EQUITY RESEARCH European Equity Strategy | 4 May 2010

EUROPEAN STRATEGY ELEMENTS

Sovereign risk: Lessons from Asia, 1997
„ Echoes of Asian FX in Greek bonds: The sharp surge in Greek 2-year bond yields to Edmund Shing, PhD
as high as 18% in the past week and the greater involvement of the IMF echoes the +44 (0)20 7773 4307
sharp movements in currencies and interest rates in Malaysia, Indonesia and South edmund.shing@barcap.com
Korea in 1997 as these countries suffered acute financing difficulties in the midst of Barclays Capital, London
foreign capital flight, requiring multi-year IMF financial support.
Dennis Jose
„ Risks of further market-driven contagion across asset markets: While the
+44 (0)20 3134 3777
confirmation of a larger IMF/EU funding package for Greece is likely to calm
dennis.jose@barcap.com
contagion fears in the short term, market assessments of the credibility of various
Barclays Capital, London
government fiscal reduction programmes can still change quickly, risking further
financial market dislocation amongst Southern European countries.

„ Some reaction from equities, but risk remains: While Southern Europe equity
indices have underperformed global equities since October 2009, any further flare-
up of deficit financing risk is likely to prompt further underperformance versus non-
Eurozone equity indices like the FTSE 100 and OMX.

„ Underweight bond-sensitive sectors, eg, Utilities and Financials, continue to prefer

Capital Goods, Luxury Goods and selected Technology names (that can benefit
from a weaker euro).

„ In index terms, we continue to favour “core Europe” indices such as the DAX, CAC-
40 and AEX versus the IBEX and FTSE MIB (Figure 1).

Figure 1: Southern European equity underperformance trend well-established

150 DAX, CAC, AEX index average (rebased)

Southern Europe equity index average (rebased)
140 MSCI world (rebased)
130

120

110

100

90

80

70
Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10

Note: Southern Europe equity indices include: IBEX, FTSE MIB, PSI-20, ISEQ, Athens SE

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Barclays Capital | European Strategy Elements
Sovereign CDS widen out, euro
sinks to a 1-year low vs. US$
S&P sovereign rating
downgrades impact Greece,
Spain, Portugal
New IMF/EU funding package to
satisfy Greek financing needs to
end-2012
4 May 2010
Sovereign spreads flag up increasing market concerns
We wrote on the risk of contagion in European sovereign spreads back in February this year
(European Strategy Elements: Looking for safe havens in Europe, 5 February 2010),
highlighting the risk that the stress seen in Greek CDS spreads back then could spread not
only across asset classes, but also to relative performance of affected regional equity indices
and even more debt-dependent Pan-European sectors such as Financials and Utilities.
Figure 3 and Figure 4 both highlight that financial stresses have increased markedly since
February for Greece with the Greek 5-year CDS now, with clear knock-on effects both for
other Southern European CDS and also for the euro, which currently resides just off a 1-year
low against the US dollar.
S&P rating downgrades
Since the publication of this initial report, the ratings agency S&P has downgraded the long-
term sovereign rating of Greece, Portugal and Spain (Figure 2), citing their widening fiscal
deficits coupled with a lack of real GDP growth for this year. In addition, S&P has kept the
ratings of all three countries on negative watch, flagging the potential for a further
downgrade in the absence of credible programmes of spending cuts and tax increases
aimed at substantial reductions in fiscal deficits.
Note that as of 29 April, the Greek sovereign 5-year CDS sat at 689bp, implicitly pricing in a
45% probability of default over the next 5 years, according to Bloomberg calculations. This
would imply that credit markets remain to be convinced of the ability of the Greek
government to reduce the interest rate burden on the economy without resorting to some
form of debt restructuring.
Rising market concerns over a potential contagion effect have been reflected in the sharp
rise in Portugal and Spain’s sovereign CDSs over the last fortnight alongside Greece’s CDS
and in the accompanying sharp under-performance versus the STOXX 600 of the Spanish
and Portuguese stock markets alongside the Athens General index).
Figure 2: Certain European sovereign long-term credit ratings have been downgraded
10-Year Govt. Bond S&P Moody’s
Ireland AA Aa1
Greece BB+ (BBB+) A3 (A2)
Spain AA (AA+) Aaa
Portugal A- (A+) Aa2
Italy A+ Aa2
UK AAA Aaa
Source: S&P, Moody’s. Note: Ratings that have changed since our report on 5 February 2010 are highlighted in bold
italics, with the previous rating in parentheses.
IMF becoming more involved
In addition, the IMF has become intimately involved in the construction of a larger joint
IMF/EU funding package for Greece to satisfy funding needs up until the end of 2012,
reportedly worth up to EUR130bn according to German MPs (Global Economics Daily I, 29
April 2010) as open market debt funding has become prohibitively expensive (Greek 2-year
bond yields rising as high as 18% on 28 April). For its part, according to the Financial Times
(30 April 2010), the Greek government has agreed a EUR24bn austerity package aimed at
2
Barclays Capital | European Strategy Elements

reducing the budget deficit by some 10-11% over three years.

