What Are We To Do by LIN SEE-YAN
About one-half of European Financial Stability Fund already committed or utilizedWITH every passing day, the shelf-life of eurozone's rescue package is getting shorter. On July 21, eurozone leaders agreed to a second Greek bailout (see Greek Bailout Mark II: It's a Default in this column on July 30, following the first, Greece is Bankrupt on July 2). European parliaments have yet to complete ratification to expand the 440 billion euros bailout fund (European Financial Stability Fund or EFSF). Already, talk has shifted to expanding the EFSF in the light of escalation of the crisis.
Frankly, the fund is just not large enough to halt the contagion. It's a matter of market confidence really the larger, the better. About one-half of the fund is already committed or utilised with more demands coming on. Greece will miss the deficit targets for this year and next despite austerity, showing the drastic steps taken to avert bankruptcy are not enough. The crisis is boiling over. Eurozone ministers have since delayed the release of 8 billion euros cash scheduled for Oct 13, threatening to revisit the deal where private bondholders may be asked to take a higher “haircut”. This has rattled markets and raised fears of an imminent messy default. Estimates are that with a 60% haircut (21% now) for private bondholders, Greek banks would suffer another 27 billion euros write-down, wiping out their capital. Inevitably, the fall-out will have much wider repercussions.
The world economy once again stands on a knife's edge. As finance leaders gathered at end-September, they all want to look forward. But markets and investors are forcing them to peer down the precipice into the abyss as growth in advanced economies slackened sharply and emerging nations grappled with inflation in the face of a fast deteriorating eurozone debt crisis, wondering how to make the needed adjustments to restore confidence. Continuing uncertainty and worries about the global economic outlook fuelled a rush into safe assets. The eurozone is seen to be on the brink of recession. Its prospects have been hit by sharp falls in consumer and business confidence as well as fiscal austerity measures across the continent and pessimism about US growth. Germany's slowdown is worrisome because of its role as Europe's powerhouse.
Gathering pessimism came to a head as global equities tumbled on Sept 22 as the Federal Reserve's (Fed) gloomy outlook (“there were significant downside risks to the economic outlook”) caused investors to sell stocks in a widespread flight to safety. UK's FTSE (All World) Index fell by as much as 23% from its May high, signifying a bear market as it fell through the 20% threshold. US and UK stocks were not yet in bear territory but German and French equities have since been there. The sell-off was mooted by a big move into government bonds. Benchmark German 10-year bond yields hit an all-time low of 1.65%, while US Treasuries fell to 1.77%, the lowest level since 1946. On a day reminiscent of 2008, Asian stocks and currencies tumbled reflecting foreign capital repatriation, with the Indonesian stock market plunging 9%, the Australian dollar falling below US dollar parity, and the Hong Kong Hang Seng index settling at its lowest point since July '09.
Amid market tumult, investors were left wondering what to do in October. The 3rd quarter had been painful and volatile. The Dow finished the quarter down 12.1%; the S&P's 500 fell 14%. Many had hoped for a 2nd half rebound after spring's “soft-patch”, only to be confronted with worries of a possible double-dip recession. There is also a new fear: weakness in emerging market economies, especially China. During the 3rd quarter, markets were tossed to and fro on a daily (even hourly) basis, reflecting developments in Europe and United States. In August and September, the Dow industrials rose or fell by more than 1% on each of 29 days; on another 15 days, the daily moves were more than 2%. The last time the market saw this was in March/April '09. The “fear index” (Vix volatility index) reflecting market instability was up 160% over the 3rd quarter, finishing at 40% (normal 15%-20%) on end September.
The problem is Europe
The damage was worse in Europe. The main German and French stock indices both lost more than 25% of their value in the 3rd quarter, the largest quarterly loss since 2002. Asian stocks also took a pounding, experiencing double-digit losses. The Hong Kong Hang Seng index lost 21%. Even gold usually the refuge suffered a collapse in September from its record high in August. The safety was in US Treasuries, German bunds and UK gilts. Yields didn't matter for now it's just preservation of capital. As I see it, the sovereign risk crisis is compounded by much weaker growth among the “core” nations, and increasing market stress. In the United States, it has just managed to avoid recession, with little buffer to insulate itself from any fallout from an European event. Complications can also come from a busting bubble in the Chinese property market, rattling Chinese banks with ripple effects on world markets.
US and European stocks tumbled when markets opened in the new 4th quarter, with S&P's 500 entering the bear market as Europe postponed a vital tranche drawing to debt-stricken Greece. Wall Street fell about 2% on Oct 3, extending decline to a 13-month low as investors feared the crisis would lead the United States into a new recession. With this drop, the benchmark S&P's 500 had fallen past 20% putting it in bear territory. In Europe, banking stocks dived as investors slashed their exposure on worries authorities are unable to contain the debt crisis. The Stoxx Europe 600 index tumbled 2.8%, hitting its lowest since Oct '08; Stoxx Europe 600 banks finished 4.3% lower. Euro-zone's problem is one of market confidence rather than solvency. In Asia, most regional markets in the 3rd quarter suffered their biggest falls since the Lehman's collapse in '08, with Tokyo losing 11% and Hong Kong 21%. Since then, Korea dropped 3.6%, Hong Kong another 3.4%, India's Sensex 1.8%, the Nikkei, 1.1% and Australia, 0.6%. Italy's latest downgrade a 3-notch cut by Moody's to A2 with continued negative outlook reflected as much euro-zone's inability to spur market confidence, as it does Italy's failure to promote growth. Without a comprehensive response to the crisis, the risk of a downward spiral remains. In the past days, European stocks posted hefty gains as policymakers were reported to be prepared to help recapitalise European banks, estimated at 100-200 billion euros. Priority remains with Spain and Italy which are basically solvent, but lacks credibility. The prospect of the IMF coming-in alongside EFSF to buy Spanish and Italian bonds boosted sentiment.
