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Will the French and Greek election results change the direction of Europe?

As French and Greek voters make their feeling about spending cuts loud and clear, we ask ourselves – why has there been such a strong swing to anti-austerity/pro-growth, how does this threaten the survival of the euro and is a Greek default still possible? The deepening slump has dampened deficit reduction, the Fiscal treaty hangs in the balance and patience is wearing thin. Crucially, according to voters and investors, time is running out.

Growth vs. Austerity: deepening slump is dampening deficit reduction

Francois Hollande’s victory in the French elections marks a significant change of focus in European politics.  In contrast to the rhetoric delivered up to this point, Hollande wants emphasis of policy to be on growth instead of austerity. Why does he want this? Because the situation is deteriorating. Unless a country grows, their debt burden, as a percentage of a decreasing national output, grows and is therefore harder to manage. As iterated by French Socialist lawmaker Arnaud Montebourg, in an interview with BFMTV “Austerity is everywhere and it’s a complete shipwreck,”.

Portugal and Spain are prime examples. While the Portuguese economy is expected to contract by 3.3% this year, the deepening slump is dampening deficit reduction. In fact, the deficit almost tripled in the first couple of months of this year alone. Spain, similarly, is struggling with a deteriorating debt situation. As almost 1 in 4 are without jobs, unemployment is boosting defaults. Bad loan ratios have reached a 17 year high (see chart below on the right).

 

Survival of the Euro Threatened

However, such a drastic change of attitude could damage the Franco-German Alliance, political progress and the very survival of the euro. This is because for Hollande to promote growth, he is threatening the fiscal treaty, perceived as crucial for keeping the euro together in its current form. The Treaty would create closer consolidation within the European union. Handing over authority for National Budgets to a Supra-National entity could ensure the various moving parts of the region interact better as a whole. However, Hollande disagrees with the primary focus on debt and deficit limits, without any pro-growth measures.

Whilst the German Finance Minister Wolfgang Schaeuble is ready to discuss initiatives to boost economic growth Merkel has said she will not renegotiate the pact. As her spokesperson asserted, it “has already been signed by 25 out of 27 EU countries”. Instead the likelihood may be a growth pact attached to the fiscal pact. Nevertheless, the problems don’t end there. Firstly, Hollande will have his work cut out for him in an economy that is barely growing, with jobless claims at their highest in 12 years and a rising debt load that keeps France vulnerable. Secondly, can both sides agree what they mean by growth?

Growth by any other name…  

France and Germany disagree strongly on how to achieve growth. Merkel maintains it is through structural reforms – making it easier to fire workers, which would encourage employers to hire, certainly a key aim for the Italian Government. However, Hollande is hesitant and instead wants growth via infrastructure spending. But Germany won’t agree to spending funded by borrowing – exactly opposite to their deficit reduction targets. Therefore, again although rhetoric can be applauded, practical plans remain elusive.

A Greece Default Still Possible

Uncertainty continues to be a key challenge for Greece as voters in a similar move to the French, overwhelmingly rejected mainstream candidates supporting spending cuts. Crucially, these cuts were aimed at securing bailouts and avoiding a default. Instead, 70 per cent of voters supported parties that promised to tear up the bailout and attempts may be made to negotiate a gradual ”disengagement” from the harshest austerity measures of Greece’s €130 billion ($168 billion) bailout. This keeps the possibility of a Greek default firmly in the picture and until a coalition is formed, a new election next month is possible.

Is time running out?

Will there be enough time for political leaders to regain credibility and encourage Eurozone growth? As confidence wanes, borrowing costs rise and debt burdens risk becoming unsustainable. Worryingly, therefore, patience is running thin. Echoing Margaret Thatcher’s thoughts on a unified Europe as “the vanity of intellectuals, an inevitable failure: only the scale of final damage is in doubt”, the German paper, Die Welt, wrote after the French and Greek elections: “In the end the results are proof that Europe doesn’t work”.

A Greek default on the cards but the banks aren’t listening

The markets expect a Greek default and time is running out. However, banks still haven’t recognised enough of this loss, highlighting the pent-up risk in the sector. Deep-seated scepticism continues to drive market volatility and this will continue until a credible plan is on the table.

A Greek default due

Markets are pricing in a 93% probability Greece will default, with the country missing its deficit reduction targets, contracting greater than anticipated (-5.5% vs. -3.8%) and unable to meet salary and pension obligations within the next couple of weeks. However, there is still much uncertainty on what the next steps will be. Politicians are still clinging to the hope further bailouts will help and hinting they will demand private investors to bear a bigger part of the pain (“technical revisions” to allow greater haircut) but Finland is demanding collateral and time is running out.

“Time to move”

Despite ‘kicking the can down the road’ and delaying decisions over the next tranche of the Greek bailout, the markets are looking to the G20 meeting in Cannes on 3rd – 4th November as the final deadline for decisive action. Political pressure is high as Geitner demands it’s “time to move” and Obama issues some stark words accusing the EU of having a fiscal plan that is “scaring the world”.