Parallels between 1997 Asian
crisis and the Greek funding
crisis today?
This has led to parallels being drawn between today’s peripheral Eurozone debt funding
crisis, and the evolution of the 1997 Asian crisis, which resulted in sharp depreciation of
several Asian currencies such as the Malaysian ringgit, the Thai baht and the Indonesian
rupiah, eventually ending up in the intervention of the IMF to provide funding to the affected
South-East Asian economies of Indonesia, Thailand and South Korea.

While the major adjustment in the initial stages of the Asian crisis was made by currencies,
due to heavy investor outflows from these 3 countries, leading to a sharp rise in interest
rates in order to support currencies (Figure 5), the status of Greece as a member of the
Eurozone (with Greece representing just 2% of the Euro zone economy) has led to Greek
government bonds taking the brunt of investor outflows, with yields accelerating upward to
as high as 18% intraday following the 28 April S&P rating downgrade to BB+ (Figure 6).

Figure 3: Southern Europe CDS spreads blow out Figure 4: Euro effective index driven down by sovereign risk

800 Spain CDS 108 40

Italy CDS
700 UK CDS 50
Greece CDS 106
600 60
Portugal CDS
104 70
500
80
400 102
Euro 90
300
100 weakening 100
200
110
98
100 Euro effective index 120
0 96 SovX CDS index (inverted, rhs) 130
Oct 09 Jan 10 Apr 10 Oct 09 Jan 10 Apr 10

Figure 5: Malaysian interest rates rose sharply in 1997-98 Figure 6: Greek yields took a larger hit, given shared FX

13 Malaysian 2-year govt. bond yield % 14 Greek 10-year bond yield %

Malaysian base lending rate % Greek 2-year bond yield %
12 12 S&P
downgrades
11
10 Greek debt
10
8
9
6
8
4
7

6 2
Onset of
5 Asian crisis 0
1996 1997 1998 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10

4 May 2010 3
Barclays Capital | European Strategy Elements

Parallels between the 1997 Asian crisis and European tensions today
IMF identified the main factors According to the IMF 1 , the five factors listed below in italics, amongst others, contributed to
underlying the Asian crisis. Many the collapse in investment sentiment which characterised the 1997 Asian crisis. What are
apply to the Greek funding crisis. the parallels between those factors then, and the Greek financial situation today?

The italicised commentary below is from the IMF report.

1. “A buildup of overheating pressures, evident in large external deficits and inflated

property and stock market values”. This appears to have been the case of late in certain
Southern European economies, with increasing budget deficits in Greece, Portugal,
Spain and Ireland leading to substantial amounts of sovereign debt being held by
foreign investors, along with boom and bust real estate markets in Spain and Ireland
over the last 10 years (Figure 7), boosted by lower mortgage rates as the 12-month
Euribor interest rate fell from 5.3% in September 2000 to just over 2% by mid-2005.

2. “The prolonged maintenance of pegged exchange rates, in some cases at

unsustainable levels, which complicated the response of monetary policies to
overheating pressures and which came to be seen as implicit guarantees of exchange
value, encouraging external borrowing and leading to excessive exposure to foreign
exchange risk in both the financial and corporate sectors”. The euro is a pegged
currency for all euro area members, which restricted the ECB from raising interest rates
to the extent it may have liked to in 2007 to respond to the overheating economic
fundamentals in some southern European countries, given the “one-size-fits-all” nature
of the Eurozone reference repo rate and the slower growth and lower inflation rates in
the core economies of Germany and France.

