21 January 2018

So The Eurozone Is Finally Recovering? Think Again!

by Elliott Morss
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For example, Derek Halpenny comments as follows:
In the second quarter of 2017, annual real growth in gross domestic product rose above 2 per cent for the first time since 2011. The Eurozone unemployment rate is also falling more sharply than expected. Recent data from the ECB reveal that foreign investors bought a record €238bn worth of Eurozone equities between May and July of this year....Because of fluctuations in the exchange rate, US investors have experienced an 8.1 per cent loss, while the S&P 500 is up 28.5%....Investors have woken up to the Eurozone recovery. They look set to stay.

Is this optimism credible? In what follows, I offer four reasons why it is not.

1. Migration

The European Union (EU) shares borders with countries where terrorists are active. As a consequence, most EU countries want to limit immigration. Angela Merkel, the Chancellor of German, has gotten herself in political trouble for favoring more open borders than her compatriots. It is not clear how this migration issue will be resolved. And it is important enough to do great damage to the European Union and the Eurozone unless it is soon resolved. Just how it will be resolved is not clear.

2. Brexit

It is also uncertain how Brexit will work out. Britain's exit request has not set well with other EU countries, suggesting the resolution of economic, political, and budgetary issues will not be easy. As Table 1 indicates, trade between Britain and the other EU countries is far more important to the UK than it is to the other EU countries. This suggests the EU will take a tough negotiating position on trade. There are numerous antagonisms and other matters to resolve that could delay a final resolution for years.

Table 1. UK/EU trade (in bil. US$)

Source: UNCTAD

3. Weak Eurozone Economies

As indicated at the outset, some see a glimmer of hope that the EU is on the "economic road to recovery." This claim is examines in Table 2. The deficits and debt are expressed as a percent of GDP. Data in red are worrisome.

Consider first the Eurozone (EZ) in aggregate against the US and China. The projected real growth rate for the EZ is a relatively unimpressive 2.1% for this year and it then falls back below 2%. Overall, the EZ unemployment is 8.5%, a definite problem going forward. Deficit and debt data for the EZ looks good, but this is largely the result of solid performance by its "power" countries: Germany, Austria, Ireland and the Netherlands.

Among individual countries, Belgium, France, Italy and Portugal are having to deal with slow growth, high unemployment and high levels of public debt. Spain has adequate growth but very high unemployment and debt. Greece warrants further comment.

Table 2. - Growth, Unemployment, Deficits and Debt in EU Countries

4. Greece

According to the IMF, Greek debt is unsustainable. However, the European Central Bank (ECB) and other Eurozone countries and don't want further debt reduction because of the write-downs banks would have to take. The IMF is adamant: it will not disburse more funds until a further debt reduction plan has been worked out. I quote from the IMF's recent Greek Request for Stand-By Arrangement:

Greece's debt remains unsustainable. While differences of view between staff and Greece's European partners have narrowed, staff believes that a debt-reduction strategy that is based on maintaining unprecedentedly high primary surpluses or output growth rates for extended periods is not credible, even with full implementation of planned policies.

Baseline projections suggest that Greek government debt will decline to 160 percent of GDP by 2022. Gross financing needs cross the 15 percent-of-GDP threshold already by 2028 and the 20 percent threshold by 2033, reaching around 45 percent of GDP by 2060. Debt is projected to decline gradually to around 150 percent by 2030, but rises thereafter, reaching around 195 percent of GDP by 2060, as the cost of debt, which rises over time as market financing replaces highly subsidized official sector financing, more than offsets the debt-reducing effects of growth and the primary balance surplus." The Fund concludes that without further debt reduction, Greek's gross financing needs become explosive after 2030.

But there is more to the IMF's concerns. Its baseline projections assume all the reforms that Greece has agreed to for the bailout money it is receiving will be implemented. I quote further the IMF:
Permanently raising growth would require a period of reform implementation that exceeds in both ambition and duration what Greece has achieved so far. In conclusion, achieving staff's assumption of 1 percent growth in the face of adverse demographics and historically weak productivity growth will require that the Greek authorities and people commit to an extended period of profound structural reform.

My translation: The IMF does not believe Greece will make the reforms it has agreed to make. So everyone continues to plod along with "heads in sand."

But even if more Greek debt is written off, Greece is not out of the woods. The problem is its use of the same currency as the strong EZ countries. Why? Because a currency union limits a country's economic flexibility. A simplified explanation follows.

Assume Germany is more productive than Greece and that the productivity gap is growing. That means Germany can produce goods more cheaply than Greece. So people, including Greeks, buy goods from Germany. This means the Greek trade deficit will widen and at some point, they will run out of Euros.

Compare the Greek situation where Greece has to use the Euro as its currency with countries that have their own currencies. In this latter case, the exchange rate of the country running up the deficit weakens to compensate for the cost differences. A good example of how this works is the US and Japanese experience. In 1970, there were ¥350 to the dollar. Now, there are only ¥100 to the dollar. The depreciation in the dollar made up for the higher productivity of Japan.

As long as it remains in the Eurozone, Greece has no such "adjustment mechanism". And it does not appear this matter will be resolved soon.

Conclusions and Investment Implications

As suggested above, European countries are not yet "out of the woods." Uncertainties over their future migration policies, what happens with Brexit, economic problems and resolving the Greek crisis constitute major uncertainties. In comparison, China and the US have strong economies with no major crises that need to be resolved. Granted, the US market will probably experience a sell-off soon. But its basic economy is strong. China? As I have written, everyone should have some Chinese investments in their portfolios.

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