1. Global Economics Research
Eurozone – Keeping it together
October 2011
Madhur Jha
Global Economist
HSBC Bank plc
+44 20 7991 6755 madhur.jha@hsbcib.com
View HSBC Global Research at: http://www.research.hsbc.com
Issuer of report: HSBC Bank plc
Disclosures and Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix,
and with the Disclaimer, which forms part of it
2. Summary
• We do not expect the Eurozone to break up; a break-up would threaten
another Great Depression
• Current proposals aim to limit contagion but only address symptoms
• More long-term solution needs political will
• Acceptance of responsibility by both creditor and debtor nations
• Eurozone economic recovery remains sluggish as global trade cycle turns
down
• Debt reduction is made harder by slowing growth
• Risk is of another credit crunch if a solution is not found to the current crisis
• Spain has managed to differentiate itself from the rest of the periphery
• But the outlook is clouded by weak global growth
• Adherence to medium-term fiscal consolidation plan is paramount 2
3. What could a Eurozone member achieve by abandoning the euro?
Currency devaluation the only significant advantage
Disadvantages of leaving
• default would not eliminate the need for fiscal adjustment as primary balances in deficit
• Increased likelihood of defaults by companies and households now holding FX-debt
• probable banking system collapse unless capital controls are put in place
• would have to leave the EU
• very hard to reinstate a legacy currency (probably become euro-ised)
• with no nominal anchor, the risk of a wage-price spiral
• no guarantee that long-term interest rates will be lower.
What about Germany leaving?
• Political commitment
• FX appreciation: impact on Germany’s export performance
• Would amount to a devaluation of external assets of German households, companies and banks
• Germany would have to leave the EU
Bottom line: the Eurozone was always a political project and has never been an optimal currency area in terms of structure or country
membership. It now requires a political solution to make it more of an optimal currency area, involving closer fiscal integration.
3
4. Parts of the Eurozone that are in trouble are still small
Other Greece
2010 Eurozone GDP Netherlands
2% 3% Spain
6%
12%
Portugal
Italy 2%
17% Ireland
2%
Austria
3%
Belgium
4%
Finland
2%
France
Germany
21%
26%
Source: Eurostat
4
5. But the main risk is of contagion spreading
bps 5-y ear CDS spread bps
2500 2500
2000 2000
1500 1500
1000 1000
500 500
0 0
Dec-08
Dec-10
Dec-07
Dec-09
Jun-08
Jun-10
Jun-09
Jun-11
Italy Portugal Greece
Source: ECB, Bloomberg, HSBC
5
6. The Eurozone crisis – how bad will it get before the
politicians provide solutions?
• Greece must be supported until a firewall is in place to protect the larger
economies in the periphery
• Building the firewall is the problem:
• Expanding the size of the EFSF or Eurobonds could put upward pressure
on core bond yields and potentially challenge ratings
• Using the ECB’s balance sheet risks inflation and moral hazard
• The question is: how much must financial markets and economies deteriorate
before politicians come up with the solution?
6
7. Short-term solutions only address the symptoms
The next “Grand Plan”…
– 1) massively increase the firepower of the EFSF/ESM
– 2) large Eurozone-wide bank recapitalisations
…designed to limit the contagion from…
– 3) lowering the size of the Greek stock
7
8. Not hard to see why current “firepower” is viewed as inadequate...
EUR bn 2010 Gov ernment debt outstanding EUR bn
2000 2000
1500 1500
1000 1000
500 500
0 0
Portugal Ireland Greece EFSF* Spain Italy
*Effective lending capacity of revamped EFSF. Source: ECB
8
9. …and quite a lot of the EUR440bn has been earmarked already
Ireland rescue
Portugal rescue
17.7bn
26bn
Remainder 192.6bn
Greece 2nd rescue
provisional 72.7bn
**Irish banks 31bn
Bank
*recapitalisations
100bn
* The IMF has suggested bank recapitalisation needs could be EUR200bn so we assume half could be provided by the EFSF with the rest being provided privately or by
national governments **The Irish government wants to convert the promissory notes it has given banks into EFSF funding Source: ECB, IMF, Reuters, HSBC
9
10. Options for increasing the firepower
Leverage options
– allow the EFSF to undertake repos
– allow the EFSF to offer credit protection (first loss of 20%)
Other options
– simultaneously lend EFSF funds (via governments) for bank recapitalisations
– bring forward timing of ESM, which is already planned to be more bank-like
and could be granted a legal mandate to buy many more bonds
Most cannot be implemented quickly, which leaves the ECB a big role, but
outright QE not imminent, in our view
10
11. The next few weeks
Troika reports
EU Council
EUR8bn for Greece
G20 Summit
ECB Meeting
EFSF buys debt
EUR5bn for Greece
20 October 23 October November 3-4 November late November early January
Troika sixth review of Greece
11
12. The ECB is reluctant to follow the Fed or the BoE…
Index Central bank balance sheets, Jan 2007 =100 Index
400 400
300 300
200 200
100 100
0 0
07 08 09 10 11
Fed ECB BoE
Source: ECB
12
13. …but the EFSF is unlikely to bring a permanent halt to ECB bond
buying
EURbn ECB gov ernment bond purchases % 10y r Bond Yield
25 28
24
20
20
15 16
10 12
8
5
4
0 0
Apr/10 Jul/10 Oct/10 Jan/11 Apr/11 Jul/11 Oct/11
ECB debt Purchases (LHS) Greece (RHS) Ireland (RHS)
Portugal (RHS) Italy (RHS) Spain (RHS)
Source: ECB, Bloomberg, HSBC
13
14. Central bank liquidity may prevent a bank failure but not a credit
crunch
EUR bn Outstanding loans from central bank to country 's EUR bn
banking sy stem
160 160
120 120
80 80
40 40
0 0
05 06 07 08 09 10 11
Greece Spain Ireland
Italy Portugal
Lending from central banks only includes the MROs and LTROs of the ECB. It does not include the emergency liquidity assistance (ELA) provided by Ireland’s and
Greece’s central banks, which is shown in the “other liabilities” category of the balance sheet.
