Deficits are no longer the issue, but rather outstanding debt too
Andy Lees wrote this morning that:
News that the ECB would resume its bond buying programme initially gave the markets some support, but later the comments from a European Monetary source that it would be limited to Ireland and Portugal and not include Spain or Italy met with disappointment. Speaking with my fixed income colleagues they tell me that the ECB already owns a lot of the paper in Greece, Ireland and Portugal, and most of the other paper is in long term hands and marked to market so there is only a small amount that the ECB could buy. The fact that it is specifically not buying Italian or Greek paper suggests that it feels that this is not a disruptive market move and its actions clearly suggest it is not targeting lower yields. (Spain cancelled a bond auction planned for August 18th but was careful to note that it was not in response to the market turbulence).
Watching a Reuters interview with Trichet I actually thought he came across as very credible, putting the emphasis on the need for proper fiscal policies and finance ministers to get ahead of the curve. What he also highlighted was that by the end of this year the combined European budget deficit would only be about 4.5% of GDP which puts Europe in a dramatically better position than either the US, Japan or Britain. Unfortunately as I have been saying for some time, the fact that the markets are now questioning Italy, which I has a primary budget surplus, highlights that deficits are no longer the issue but rather outstanding debt, indicating that stagnating economic growth and the resultant inability to service that residual debt in such an environment is the real issue.
I think this is mostly right. Investors have moved beyond the fixation with high cyclical deficits to thinking about longer-term solvency issues. Since solvency issues are medium-term issues, it is liquidity which matters most. Investors are of a mindset that they are fleeing any sovereign debt that has questionable combined debt, deficit and governance issues. The thinking is sell first, get liquid, and then ask questions.
Moreover, that is the kind of mentality which makes the entire euro zone vulnerable. It is not that the markets are thinking only about debt. Rather, markets are looking at the combination of debt, deficits, and political will and the implication on solvency. Spain has a better debt profile than Germany and France, for example. And Belgium has a high debt to GDP and no active government to make tough decisions.
So, looking at the profiles of Italy and Spain, you see one sovereign debtor in Spain which has a lower debt-to-GDP and a previous track record of budget surpluses but a high cyclical deficit, high unemployment and a private sector debt overhang and uncompetitiveness which makes growth difficult. The other debtor in Italy has had chronically high debt and slow growth combined with government dysfunction. In both cases, there is legitimate reason to be concerned about the medium-run budgetary issues, albeit for different reasons.
But, I could make the same case right across with France with its high debt to GDP and high primary budget deficit or with Germany where export strength masks a relatively high debt to GDP declining growth in an aging society. See the graphic from Edward Hugh below.
And the Germans’ export dependence creates a lot of economic volatility in this kind of slower growth environment.
The point is that this is a rolling crisis where investors have realised that the sovereign debt profiles right across Euroland have problems. And because there is no lender of last resort, the weakest debtors get plucked off one by one until there is nobody left. The right thing to do is to address the respective weaknesses in the sovereign profiles (Italy needs growth, Germany needs consumer demand, etc) while a lender of last resort backstops the likely solvent countries – no bailouts, just liquidity. That’s been my position all along. Let’s see if policy makers get on board with it.