15 Feb 2011

EU may be reaching Tipping Point

Gradually the realisation seems to be dawning on the more savvy investors that European
troubles may be reaching a tipping point. Troubles are always noticed (and discounted) first in
the Bond markets for the simple reason that a lender is more interested in the return of his
principle amount as well as interest on monies lent. The Equity markets on the other hand are
notorious for their short-term orientation. If the European bond markets are any indication then it
would be time to prepare for the next round of economic storm that may now originate in
Europe. How big this would depend on the leadership abilities exhibited by their leaders – which
till now do not inspire too much confidence. It has been pointed out the people look at the future
through the prism of the present based on their experiences of the past. But the problem with EU
leaders seems to be that they seem to be living too much in the future or the past rather than the
present. However, due credit should be given to the ECB for seeing to it that they have managed
the crisis well till date, but unfortunately they are running out of options. It has diluted most of
the prudential norms that were in place before the crisis.

EU created a bailout fund (that would be based on contributions from all the countries including
those indebted countries) that would lend 440 billion Euros. But market logic dictates that if the
fund has to maintain its AAA rating then it cannot lend more than Euro 250 billion. But market
estimates point out EU will need at least Euro 2-3 trillion to overcome the crisis. Where they will
be able raise that much money in the present conditions, is a question that has no answer. It is
clear that Germany and France (along with USA, Japan and China) will have to share that
burden. The bond market seems to believe that German and French Balance sheets will
deteriorate as the crisis drags on. That is the reason why the yields have shot up since November
2010 as the table below indicates.

Country Yields on 2 November 2010 Yields on 15 February 2011

Germany 2.47% 3.30%
France 2.88% 3.68%
UK 3.03% 3.84%
Spain 4.28% 5.45%
Belgium 3.31% 4.31%
Italy 3.96% 4.83%
Portugal 6.23% 7.42%
Ireland 7.29% 9.15%
Greece 10.79% 11.58%
Source: Compiled from Bloomberg

It is important to note that the growth rates of Germany and France (which make up nearly half
of EU growth) may have already peaked. German GDP rose 4% against the previous quarter year
on year. This was against the expected 4.1%. France’s GDP rose 0.3% on a quarterly basis
against the expected 0.6%. German growth was largely due to the recovery of exports. At the
same time, private investment is not growing sufficiently fast enough to offset government fiscal
consolidation. Almost all the important companies (the latest being food major Danone) has
warned of a sharp rise in cost of raw material – a global phenomena in the era of low growth.

1
15 Feb 2011

The European bond yields have jumped substantially since early November in almost all the
countries. The exceptional rise in bond yields has been for varied reasons in different countries.
But it is increasingly clear that the solutions adopted by the EU may not be enough and
increasingly investors seem to be thinking that troubles may be spreading to their respective
banking sectors. In case of the troubled nations that are derogatively called PIIGS (Portugal,
Ireland, Italy, Greece and Spain) they are indicating a rapid loss of confidence with bond markets
indicating that after the Irish bail out Portugal will need one very soon – probably within the next
two months.
German Bond Yields

The above chart depicts the bond yields of German 10 Year bond. The last time the yields were
so high was when the ECB mistakenly raised interest rates exactly when Germany was tipping
into a recession as they mistook food and oil price induced inflation with core inflation. This
jump in bond yield comes despite the ECB buying nearly Euros 76.5 billion of bonds. It is clear
that long-term investors are fleeing the bond markets of the indebted countries.

European leaders’ actions have till now always been a case of missing the woods for the trees or
at best: too little, too late. The most immediate trouble spots are Ireland, Portugal, Belgium and
Spain (all for different reasons). This is after the bailout of Greece and a bailout of Ireland
(which may be in trouble once the opposition comes to power in February 25th election).
Complacency seems to have increased due to the fact that most severe impact of fiscal
consolidation will only be felt by the end of this quarter. Therefore it has not yet reflected in
most of the economic news releases yet. But a number of advance indicators are all flashing
danger signs. In UK a cabinet minister has already asked people to prepare for massive job
losses. UK’s service sector optimism index had the second largest fall in its history. This
quarter's Labour Market Outlook by the Chartered Institute of Personnel Development (CIPD)
and KPMG in UK further added that the employment index had fallen from plus +11 to -3 over
the past three months - indicating that job losses (and with it consumption) will plunge in the
next few months in that country.

