reached to take the integration of the Eurozone to the next level. Paragraphs 10 to 16 of the statement detail the plans for fiscal alignment and economic governance. Public deficits in all countries (except those under a program) will be brought below 3 percent by 2013 at the latest. Leaders commit to implementing the national fiscal frameworks foreseen in the fiscal directive by the end of 2012.
In conclusion, then, stakeholders realized that any immediate financial solution to the European debt crisis had to come with fundamental reform. Having taken the leap, the future of Europe has got decidedly brighter. It will not be an easy road, and fringe nations still need much help in putting their economies back on a sustainable growth path. Part of the deal reached on July 21 was a kind of “revival package” for Greece, pledging support from EU structural aid funds and technical assistance in implementing reforms. But importantly, leaders have come together and communicated a firm commitment to the Euro area, along with their willingness to act in the interest of the whole within a clear structure and abide by the rules of enforcement. If that can be put into practice, it will prove an old saying right: “Never waste the opportunities offered by a good crisis.”
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Sluggish Recovery or Double Dip Recession, that is the question!