3. “A lack of enforcement of prudential rules and inadequate supervision of financial

systems, coupled with government-directed lending practices that led to a sharp
deterioration in the quality of banks' loan portfolios”. This appears to have been the
case during the recent financial crisis, with European banks suffering a significant

Figure 7: Irish, Spanish house price bubbles to 2007-08 Figure 8: Euro area to see $665bn bank writedowns/losses

350,000 Irish house prices, EUR (lhs) 2400 2,500 Expected additional writedowns/losses 10
Spanish house prices, EUR/m2 (rhs) Realized writedowns/losses
Implied cumulative loss rate (%, rhs) 9
2200
300,000 2,000 8
2000 7
1800 1,500 6
250,000
+155% in 8 5
1600 1,000 4
years to Q1
200,000 1400 3
2007
500 2
1200
150,000 +169% in 9 1
years to Q1 1000 0 0
2008
100,000 800 US UK Ar
ea ur. As
ia ta l
r o erE To
Eu h
1999 2001 2003 2005 2007 2009 Ot

Source: IMF Financial Stability Report, April 2010. Note: realized

writedowns/losses Q2 2007 – Q4 2009. Expected additional writedowns/losses
over Q1 – Q4 2010.

1
IMF World Economic Outlook, May 1998. See http://www.imf.org/external/pubs/ft/op/opfinsec/index.htm

4 May 2010 4
Barclays Capital | European Strategy Elements

expansion in write-offs for toxic assets as a result of the global financial crisis (Figure
8), in addition to the leap in provisioning for a rising tide of non-performing loans.
While not exclusively a Southern European issue, this is forcing many southern
European banks to raise fresh capital or even merge with stronger counterparts as in
the US or UK, along with drawing on additional financing via specific government bank
recapitalisation programmes such as the Spanish FROB. Note that according to the
IMF’s April 2010 Financial Stability report, Eurozone banks have been slower to
recognise total writedowns and losses, with only 62% of the IMF-forecast total in
writedowns and losses recognised by the end of 2009 (compared to 77% by US banks
and 78% already recognised by UK banks), with the remaining 38% (USD250bn) still to
recognise this year.

4. “International investors had underestimated the risks as they searched for higher yields
at a time when investment opportunities appeared less profitable in Europe and Japan,
owing to their sluggish economic growth and low interest rates”. A global hunt for yield
appeared to be in place up to the emergence of the global financial crisis in mid-2007,
following a 20-year decline in global inflation and thus long-term bond yields. This
drove credit spreads tighter (Figure 9) and effectively led investors up the risk spectrum
in search of yield enhancement, once again prompting international investors to
undervalue the additional risks associated with these higher yields.

This was true not only in terms of corporate credit spreads but also in terms of
peripheral European sovereign spreads over Bunds, which converged to an average of
less than 10 basis points over 10-year German bunds between 2003 and 2007. This
average spread has now widened back out to 240bp for the basket of Greek, Spanish,
Portuguese, Italian and Irish 10-year bonds.

5. “Since several exchange rates in East Asia were pegged to the US dollar, wide swings in
the dollar/yen exchange rate contributed to the build-up in the crisis through shifts in
international competitiveness that proved to be unsustainable (in particular, the
appreciation of the US dollar from mid-1995, especially against the yen, and the
associated losses of competitiveness in countries with dollar-pegged currencies,
contributed to their export slowdowns in 1996-97 and wider external imbalances)”.

Figure 9: Hunt for yield drove bond investors to higher risk Figure 10: Greece, Spain lose competitiveness vs. Germany

7 Average of US, German 10-year bond yields % 350 Germany: unit labour costs (rebased)
BarCap Baa corp. avg. spread (OAS) Greece: unit labour costs (rebased)
6 Spain: unit labour costs (rebased)
300 Ireland: unit labour costs (rebased)
5

