awaiting a solution to the european crisis€¦ · eurobonds: convenient as an insurance mechanism...

Awaiting a solution to the European crisis

Jorge Sicilia

BBVA Research │Chief Economist

5th International FIAP Congress - Asofondos│ Cartagena, 27 April 2012

Europe: challenges and opportunities / April 2012

1 Global economic outlook

2 Awaiting the solution to the European debt crisis

Index


The world economy has survived the major recession of 2008

Industrial output (% qoq of 3 month moving average)Source: BBVA Research, CPB and national sources

Business expectations (PMI)Source: BBVA Research and Bloomberg

30

35

40

45

50

55

60

65

Oct 08 Apr 09 Oct 09 Apr 10 Oct 10 Apr 11 Oct 11 Apr 12

USA China EMU Brazil Global

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

USA Asia Eurozone Latin America Global


But with major differences between developed and emerging countries

GDP (Q4 2007 = 100)Source: BBVA Research

90

95

100

105

110

115

120

125

130

135

140

145

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2007 2008 2009 2010 2011

US EMU Japan China Asia ex China Latam 7


Emerging economies responsible for much of global growth

EAGLEs (Emerging and Growth-Leading Economies) will continue to lead growth over the next decade.

EAGLES vs. G7: current size and “incremental business”Source: BBVA Research

EAGLEs G7


EAGLES©

Global growth will be lead by: China and India will contribute more than the USA; Korea and Indonesia more than Russia; Mexico, Egypt, Taiwan and Turkey more than the G6 averageEAGLES©: Current size and contribution to global growth 2011-2021Source: BBVA Research

GDP PPP 2011 Incremental GDP 2011-2021

Slightly in excess of the US contribution

Reaching US$ 25,000 Bn, 5,000 Bn more than USA

Turkey

Taiwan

Russia

Mexico

Korea

Indonesia

India

China

Brazil

0 1500 3000 4500 6000 7500 9000 10500 12000 13500 15000


Advanced economies need to deleverage…

US: Debt to income ratioSource: BBVA Research

The increase in debt was largely due to real estate expansion (USA, UK, Spain, Ireland)

Deleveraging will impact on domestic demand whilst households and companies reestablish their financial position

Structural reforms are essential fora return to growth, which ishampered by weak demand


… The deleveraging process is usually long and painful

Deleveraging is often a long process, lasting 7 years on average. This involves both lack of capacity to grant credit and low demand for loans

Domestic bank lending/GDP in the 10 years before and after a serious financial crisisSource: BBVA Research based on Reinhart and Reinhart (2010)

-10

-7

9 9

8.69.4

-7 -5

-80

-60

-40

-20

0

20

40

60

80

100

Average Developed Economies Asian crisis Other emerging economies

Ch

ang

e in

do

mes

tic

len

din

g/G

DP

Difference between min. and max. credit/GDP in the decade before the crisis

Difference between min. and max. credit/GDP in the decade after the crisis

Years to bottom out

Years to reach peak


Fed and BCE: At the limit of their effectiveness because of the crisis?

BBVA financial stress index Source: BBVA Research Central banks were successful in

containing the 2008 financial shock …

… but are now having limited success in supporting growth …

•Decreasing returns from increasing interventions

• Increased pressure for political oversight

•Uncertain collateral damage

Actions are required that can only be taken by other authorities and

institutions: labour market and fiscal reform, etc. There is a debate over

strategy and tactics

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

2008 2009 2010 2011 2012

US EMU


Additionally, long-term fiscal consolidation must be addressed

Developed economies emerged from the crisis with unprecedented peacetime levels of public debt. And under pressure from ageing populations

Forecast health and social security expenditure (% GDP)Source: BBVA Research and IMF

Public debt (% GDP)Source: BBVA Research and IMF

0

20

40

60

80

100

120

2000 2002 2004 2006 2008 2010 2012 2014 2016

US Europe Emerging Economies

0

2

4

6

8

10

12

14

2010 2015 2020 2030 2040 2050

Pension expenditure: G20 developed Health expenditure: G20 developed

Pension expenditure: G20 emerging Health expenditure: G20 emerging


1 Global economic outlook

2 Awaiting the solution to the European debt crisis

Index


What is going on in Europe? Is this an economic or a political crisis?

Known unknownsA

B Surprises (unknown

unknowns)

Two types of unknowns on the path to monetary union in the euro

zone

Why aren't theytaking action?


