The world’s capital and currency markets are getting roiled once again as they were earlier in the year, raising new fears about a double dip global recession. This time the culprit is not Greece but Ireland, the second of five European Union nations seen as particularly hard hit by the recent global recession. The EU agreed on a US$113-billion rescue package for Ireland on November 28, but uncertainty lingers.
Ireland's Woes: Limited Impact on Asia -- For Now
Sitting at the heart of Europe in Liechtenstein, Dr. Joerg Zuener has a ringside view of the turmoil as chief economist of private banking services provider VP Bank. He spoke to CFO Innovation’s Cesar Bacani as the rescue of Ireland was unfolding.
How are Ireland’s fiscal and banking problems affecting your economic outlook for 2011? Do you anticipate a direct impact on the U.S. economy, for example, and therefore a huge effect on economies in Asia?
No, at this point, no. Our baseline is that Ireland and Greece are receiving funding, that this funding will be extended to other countries if necessary, and that the Eurozone as a whole will remain in place. The fallout from the austerity measures [in Ireland, Greece and the rest of Europe] is slow growth in the Eurozone because of slow demand. There is less of an impact on the U.S. In terms of the global impact, it is our view at this point that it is still limited.
The other more recent effect on Europe is that the uncertainty in the bond market will continue. It looks like the spreads for Portugal and Spain are not coming down as they did after the [US$102-billion rescue] package for Greece [was agreed to in May], and that’s because the Eurozone is now discussing a debt resolution mechanism as of 2013. It means that there is high uncertainty among bond investors and that will keep the markets volatile and the uncertainty going for some time. That’s why we’re not seeing the same reaction as after the Greek programme.
But many economies [in the European Union] can still achieve the Maastricht Treaty criterion of government deficit equalling 3% of GDP by 2015. However, one should not expect a fall in the debt levels [to 60% of GDP as mandated by Maastricht]; they will rise way beyond 100% at least for Ireland and Greece.
It was not realistic to begin with to think that debt levels would come down in the short run. That’s a medium-term process. We always said it was a three-step process. First was solving the bond market problems. The second step is bringing down the deficit to a sustainable 3% or less. And the third step is to bring down the debt levels.
The first step has at least been taken?
They have taken the first step for Greece and for Ireland. So we’re not anticipating any major hiccups in the bond markets from those two countries because they have financing assurances from the Eurozone and the European Central Bank. What we have pencilled in is slow growth for the Eurozone because of the budget cuts that are happening across Europe.
And both Greece and Ireland are small markets, so the impact on other economies should be small. It’s really the news flow, the fear of what may happen . . .
Yes, and the Greek economy, for example, is one of the less open economies in Europe, so it’s geared towards the domestic economy. The biggest link from Ireland to the rest of Europe is also not the real economy. If anything, it’s the banking sector because most of Ireland’s debt, as well as the Greek debt, is held by foreigners. A large part is held by foreign banks. That’s a chain of contagion that is still there in the banking sector, depending on how [Greek and Irish] bonds are going to be evaluated or priced in the future.
Is this true as well of Portugal and Spain, that the impact on the global economy has more to do with news flow rather than real-world effects?
Portugal, yes. Spain, we’re talking a larger economy here and also in terms of its contribution to the Eurozone. Structurally, [the EU countries seen as vulnerable – Greece, Ireland, Italy, Portugal and Spain] are all very different. Spain is the one among those five with by far the lowest debt levels. Yes, Spain has a large government deficit and may have some problems in the housing market, but it has a low debt ratio of 53% towards the end of 2009. That’s sustainable. The critical level is 90%.
So Spain from that angle is more stable than many other economies in the Eurozone. Ireland, especially because of the banking sector, the bailout costs are large there. Greece didn’t have the banking bailout problem, but more of a loose fiscal policy for a number of years.
DEFICIT AND DEBT
The second step, reducing the deficit, and the third, bringing down debt levels, are far more difficult to pull off.
Exactly. In terms of bringing the debt levels beyond 2015, that gets more and more difficult. The higher the debt levels are, the worse the outlook before the European Union. That’s my real worry at the moment. If growth in Europe is not picking up fast enough and stays at a more disappointing level, it will be hard to bring those debt levels down and that will increase the chances of some sort of restructuring. But it’s too early to say that that’s the largest medium term risk.
There are political repercussions as well. Ireland holds new elections early next year.
Of course, the political part of it is always a risk. If you have to go into cutting expenditure, including benefits programme and in the social services area, it’s always politically controversial and rightly so. It can lead to things like what just happened in Ireland, the coalition there having to struggle to stay together.
In Greece, one of the problems is the competitiveness of the economy and the rather large unit labour costs. The changes to the benefits programmes and working hours, pension reforms and so on will have a positive effect not only on the budget but also on the competitiveness of the economy. That’s very important to support stronger growth.
What is your judgement of the way Greece is handling its crisis?
They [Greek’s ruling party] were supported in local elections by the Greek population. They have achieved significant budget cuts in a relatively short period of time. Unfortunately, tax revenues fell short of expectations. We’ll have to see the final number from the IMF from the review it is conducting at the moment, but that’s how it looks like. It has to do with the slow growth. But I think they’ve done a lot of progress. Comparing the expected budget deficit this year with last year, we’re going to see a significant cut.
It’s probably too early to tell in Ireland’s case.