4 250

3 200
2
150
1

0 100
2000 2001 2002 2003 2004 2005 2006 2007 1991 1996 2001 2006

Source: OECD

4 May 2010 5
Barclays Capital | European Strategy Elements
Weak real GDP growth forecast
by the IMF for Southern
European countries and Ireland
even in 2011e
Much higher long-term
unemployment rate, and
depressed real wage growth in
prospect to improve productivity
Fiscal deficit reduction much
easier with strong nominal GDP
growth
4 May 2010
One can make this argument with the Eurozone today; since the introduction of the euro
in 1999, faster economic growth up to 2007 encouraged by a low ECB reference interest
rate led to national inflation rates consistently exceeding the Eurozone average CPI.
This factor, combined with a relative lack of supply-side labour market reform in
Southern European countries, led to a significant expansion in unit labour costs that
was not seen in Germany (Figure 10). While these nations lost international and even
intra-Eurozone competitiveness, they were allowed to continue to finance their
ongoing consumption growth by what David Bowers, writing in the Financial Times (29
April 2010), has called a “vendor financing” dynamic between the current account
surplus-generating Germany and the debtor nations of southern Europe plus Ireland.
A euro conundrum: How to cut fiscal deficits when nominal growth is weak
Now constrained by rapidly rising fiscal deficits to enact tough deficit-reduction measures
that act as obvious depressants on future economic activity, this group of Eurozone
members are now forecast to see very modest real GDP growth or even a return to
recession this year and next by the IMF in their April 2010 World Economic Outlook report
(Figure 11).
With currency depreciation no longer a unilateral measure to which Eurozone members can
resort (unlike Sweden and the UK) to boost their relative levels of economic
competitiveness, these economies look set to experience a long-term resetting of global
competitiveness by real wage deflation and a higher natural rate of unemployment (NAIRU),
substantially lowering trend GDP growth rates for at least the next few years.
All of which makes the process of cutting fiscal deficits even tougher, as history dictates
that faster nominal GDP growth is the best economic backdrop for achieving substantial
reductions in fiscal deficits (according to Reinhart and Rogoff’s The Aftermath of Financial
Crises paper, 19 December 2008).
Our economists’ view is that Ireland, Spain and Portugal should take advantage of the
firebreak afforded to Greece to put in place major fiscal consolidation, including the raising
of VAT rates (Euro Weekly, 30 April 2010).
Figure 11: IMF real GDP growth forecasts – all under 2% even in 2011e
4 Greece Ireland Italy Portugal Spain
-2
-4
-6
-8
2008 2009 2010e 2011e
Source: IMF
6
Barclays Capital | European Strategy Elements

Conclusion: The echoes of 1997 are surprisingly loud

In sum, we would argue that when we examine the factors identified by the IMF, we see a
number of interesting parallels between the Greek sovereign issues today and the 1997
Asian crisis.

Bond vigilantes to watch for
detailed programmes, and
successful execution
So what can we expect next? There is a significant risk that the financial markets continue
to exert mounting pressure for European governments, and for Southern European nations
in particular, to reinforce their credibility by detailing programmes for (a) substantial
reductions in government spending, coupled with (b) rises in taxation, in order to lay out a
clear roadmap towards required drastic reduction in fiscal deficits to avoid a debt spiral.

In addition, the so-called “bond vigilantes” of the global fixed income market will clearly
monitor execution of these fiscal programmes to ensure that deficit reduction targets are
met, with further sanctions, in the form of higher bond yields, the potential penalty for
falling short.

Financial market reactions so far: the euro, euro equities

FX, equity market reactions so
far relatively muted
Thus far, there have been relatively muted reactions in the European FX and equities
markets of late, when compared to the sharp moves seen in Southeast Asia in 1997-98. Yes,
the euro has fallen 12% since late October 2009 to close to a 1-year low against the US
dollar in large part on the back of this current crisis; but as can be seen in Figure 12, the
euro still hovers above the USD1.25 lows touched back in early 2009. By way of a crude
comparison, between June 1997 and January 1998 the Malaysian ringgit, Thai baht and
Indonesian rupiah against the US dollar fell by an average of 59%.

Note that the weaker euro is, in effect, a way for the whole Eurozone to accomplish a form
of modest currency devaluation versus its main US and Asian trading partners. While our FX
strategists currently maintain fairly neutral EUR/USD forecasts (USD1.30 in 3 months,
USD1.35 in both 6 and 12 months from now) 2 , the risk is that any further concerns over
Euro area members’ fiscal positions and fiscal reduction measures will trigger further euro
weakening – which would then benefit the Eurozone via better export competitiveness.

Figure 12 Euro has only mildly followed Asian depreciation Figure 13: Euro STOXX not underperforming radically, yet

120 Ringgitt, Baht, Rupiah vs. US$ Jul 1995- (index, lhs) 1.7 120 MSCI Asia-Pacific ex Japan/ MSCI World (Jul 1995-)
EUR vs. US$ Jan 2008- (rhs) Euro STOXX / MSCI World (Jan 2008-)
110 110
1.6
100 100
1.5
90 90
80 1.4 80
70 1.3 70
60 60
1.2
50 50
1.1
40 40
30 1 30
2008 2009 2010 2008 2009 2010

4 May 2010 7
Barclays Capital | European Strategy Elements

Equally well, when looking at the relative performance of the Euro STOXX index versus the
MSCI World index, the relative underperformance since October 2009 has been limited at
-6%; put with the 55% cumulative underperformance of the MSCI Asia-Pacific ex Japan
index from July 1997 to June 1998 (Figure 13), and it is clear to us that the reaction in euro
equities to this debt crisis has thus far been relatively muted.