What do some critics fear might happen in a monetary union?A

The euro is not an optimal monetary area (and will not become so endogenously)

A single monetary policy might be destabilising for some countries

There could be imbalances in real exchange rates for long periods

The markets will not value sovereign risk appropriately: fiscal union is needed

Difficult to honour the promise “no bail- out” a member state

Is financial integration needed: European bank resolution?

Known unknowns


Why aren't they taking action?A

Nominal rather than real criteria (Maastricht)

Few countries are taking regional differences seriously: flexibility, reforms, European-level banking supervision

Lack of vigilance and lack of European policies for a single market (also applies to international bodies)

“State politics” against “insignificant details”

Reform fatigue after entry efforts

Good times lead to self-deception

Complacency about capacity to solve problems as they arise


What was a surprise (partial or total)? B

Current account deficits should not be relevant in a monetary union

High correlation between sovereign risk and banking risk

The consequences of not having a a central bank as bond purchaser of last resort (issues in foreign currency?)

Unknown unknowns


Two (internally consistent) routes towards a viable monetary union

Common monetary policy

National fiscal policies

Two internally consistent

alternatives

Keep and develop the current treaty

[Stability and Growth Pact, without bailouts]

1

2Fiscal union: a major centre-periphery agreement

[Loss of fiscal sovereignty, Eurobonds]

An unstable mixture

National supervision and regulation

National structural policies

European Banking regulator/supervisor

Reform agenda


Both options have challenges and risks

Keep and develop the current treaty

[Stability and Growth Pact, without bailouts]

1

2Fiscal union: a major centre-periphery agreement

[Loss of fiscal sovereignty, Eurobonds]

Options

Main dilemma: Instability vs.

incentives

… and risks

• Risk of depression• Risk of non-payment and

global contagion• Risk of social and political crisis

and collapse of the euro

• Moral risk if poorly designed• A two-speed Europe?

The "muddling through" strategy will probably continue, with gradual progress towards a model of fiscal union


Possible structural ways out

Many potential ways out for the structural problem of the monetary union have been suggested, but these are not all compatible with the current degree of economic and political integration, which will have to change

Bond purchases by the ECB (ultimate sovereign lender of last resort)

Frequently mentioned optionsLevel of integration and centrality of governance

TOTAL

Mutualisation of debt(Eurobonds) HIGH

Support mechanisms and giving time for structural reforms and fiscal adjustments REASONABLE


The European crisis must be addressed on 3 main fronts

Dissipate concerns about sovereign solvency outside Greece and avoiding contagion to

countries that are solvent but illiquid

Progress with reforms to increase growth: pace of fiscal adjustment

and policies to stimulate growth

Make changes to the governance of the euro to design a roadmap towards fiscal union and a

single bank resolution fund

Some progress so far, but more

needed


Timid advances, but there are important pending issues

Some progress… … but some issues still pending

Implementation of the Greek debt haircut

Approval of the fiscal compact

Provision of ECB long-term liquidity

A credible sovereign firewall

Further advances towards fiscal union and slowing its application

1

2

3 A pro-growth agenda

Measures taken so far have only enabled us to muddle through the crisis The authorities remain behind events


Greece: concerns linger about solvency. Attention on Portugal

Greece and Portugal: public debt projectionsSource: BBVA Research and IMF

Greece

• Risks remain:

– The 6 May elections

–A long hard slog for further reforms

–Recession to continue

Portugal• Fiscal adjustments and reforms are on

track

• External imbalance closing

• But this will not be sufficient to access markets in Q3 2013

1

40

60

80

100

120

140

160

180

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Portugal Greece*

* Optimistic scenario for Greece. Assumes 95% bond holder participation in haircut; growth of around 3% from 2015; and a primary surplus of 4.5% of GDP from 2014 (primary deficit 2.4% in 2011)


The sovereign firewall (EFSF/ESM) is not enough to reassure markets

ESM/EFSF resources and gross financial needs in Spain and Italy (long-term debt and deficit)Source: BBVA Research and Bloomberg

1

(ESM)New available lending capacity: EUR 500 Bn (more than 200 Bn already committed

by EFSF), and a further 420 Bn from theIMF

It is not enough to reassure markets, given financing needs in Spain and Italy

But…

Unless it lends pari passu it risks alienatingprivate demand for sovereign bonds

It cannot intervene directly in financial systems

ESMlending

capacity

EFSF fundscommitted

Spain

Italy

0

100

200

300

400

500

600

700

800

Firewalls Financing needs for Spain and Italy

2012-2013

Financing needs for Spain and Italy

2012-2013


Fiscal compact is sanctioned, but may be seen as too lax

Fiscal compact

2

A significant change towards fiscal control of member states

May be seen as not strong enough to justify a more forceful and decisive

action by the ECB or German hardliners

Eurobonds: convenient as an insurance mechanism and roadmap

Proposal of “blue” and “red” bonds has the advantage of maintaining

market discipline

Still pending: a roadmap to a fiscal union

• The fiscal compact commits governments to establish a fiscal rule at constitutional level, limiting structural budget deficits to 0.5% of GDP