Banks are not prepared

Dexia, one of Europe’s largest banks, hit the news with their need for some form of rescue. Their reliance on short term funding may be their current problem but the outlook is no more rosey. They have only reduced the value of their Greek bond debt exposure by 21%. If they, along with BNP Paribas and Soc Gen write-down these debts by 51%, that will cause massive losses amounting to E3bn. That’s of course assuming Greece doesn’t fully renege on all outstanding loans due.

Pent up risk

Therefore there are still many events that could shock the markets. Although so far market falls have been followed by short term rallies as investors use the opportunity to buy back into the markets. Crucially though, upside and downside moves are exhibiting a large amount of intra-day volatility. This highlights the deep seated scepticism that will only be removed once a credible and clear long-term plan is put into action. Until that time, the swings will continue.

CNBC Clip: Europe Weighing on Markets

EU Differentiation… The Key Points you should know…

“United we stand; divided we fall” Aesop (Ancient Greek Fabulist and Author of a collection of Greek fables. 620 BC-560 BC)

The problem with the “EU” banner is that it links together economies that are quite different from each other. Much press has been dedicated to the fate of the PIIGS – Portugal, Italy, Ireland, Greece and Spain but it is interesting to compare journalistic exposure with economic impact. Greece Ireland and Portugal account for less than 5% of EU GDP. To save you shifting through pages of research – here are the key pertinent points for each economy… The structure follows that of my earlier assessment of the futility of EU bailout mechanisms–

  1. FLAWED LOGIC – what are the real issues?
  2. NOT SOLVING THE PROBLEM – will the economy in question be able to grow enough / will the debt burden be manageable enough so that it will fall as a % of GDP?
  3. UNCERTAINTY – what are the political issues?

Source: "Belgium Joins The PIIGS: And Then They Were Six" - Gavan Nolan, Econotwist The Swapper - learning and understanding the increasingly complex financial world.

Portugal – A Disappointing Deficit, Dipping Back Into Recession

  1. DISAPPOINTING DEFICIT and FOREIGN PRESSURE – Disappointed the market with its deficit reduction plan for this year, amounting to a value for the first 10 months of 2010 which was than for the whole of 2009 and forecasted to exceed the EU limit until at least 2012. Exposed to more foreign pressure with around 70% of its debt is held abroad
  2. LOW GROWTH – estimated to only amount to 1.3% for 2010 for an economy expected to fall into recession next yr
  3. POTENTIAL SOCIAL UNREST – planning to reduce its public workforce

Italy – Saved by its Savings, Economic Exposure but Debt Isolation

  1. TOO BIG TO BAIL OUT – second largest debt burden after Greece (public debt equates to 120% of GDP)
  2. LOW GROWTH

  • HOWEVER: High savings rate, exposure to German and Emerging Market economies, less dependant on foreign creditors and therefore more flexible

Ireland – The Public Prefers a Default

  1. HUGE BAILOUT – amounting to 60% of GDP vs. “only” 47% for Greece
  2. POTENTIAL FOR DEFAULT – 57% of the public believe the country will not be able to support the annual interest payments involved with this debt burden (€5bn over 9 years) and would prefer the government to DEFAULT on its commitments
  3. PROTEST and INTERNATIONAL IMPACT – 50,000 took to streets to protest against the Government’s plan to cut the budget deficit. The UK has £140bn exposure to Irish banks

Greece – Flirting with Insolvency

  1. STRUCTURAL LIMITATIONS“overblown state sector”, “uncompetitive and relatively closed economy”
  2. SOLVENCY – It has been argued that the bailout package will only prevent Greece from insolvency for ~a year
  3. CIVIL UNREST – has been seen in response to social program cutbacks

Spain – Pulling a “Sickie”

  1. UNEMPLOYMENT and a potential for DEFAULT – the highest in the EU at around 20% of the population. A third of private sector debt (€0.6tn) was generated from the housing boom and liable to default.
  2. INTEREST PAYMENTS HAVE JUMPED – Since Oct, yields have jumped from 4% to 5% leading to a larger debt burden as a percentage of GDP
  3. SOCIAL UNREST – Just the other week we saw one of the largest “sickies” thrown by their air traffic workers

Hungary – The Government Can’t Win

Although not within the PIIGS acronym – it is important nonetheless to mention this economy at this point and a great example of the potential impacts to investment. It’s a case that highlights the Government can’t win – if it decides that instead of implementing austerity programs eliciting social unrest, it will instead employ more crowd-pleasing reforms, it will get punished nonetheless….

  • DOWNGRADED – Moody’s has downgraded its debt to the lowest investment grade status. One more downgrade and it changes classification and those restricted to investing in Investment Grade debt only will be forced to sell, regardless of any other factors. Great opportunity to pick up dent at a discount (whilst watching the quality of the issuer!)
  • REASON – Short term (less antagonistic) measures are not sustainable – special taxes and utilising private pension schemes to fill holes! The Government is relying on future growth to afford its pension liability in the future and anyone not transferring to a state pension by end Jan may lose 70% of their pension value.

Contrast with the Core

Just to contast these economies with the one seeming to be driving force behind the union – Germany’s deficit could potentially fall to the 3% EU limit next year

INVESTMENT INSIGHT: When investing in the EU – differentiate between countries!