European equity market conclusions

So yes, there appears to have been a knock-on effect on Eurozone equities, but some
sovereign risk may still remain: while Southern Europe equity indices have underperformed
global equities since October 2009 (Figure 1), any further flare-up of deficit financing risk is
likely to prompt further underperformance versus non-euro equity indices like the FTSE 100
and OMX.

As our economists note in their latest Euro Weekly report (30 April 2010), “the risk that the
German government fails to agree on financial assistance to Greece is not zero”. While a low
probability according to our economists, were the German government to withhold their
consent to contributing to the Greek financing programme, Eurozone equity market
volatility would likely spike anew.

Index Recommendations – Favour “core Europe” to Southern Europe

In index terms, within the Eurozone we continue to favour “core Europe” indices such as the
DAX, CAC-40 and AEX versus the IBEX and FTSE MIB in spite of moderate outperformance
of the former group of indices in 2010 to date (Figure 14), as we believe that the volatility in
the latter indices is likely to remain for some considerable time, given the long-term nature
of required fiscal reduction measures.

Figure 14: DAX, CAC, AEX diverging from IBEX, FTSE MIB Figure 15: Investment-grade credit hit by sovereign woes

110 DAX, CAC, AEX index average (rebased) 110 110

Investment grade credit
IBEX, FTSE MIB index average (rebased)
spreads dragged up by
100 100 100
sovereigns widening
90 90 90

80 80 80
No difference in
70 2008, 2009 70 70

60 60 60
Divergent
Itraxx Europe Main
50 2010 50 50
Itraxx Senior Financials
trends
Itraxx SovX
40 40 40
Oct Nov Dec Jan Feb Mar Apr
2008 2009 2010

2
FX Forecasts, 23 April 2010

4 May 2010 8
Barclays Capital | European Strategy Elements

Sector recommendations – Underweight bond-sensitive sectors such Banks

and Utilities, Overweight euro-sensitive sectors – Capital Goods, Technology
We maintain our recommendations from our 5 February report, ie, we remain underweight
bond-sensitive sectors like Utilities and Financials given the risk that sovereign-linked credit
spreads continue to widen on the back of widening sovereign spreads (Figure 15).

Within the Eurozone banks sector, this effect has been most marked in Southern European
banks, which have underperformed French, German and Belgian banks substantially since late
January this year (Figure 17). Our banks sector analysts continue to favour both BNP Paribas
(1-OW, EUR68) and Deutsche Bank (1-OW, EUR61) within their Eurozone coverage universe.

Given the ongoing risks to the euro from this sovereign theme, we continue to prefer
export-oriented sectors that can benefit from a weaker euro such as Capital Goods, Luxury
Goods and selected Technology names (particularly within the semiconductor space).

Figure 16: Utilities, Telecoms underperform alongside Sovx Figure 17: “Core” Euro banks beat Southern Europe banks

106 Euro Utilities vs. EuroSTOXX 20 120 Sp, It, Pt banks

Euro Telecoms vs. EuroSTOXX Fr, Gm, Bg banks
104 iTraxcx Sovx index (inverted, rhs) 40
110
102
60
100 100
98 80
96 90
100
94 Little differentiation
80 here
120
92 But now sovereign
90 140 70 concerns weigh
Oct Nov Dec Jan Feb Mar Apr Oct Nov Dec Jan Feb Mar Apr
09 09 09 10 10 10 10 09 09 09 10 10 10 10

Note: Fr, Gm, Bg banks: BNP Paribas, Societe Generale, Deutsche Bank, KBC.
Southern Europe banks: Santander, BBVA, B. Popular, BCP, Unicredit, Intesa
SanPaolo, B. Monte dei Paschi

4 May 2010 9
Barclays Capital | European Strategy Elements

Analyst Certification(s)
We, Edmund Shing and Dennis Jose, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or
all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to
the specific recommendations or views expressed in this research report.
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Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether
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4 May 2010 10
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marketing of the transactions or other matters addressed herein. Accordingly, you should seek advice based on your particular circumstances from an
independent tax advisor.
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