• Still no progress on fiscal union, or on short-term fiscal adjustment


Provision of long-term liquidity by the ECB calmed markets temporarily, with some unease…3

Sovereign spread vs. Germany (10 year bond, bps)Source: Bloomberg and BBVA Research

Liquidity risk on European banks eased during the first quarter…

… and funding markets were opening up cautiously, helping to reduce sovereign

spreads

but these effects have been short-lived. Recent doubts on Spain have increased

tensions

In any case, the ECB can only serve as a bridge to the long run, which depends on structural

reforms and a growth agenda

0

200

400

600

800

Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12

Ireland Spain Italy Belgium

France Netherlands Austria


… but it has also increased the exposure of banks to the sovereign 3

Holdings of euro area government bonds over total assets (%)Source: ECB and BBVA Research

Indirect ECB intervention in the sovereign bond market through banks

Increased exposure of banks to the sovereign increases potential negative

feedback effects

Reinforces the need for a definitive solution to sovereign solvency doubts

and to the provision of liquidity

4,0

4,5

5,0

5,5

6,0

6,5

7,0

7,5

Jan

-10

Mar

-10

May

-10

Jul-1

0

Sep

-10

No

v-10

Jan

-11

Mar

-11

May

-11

Jul-1

1

Sep

-11

No

v-11

Jan

-12

Spain Italy


The reforms presented must be implemented and deepened

Spain(Government with absolute

majority for next 4 years)

Italy(technocratic government)

Portugal(Government with simple majority

for next 3.5 years)

Greece(technocratic government)

• Fiscal compact and consolidation• Reform of pensions and professions• Labour market reforms being prepared

• Fiscal consolidation, constitutional rule• Restructuring of financial system underway• Labour market reform

• Major challenges for fiscal consolidation• Privatisations (?)• Reforms to restart long-term growth

• Fiscal consolidation without accounting adjustments• Deep labour market reform• Reform of product markets underway

3


Monitoring of structural imbalances in Europe (“six pack”).

Macroeconomic imbalances in Europe's periphery (six pack) Index. Standard deviations from the euro zone average (euro zone average = 0)Source: BBVA Research, Eurostat and Haver

3

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5Public debt (% GDP)

Household debt (% GDP)

Increase in real house prices

Increased private sector credit (% GDP)

Unemployment rate

Current account balance (% GDP)International investment position (% GDP)

Increase of real effectiveexchange rate

Loss of share of export markets

Increase of ULCs

Public deficit (% GDP)

Germany France Itally Spain Greece Portugal


Very rapid correction of imbalances might be counterproductive: the fiscal example

Breakdown of fiscal consolidations in OECD countries with deficit reduction targetsSource: BBVA Research based on Devries et al (2011)

Few deficit reductions have exceeded 3% of GDP

in one year

3

0

5

10

15

20

25

30

35

40

45

50

0.33 1.00 1.33 1.67 2.00 2.33 2.67 3.00 3.33 3.67 >4.00

Nu

mb

ero

f cas

es

Based on 173 examples of fiscal consolidation between 1978 and 2009 involving 17 OECD countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Holland, Portugal, Spain, Sweden, the UK and the USA)

Italy 1992 (0.7%)Sweden 1995 (3.9%)Finland 1994 (3.6%)

Ireland 2009 (-7.0%)Italy 1993 (-0.9%)Italy 1995 ( 2.8%)Finland 1993 (-0.8%)

GDP increase

0.67


General government: deficit adjustment (pp of GDP)Source: BBVA Research based on MINHAP

Major deviation from 2011 deficit target and unilateral decision to increase the

2012 target

Budget Stability Law:structural deficit of 0% of GDP in 2020

The central government adjustment is credible: more doubts about regional

governments

Increasing fears about lack of growth

Spain: the fiscal adjustment should focus on the structural component

Fiscal consolidation process

A new compact is required

3

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

2011 (Deficit: -8.5%) 2012 (Target: -5.3%) 2013 (Target: -3.0%)

Cyclical deterioration Cyclically adjusted Additional resourcesStructural deterioration Total adjustment


Crisis

Why?