Source: ECB, CEIC, National central bank balance sheets
14
15. Overall financial conditions are deteriorating rapidly
% Eurozone Financial Conditions Indicator Forecast* %
5.0 5.0
3.0 3.0
1.0 1.0
-1.0 -1.0
-3.0 -3.0
-5.0 -5.0
06 07 08 09 10 11 12
Real rates High Yield Spread Credit Standards Real Ex change rate Wealth effects
Note: Chart shows estimated impact of changes in real short- and long-term interest rates, high-yield corporate bonds, lending standards, the real exchange rate and wealth effects
from equities upon the year-on-year GDP growth rate. * Forecasts assume unchanged or early October 2011 levels. Source: ECB, OECD, Bloomberg, HSBC
15
16. Banks in France and Italy tightened standards the most since the
summer
Credit standards applied to new loans to businesses
Bal. of opinions Bal. of opinions
80 80
60 60
40 40
20 20
0 0
-20 -20
-40 -40
06 07 08 09 10 11 12
France Eurozone
Sources: Banque de France, HSBC
16
17. Industrial sector is about to move into recession...
Index %3m-on-3m
65 4.5
60 3.0
55 1.5
50 0.0
45 -1.5
40 -3.0
35 -4.5
30 -6.0
25 -7.5
20 -9.0
15 -10.5
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
EMU PMI manufacturing output index (LHS) EMU industrial production (RHS)
Source: Markit, Thomson Reuters Datastream
17
18. ...so Eurozone can’t rely on exports as the growth driver
% Yr Eurozone % Yr
18 6
12 4
6 2
0 0
-6 -2
-12 -4
-18 -6
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Ex ports (LHS) GDP (RHS)
Source: Eurostat and HSBC
18
19. Consumer spending may provide some offset…
Index , 4Q07=100 Consumption Index , 4Q07=100
104 104
102 102
100 100
98 98
96 96
94 94
92 92
Dec07 Dec08 Dec09 Dec10
US UK
Germany France
Source: ECB, Bloomberg, HSBC
19
20. …but the oil price is unlikely to be the same stabilising factor as it
was in 2009
% pts Impact of food and energy on real w ages* % pts
1.0 Forecast 1.0
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0.0 0.0
-0.2 -0.2
-0.4 -0.4
-0.6 -0.6
-0.8 -0.8
-1.0 -1.0
08 09 10 11 12
Energy Food
* HSBC calculations based on the inflation contributions from all of the food and energy components of HICP inflation. Assumes oil price stabilises at early October 2011 level
of about EUR80/barrel. A negative value denotes a period when energy is adding to the q-o-q change in consumer prices and therefore causing a drag on real wages.
Source: Thomson Reuters Datastream, Eurostat and HSBC calculations
20
21. Once inflation is heading lower, the ECB should be more
comfortable with cutting rates
%pts Contribution to EMU inflation % Yr
5 5
4 Forecast 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
03 04 05 06 07 08 09 10 11 12
Energy contribution Food contribution
HICP inflation
Source: Thomson Reuters Datastream, Bloomberg
21
22. Conclusions
• Muddle-through is increasingly unsustainable…
• … but a permanent solution will take time, political will and legal changes…
• …which means the ECB will continue to have a critical role to play…
• …in buying bonds, supporting banks and cutting rates
22
24. Spain’s fiscal metrics are not as bad as for some other peripheral
countries…
% GDP Budget deficit % GDP
% GDP % GDP
40 40
160 160
140 140 30 30
120 120
100 100
80 80 20 20
60 60
40 40 10 10
20 20
0 0
0 0
Spain Portugal Greece Ireland
Spain Greece Ireland Portugal
Change in gross debt 2007-2010
Change in gross debt 2007-2012f 2009 2010 (Actual) 2010 target (from 2011 budget)