The problem is that Europe’s debt owes see no end in sight. The following chart illustrates
various scenarios for the debt of various countries. The following chart illustrates the various

2
15 Feb 2011

scenarios for public/debt to GDP ratio for various countries. None of them portray a pretty
picture, indicating that the present problems will take a very long time before they reach
manageable levels. It points out that even in the baseline scenario, debt/GDP ratios rise rapidly in
the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in
Belgium, France, Ireland, Greece, Italy and the United States.

The chart below shows that it will take at least till 2015 (if there is no further deterioration) for
most of the indebted countries.

3
15 Feb 2011

Unfortunately, the problems in Europe will only reduce if unemployment decreases, house prices
increase and government revenues rise. They are cutting spending but that will only make

4
15 Feb 2011

matters worse. As they cut spending, it will probably push most of the economies into a
recession thereby reducing their revenues, increasing their debt service ratio. The following chart
illustrates the debt service ratio of various European countries which is in short unsustainable.

The problem for EU seems to be that the bond markets are discounting problems in their
economy and mainly the banks. Take the case of Ireland. They have survived due to a bail out
agreement (which the opposition has threatened to walk out after elections) but in the meantime
their banks are being haemorrhaged. Deposits are flying out. In 2010 deposits worth nearly Euro
110 billion (about 60% of the GNP) flew out of the country. Out of this nearly 35% of the
deposits exited in December 2010. How did the banks meet this problem: borrow from the ECB.
Now they are running out of collateral to pledge.

Spain’s regional savings banks (Cajas) that specialised in lending to real estate are said to need
up to Euro 80 billion of new capital. The problem for Spain is that unemployment is nearly 20%
and there is an unsold housing inventory of nearly 1 million units. Apart from this other credible
estimates point out that European banks need new Tier I capital of Euro nearly Euro 200 billion.
This excludes the need for sovereign debt write offs (or rescheduling). Last year stress tests were
discredited because they claimed that the banks were safe and that they need only about Euros
3.5 billion.

Political wrangling only makes the problems worse. One thing that is certain is that EU nations
are likely to see new governments in each election. None of the governments are likely to be re-
elected. Germany faces elections in five important provinces at the end of this month. Italy has
its share of political problems. Belgium has not had a full-time government for nearly a year
after elections as the political parties are not in a position to agree to a common programme.
There are now increasing calls for the break up of the country (ironically, EU is headquartered in
Brussels the capital of Belgium). There is however little possibility of any immediate resolution
to the crisis before the Summit of EU leaders on 24-25 March 2011 in order to discuss the
problem of debt. Till that time, bond yields may continue their upward journey. Hopefully the
EU leaders would feel the urgency to solve the crisis before the situation gets out of hand.

The US bond markets too have witnessed a sharp rise in yields. The yields softened only due to
aggressive buying by the US Federal Reserve, as in the case of Europe, where the ECB has been
buying bonds of the troubled nations. There is a semblance of recovery in USA, EU and UK are

5
15 Feb 2011

only due to the aggressive expansion in the balance sheet of the respective central bank or more
importantly due to government stimulus programmes. Interestingly USA is the country with the
largest fiscal deficit and would have to take up serious measures to cut its deficit in the next three
to five years, if it has to retain its top AAA rating. The new US budget projects a fourth
continuous increase in deficit of more than US$1 trillion. The deficit last year was US$1.6
trillion – more than the size of the Indian economy.

Investment Outlook:
The bond market direction will in the next 6-9 months be the most important factor that moves
the equity and commodity markets, as well as the real economy. Any rise in interest rates in
different parts of the world would lead to a sharp fall in the ‘risk assets’, especially the
commodity markets and the Emerging Markets. This would also be accompanied by further rise
in the bond yields. However, this interest rate rise, if it comes this year would be a reality only in
the last quarter of 2011. We however, believe that in the USA and EU will not see a rate rise till
the middle of 2012, if not beyond that. Any rise in interest rates would induce further outflows
from the emerging markets. Any temptation to raise rates in the UK will be tempered due to a
downswing in the fortunes of the economy due to growing lay offs in the world economy.

India is relatively insulated in the next one month due to the more immediate concern about the
Union Budget. But however, once the importance of the budget gradually recedes, any flow out
of the emerging markets will hurt the Indian markets. Since India is a capital deficit country, any
tightness due to withdrawal of liquidity would hurt India substantially because we are already
witnessing unprecedented disappearance of liquidity. Hence it pays to watch the European Debt
crisis along with the domestic inflationary conditions. Paying down debt and increasingly cash
holdings is best insurance when the cycle of liquidity turns as it would provide the best
opportunities.