Solution: eliminate the euro area exit

scenario

The tensions have returned quickly after: (i) the ECB's injection of long-term liquidity; (ii) structural reforms in Spain and Italy, and (iii) advances in the

fiscal compact and the ESM

Investors anticipate the negative impact on growth of fiscal austerity; still see the possibility of a restructuring; and see any ESM intervention as

being a trap

Roadmap to fiscal integration

Fiscal consolidation needs to be gradual and multiyear. It should focus on structural deficits.

We should not rely only on austerity measures. But rather on structural reforms in exchange for a growth strategy: symmetrical incentives are

needed

Re-launch European investment in infrastructure

The European crisis is the main risk to the global economy


… the political factor is becoming every more important (déjà vu Latam?)

Apr 22: French presidential elections (1st round)

May 6: Greek legislative elections

May 6: French presidential elections (2nd round)

May 6: German state election (Schleswig-Holstein)

May 13: German state election (North Rhine-Westphalia)

May 31: Irish referendum (fiscal compact)

End May: Troika fourth review of Portugal’s package

Jun 10,17: French legislative elections

Jun 18-19: G20 summit.

Jun 27: Possible date of general election in Holland

Jun 30: Deadline to reach 9% core tier 1 capital ratio

July: ESM enters into force

Summer: Negotiations for second Portuguese bailoutprogramme

European event calendar. April-July 2012Source: BBVA Research

EMBI Latam spread in electoral periodsSource: BBVA Research and JPMorgan

0

200

400

600

800

1000

1200

1400

1600

1800

2000

Lehman Brothers

Crisis at

Elections in Mexicoand Brazil

Elections in Mexico and Brazil

ElectionsIn Brazil

Brazilelections

Sep

-92

Jun

-93

Mar

-94

Dec

-94

Sep

-95

Jun

-96

Mar

-97

Dec

-97

Sep

-98

Jun

-99

Mar

-00

Dec

-00

Sep

-01

Jun

-02

Mar

-03

Dec

-03

Sep

-04

Jun

-05

Mar

-06

Dec

-06

Sep

-07

Jun

-08

Mar

-09

Dec

-09

Sep

-10

Awaiting the solution to the European crisis

Jorge Sicilia

BBVA Research │Chief Economist

5th International FIAP Congress - Asofondos│ Cartagena, 27 April 2012


•Reform of the pension system will help to improve the outlook for sustainability of the system by reducing pension expenditure as a share of GDP•This is a substantial reform, making significant changes to the system

Contributory pension expense as % of GDP. Post-reform simulationsSource: BBVA Research

• Given uncertainties about employment, productivity and demographics, it is appropriate for the reform to be assessed from the moment that it is implemented

• If necessary, the sustainability factor will have to be applied prior to 2027

Sustainability factor

For example, progress has been made in Spain on pension reform

0%

5%

10%

15%

20%

25%

2011

2014

2017

2020

2023

2026

2029

2032

2035

2038

204

1

204

4

204

7

2050

2053

2056

2059

Expenditure without reform

Expenditure with reform Revenue


There are notable similarities in the reforms of the Spanish and German public pension systems.However, the Spanish system continues to be more generous

Spain Germany

Official retirement age 67 67

Number of years' contributions at official age to get 100% base pension

38.5 45

Rate of public pension substitution before reforms 81.2% 48%

Early retirement age 61/63 63

Number of years' contributions for early retirement 33 35

Rate of public pension substitution after reforms 69% (e) 43%

Correction for sustainability factor From 2027 YES

Years' credit for dependent children 2 3

Third-pillar coverage of population 7% 64%

Contributory pensions systemSpain vs. Germany


Major deficit reductions have involved significant tax increases

Larger fiscal consolidations in the OECD, 1978-2009: breakdown by adjustment typeSource: BBVA Research based on Devries et al (2011)

In cases of large deficit reductions, spending was not trimmed by more than 2.5 pp of GDP (except in cases of high initial tax burden)

3

0

1

2

3

4

5

6

7

8

9

ITA FIN ITA ITA ITA SWE IRL DNK FIN NLD

199

2-19

93

199

3-19

94

199

1-19

92

199

3-19

94

199

4-1

99

5

199

5-19

96

198

2-19

83

198

3-19

84

199

4-1

99

5

199

3-19

84

Lower expenditure Higher revenue

awaiting a solution to the european crisis€¦ · eurobonds: convenient as an insurance mechanism...

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