The proposed three-year plan that Ireland has been suggesting is ambitious, but if they implement it, it’s also definitely a big step in the right direction.
Are Portugal and Spain putting in place some of the structural reforms needed going forward?
Yes, from the numbers we have so far, in Spain more than in Portugal, they seem to be on track. The right policies are being put in place.
TAXES IN IRELAND
Some Asian companies are taking advantage of the low-tax regime in Ireland to manage global taxation issues and other goals. What are the signals you’re getting from there? Is Ireland likely to change its corporate tax regulations?
One has to wait for the outcome of the negotiations [with the IMF and the EU] before making the final judgment on this. This kind of tax regime is very competitive and keeping it in place would protect the foreign direct investments into Ireland from disappearing and that’s certainly needed at the moment – any kind of foreign direct investment. In that sense, Ireland has done a lot of structural performance in the past that have improved competitiveness. The issue there is the banking sector. A good [tax] system is in place already.
So they would probably be raising income taxes and other fees to raise revenues?
Yes. Or at least a mix of measures, sales tax and so on. It’s up to the Irish government to decide what it wants to do. But there seems to be awareness of what helps competitiveness and what doesn’t.
Greece has been criticised for fudging its numbers. How confident are you about the economic data that emanates from there now, and also with the figures put out by Portugal, Spain, Italy?
In Greece, we certainly had a number of revisions of fiscal numbers, and that always raises question marks. But that’s in adjusting the starting point; it seems like that’s complete now, judging by what the Eurostat [the EU’s statistical agency] has been communicating. There are unlikely to be further large revisions.
To my knowledge, Eurostat has not announced any revisions to the macro or fiscal numbers for Ireland. The necessary write-downs of [bank] assets just needed to go further than had been anticipated. Once your banks are affected you have to start making estimates, and it’s unfortunate that they had to be revised. It’s not unusual, I think, those things happen and they will have to be revised a number of times.
Bonds in Ireland and Greece are really cheap. Is it a good time to be buying them?
We have been advising against it, particularly for private investors. Institutional investors [including corporate treasuries] have a different kind of diversification [needs] and maybe a different kind of risk management in place.
For us [at VP Bank], those high yields are not attractive or are not an argument for buying at the moment largely because of the uncertainty surrounding the future debt resolution mechanism. Emergency funding expires in 2013 and the discussion on what happens next is ongoing. There are debates about having private investors participate in debt restructuring and until that debate is settled, for us the yields are not an argument for those bonds.
You are positive on corporate and emerging market Asia bonds, though.
Our main argument there is that they pay risk premium over benchmark government bonds. We have been receiving this extra return because the actual underlying economic and financial conditions of most emerging markets and the corporate sector are much stronger than that of the governments. The UK has a high debt, Japan has high debt, the U.S. has increasing debt, yet their respective corporate sectors have declining debt levels, large free cash flows, increasing profits. We are happy to take the credit risk on the side of the companies and the emerging market more than on the government.
And you also potentially win in terms of currency appreciation, if you’re USD- or euro-based and you’re buying into emerging market currencies.
Whether or not we would buy into the local currency, that depends on what your expectations are about interest rate policy in the respective countries. If interest rates are going up, in countries such as Korea, this will put pressure on bond yields, so bond prices will suffer from that. But if you expect the won to appreciate by more than what you lose [on falling bond prices], then it’s attractive to buy those bonds in local currencies.
At the moment, we have interest rates levels in the emerging markets at 4% on average, and economic growth at 10%. Interest rates will have to rise eventually in emerging markets [to catch up], but not everywhere at the same pace, so that’s the thing to think about. Also, in countries that have a fixed exchange rate or at least a managed exchange rate, you may see interest rates rise but you may not see the currency [strengthen] because they will manage the exchange rate.
What about money market funds? Some corporate treasurers put part of their company’s idle cash into them.
That’s very short term and you’re more at the very short end, so it very much depends on the policy rate environment. In countries where interest rates are rising, like Korea, that’s something to look at very closely if you are [parking money in] money market funds.
You’d probably go with a money market fund with a weighted average maturity of shorter than 60 days or 45 days, given the interest rate expectations.
You would go shorter, wouldn’t you? Then you can pick up any rise in interest rates. But if in the somewhat longer perspective an interest rate rise is already priced in, then you may also be good in three to six months. But I would think you go for short [tenures] and then pick up any policy rate increase right away, rather than having to wait.
2011 ECONOMIC FORECAST
Your forecast for next year is a weak but stable U.S. economy, with no likely trigger for another plunge, and an even weaker Europe. But you see Asia as the engine of global growth. Isn’t there a danger, though, of asset bubbles and overheating in Asia in part because of capital inflows that normally would have gone to the West?
The short-term problems will continue to dampen growth prospects in Europe and the U.S., so the growth rate differential [with Asia] will remain. This suggests to me that there is quite a bit of upside potential in asset prices here. The fear that they would collapse quickly assumes that the money is here only in the short run and will be pulled out quickly. My belief is that some of it at least is here to stay.
Fundamentally, the economic prospects are strong. China is reaching per capita income level of US$5,000. That’s a level at which you tend to see more in extra dollars earned spent rather than saved. With rising income, there is potential for domestic consumption growth in the region. The trade among the countries with each other is also increasing. So there are some structural shifts that to me support higher expected yields that justify the reasons for the capital inflow, at least for a number of years.