2010 gross debt
Source: European Commission Source: National Ministries of Finance
24
25. …but official assumptions for growth are too optimistic
Government medium -term GDP forecasts
Real GDP Forecast horizon
growth
US 3.4 2013 -2016
UK 2.9 2013 -2015
Germany 1.6 2013 -2016
France 2.5 2013 -2014
Spain 2.5 2013 -2015
Italy 1.5 2013 -2014
Portugal 2.0 2013 -2016
Ireland 3.0 2013 -2015
Greece 2.1 2013 -2014
Source: National Ministry of Finance
25
26. Spain’s growth has been largely a net trade story...
% pt Contribution to GDP % qtr
s
1.8 0.4
1.2 0.3
0.2
0.6
0.1
0.0
0.0
-0.6 -0.1
-1.2 -0.2
Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11
Consp Gov t GFCF net trade GDP (RHS)
Source: Thomson Reuters Datastream, HSBC
26
27. …and Spanish exports are higher than they were at the 2007 peak
Ex ports of goods 2008=100
110 110
100 100
90 90
80 80
70 70
08 09 10 11
Germany France Italy Spain
Source: Thomson Reuters Datastream, HSBC
27
28. But Spain is facing an industrial recession as the global trade cycle has
turned
Index % Yr Index Index
60 10 60 60
50 0 50 50
40 -10 40 40
30 -20 30 30
20 20
20 -30
Jan-08 Jan-09 Jan-10 Jan-11
Jan-08 Jan-09 Jan-10 Jan-11
Manufacturing output PMI
Manuf output PMI Industrial production Serv ices business activ ity PMI
Source: Thomson Reuters Datastream, Markit
28
29. High unemployment and debt de-leverage imply slow consumption
spending
% Unemploy ment rate % % GDP Priv ate sector indebtedness % GDP
24 24 230 230
20 20
16 16 220 220
12 12
210 210
8 8
4 4
200 200
00 01 02 03 04 05 06 07 08 09 10 11
08 09 10 11
Germany Eurozone
Spain UK Spain Portugal
Source: Thomson Reuters Datastream, Eurostat Source: Bank of Spain and Bank of Portugal
29
30. Regional government finances remain worrisome
% GDP Autnomous regions % GDP %GDP Gov ernment deficit %GDP
1 1 0 0
0 0
-2 -2
-1 -1
-2 -2 -4 -4
-3 -3
-4 -4 -6 -6
2007 2008 2009 2010 2011 Autonomous regions Central gov ernment
Year-beginning target Actual 2011 target 2011 H1 actual
Source: Spanish Treasury
30
31. Some progress on structural change...
Ind e x
Product Market Regulation
Ind e x % %
Persons w ith Tertiary education attainment (%)
3.5 3.5
35 35
3.0 Higher 3.0
2.5 2.5
25 25
2.0 2.0
Lower
1.5 1.5
15 15
1.0 1.0
0.5 0.5
5 5
0.0 0.0
IE
DE
IT
FI
CH
UK
ES
RO
EMU
FR
GR
PT
JP
IE
US
EMU*
DE
ES
UK
GR
CN
BR
FR
PT
IT
2000 2009
Note: This indicator measures the degree to which polices promote or inhibit Note: For EMU, the value is 2008, Population aged 15-64 yrs
competition in areas of the product market where competition is viable. The indicator
covers formal regulation in: state control of business enterprises, legal and Source: Eurostat and HSBC
administrative barriers to entrepreneurship and barriers to international trade and
investment. It is a broad based reflection of state control, barriers to entrepreneurship
and barriers to trade and investment. It is not just for manufactured products.
*EMU here is weighted average of EU-13 countries
Source: OECD, HSBC.
31
32. ...but more still needs to be done
Index Strictness of Employment Protection Legislation Index
4 4
Higher
3 Lower 3
2 2
1 1
0 0
DE
ES
JP
UK
US
IE
FR
GR
IN
CN
EMU
BR
RU
PT
IT
2000 2008
Note: Employment Protection are synthetic indicators of strictness of regulation on dismissals and the use of temporary contracts. The higher the index value the higher the strictness of
employment protection legislation.EMU here is weighted average of EU-13 countries, Data not available for BR, CN, IN, RU for 2000
Source: OECD, HSBC.
Ranking Ease of doing Business Ranking 2010 Ranking
160 160
135
Harder 124
120 97 99 120
76 78
80 Easier 80
48
28 33
40 19 21 24 40
4 5 8
0 0
EG
JP
ES
UK
US
DE
IE
CH
FR
PT
CN
GR
BR
IN
IT
Country Rankings
Note: In total, 183 countries have been ranked globally. The index is survey-based. Especially significant to small to medium sized businesses.
Source: World Bank’s Ease of doing business index 2010, HSBC.
32
34. Private sector indebtedness is not high in core Eurozone
Private sector indebtedness ratio
% of GDP % of GDP
200 200
150 150
100 100
50 50
0 0
Germany France UK US
08Q2 11Q1
Sources: Banque de France, HSBC
34
45. Research
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45
46. Disclosure appendix
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The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or
issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or
indirectly related to the specific recommendation(s) or views contained in this research report: Janet Henry
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46