Default by Greece?
Greece will miss the targets set just two months ago. The 2012 approved budget predicts a deficit of 8.5% of GDP for '11, well short of the 7.6% target. For '12, the deficit is set at 6.8%, short of the target of 6.5% reflecting the sluggish economy. Its 8.5% target remains a challenge in the current environment. GDP is expected to fall by 5.5% in '11 pushing unemployment to 16%, and a further GDP shrinkage of 2%-2% is in prospect. The '11 shortfall meant Greece would need another 2 billion euros just to bridge the gap. Greece is now off-track, reflecting disappointing revenues and missed targets. On Sept 21, it acted to raise taxes, speed-up public lay-offs, and cut some pensions. Ongoing austerity measures are already deeply unpopular.
My mentor and teacher at Harvard (Marty Feldstein) believes the only way out is for Greece to default and write down its debt by at least 50%. This strategy of default and devalue is standard fare for nations in Greece's shoes. But this hasn't happened because “Greece is trapped in the single currency.” So why are the political leaders trying to postpone the inevitable? He offered two sensible reasons: (i) banks and other financial institutions in Germany and France have large exposures to Greek debt, and time is needed to build capital; and (ii) default would induce sovereign defaults in other countries and runs on their banks. The EFSF is just not large enough to bail out Italy and Spain. Europe's politicians hope to buy enough time (2 years) for Spain and Italy to prove they are financially viable. As I see it, both these nations don't have another two years to prove their worth. The markets will decide the fate of Greece (and possibly Spain and Italy), not the other way around.
The shadow of recession
International Monetary Fund's September forecast pointed to growth in emerging economies exceeding 6% in '11 and '12, but with the advanced nations sliding to below 2%. On current trends, the latter prediction is perhaps closer to 1%. I think the outlook for the eurozone is deteriorating fast: at best, they are already in the throes of a severe slowdown; at worst, a relapse into recession. The European Commission recently stated growth is at a virtual standstill, with eurozone GDP rising by 0.2% in 3Q'11 and 0.1% in 4Q'11. Pain will be most intense in the south (no growth in Italy in '11 and '12) where the pressure of austerity is greatest. But the “core” economies are also hurting. IMF estimated German growth would slow down from 2.7% in '11 to 1.3% in '12. The short-term outlook is even worse. According to Markit Economics, eurozone's factory activity fell to a 25-month low of 48.5 (a reading below 50 indicates contraction). Indications are economic conditions will deteriorate. Germany's index fell in September with overall activity just above 50 the worst performance in two years. France's index stood at 48.2; Italy, 48.3 both in contraction territory. Eurozone contractions reflected lacklustre domestic demand and falling export sales. More sluggish growth will make it harder to achieve fiscal targets. Rising risk of recession will damage efforts to deal with the crisis.
The Fed's latest assessment is for the US economy to falter needs to be taken seriously. Citing anaemic employment, depressed confidence and financial risks from Europe, its chief urged Congress not to cut spending too quickly in the short-term even as they grapple with fiscal consolidation over the medium-term. The IMF expects the United States to grow by 1.5% in '11 (less than 1% in 1H'11) and 1.8% in '12. The short-term outlook isn't looking better. Indeed, the business cycle monitoring group ECRI concluded last week that the US economy is tipping into a new recession. Latest data are mixed after a dismal August. US manufacturing managed to keep expanding and employment strengthened in September but the tone has not been sufficiently robust to dispel fears of another downturn. Sure, United States was not in recession in 3Q'11 but the lack of new orders remains of concern. While even sluggish job growth is welcome, the government's belt-tightening is likely to prove a significant drag on the economy. The Fed's commitment to ensure recovery continues will re-assure. But if Europe falters badly, there is little the Fed can do.
Over the past 35 years, housing had added value to the GDP. Empirically, in the two years following most recessions, housing adds about 0.5%point to US GDP growth. So far, the contribution has been negative. This is so because: (i) home prices dropped 2.5% this year; since its '05 peak, home prices have fallen 31.6%; (ii) United States lost US$7 trillion (close to one-half of GDP) in the value of homes they own: homeowners equity has since fallen to 38.6% of home values; (iii) home-starts are at an all time low and still falling. The housing bust weighs heavily on consumers making them more reluctant to spend. Innovative ways to unleash housing are needed.
Looks like the world remains in a bad shape. It is also a dangerous place with growing uncertainty, high volatility and increasing social unrest. Europe in particular is in a high risk gamble. I worry European politicians may learn the hard way in trying to outsmart the markets.
> Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching & promoting the public interest. Feedback is most welcome; email: email@example.com