Bracing for Balance Sheet Repair Mode - Presentation: Christian Menegatti, Roubini Global Economics - Elite Summit

Christian Menegatti, Global Head of Economic Research

May 2012

© Roubini Global Economics Copyright 2012
No reproducing or redistribution without written consent. Roubini Global Economics
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Contents
• 2012 Global Themes and Outlook

• EZ: Lurching From Crisis to Crisis Before Getting There

• US: Better But Not Cigar

• China: An Unsustainable Broken Growth Model

• Conclusions
roubini.com | americas@roubini.com Tel: 212.645.0010 | europe@roubini.com / asia@roubini.com Tel: +44 (0) 207 420 2800 2

Global Themes
Balance-sheet repair in DMs is the theme of the day… or the decade…

EZ balance of payment and growth crisis will continue as long as the adjustment remains asymmetric, there is no credible plan to
arrest the current run on banks and to recapitalize banks, and there are no concrete moves towards deeper political and fiscal
integration

EM are slowing from an almost V-shaped recovery. EMEA is most exposed to Europe due to trade links and weaker balance
sheets, but weaker demand, financing pressures will also hit Asia and LatAm, which are also exposed to the Chinese slowdown.

Political gridlock and could delay policy action and result into policy mistakes, including in the U.S. (fiscal cliff) and China, which
face election and political transitions, respectively.

An oil price shock would stall global growth and raise the risk of recession. Geopolitical risks will keep oil prices elevated,
weighing on consumption.


Global Growth Forecasts
Growth Inflation
2012 2013 2012 2013
U.S. 2.0 1.8 2.3 2.0
EZ -0.6 0.0 2.0 1.7
Japan 1.8 1.7 0.1 -0.2
China 8.1 7.8 3.3 3.8
G7 1.4 1.3 2.0 1.7
Advanced Economies 1.1 1.2 2.0 1.7
Emerging and Frontier Markets 5.5 5.7 5.3 5.2
Asia/Pacific 5.8 5.9 3.4 3.4
Emerging Asia 6.7 6.8 4.1 4.1
Latin America 3.9 4.0 8.7 8.1
Emerging Europe 3.0 3.2 5.9 6.4
Middle East and Africa 3.1 3.4 5.9 6.8
BRIC 6.8 6.9 4.5 4.9
World 3.3 3.4 3.6 3.5


Debt Supercycles

Source: Bridgewater Associates


Debt Supercycles



Debt Supercycles
Debt %GDP (Households and Business on right, Federal gov on left)
105% 80%

100% 70%

95%
60%

90%
50%

85%
40%
80%

30%
75%

20%
70%

65% 10%

60% 0%
1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011
Household Business Federal gov


Debt Levels in DMs Are Still High
1400

1200

1000

%GDP 800

600

400

200

0

Non-financial Corporate Financial Government Household


Balance Sheet Repair

• EZ: sovereign and financial, will be ongoing for a long time and the ECB might be
the only game in town for a while

• U.S.: mainly in the household sector, eventually in the fiscal sector…watch the
fiscal cliff in 2013

• China: broken growth model, insolvent local governments and a forthcoming
NPL problem for the banking sector

A Far From Optimal Currency Area
Requirements for an optimal currency area: EZ grade
Pass Fail

Monetary unions have to be associated with a full political union given
the need for political legitimacy for monetary policies oriented towards
price stability, and disciplined fiscal policy

There has to be a high degree of business cycle synchronization;
local/national specific shocks to output or growth need to be limited

There has to be a high degree of capital mobility

There has to be a high degree of labor market flexibility – both in terms
of real wages and labor mobility – to deal with real asymmetric shocks

There is the need for risk/burden sharing mechanism, also via the fiscal
sector


Europe Is Just Returning To Normal
25
Normal
Government Bond Yield

20

15

10 Abnormal
5

0
1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Italy Spain Portugal Ireland France Germany Source: IMF

Europe’s longer history is continual war with outbreaks of peace. The EU (not the EZ) is a strong safeguard against a
return to that “normal”. But the EU was difficult to sustain without a stable/fix exchange rate regime.
Government bonds go through cycles of default, devaluation, and inflation. Not being paid for these risks from 1999
– 2008 was abnormal.
Higher yields reflecting restructuring and currency risk premia are the New Normal, same as the Old Old Normal.

A Remarkable -- Though Temporary -- Recovery in European Bank Debt
Issuance in Jan, Feb and Mar
Gross issuance by region/country of parent issuer (private banks only) - USD billion on left, EUR billion on right

Debt overall has bounced back but it is really a story about Germany and the core (and Switzerland) being more able to finance themselves and the periphery
and France still struggling.


But Watch the Run
Net issuance (USD billions, this is gross issuance less redemptions)


It’s the Political Economy…
If Greece ends the reform process it has undertaken, then I can’t see that the
respective tranches [of aid] can be paid out.
– Guido Westerwelle

If Greece does not decide to stay in the eurozone we can’t force them to stay
in it.
– Wolfgang Schäuble

If I had political responsibility, I would want to prepare myself for a plan B in
which the eurozone is no longer necessarily composed of 17 members.
– Peer Steinbrück


Greece: In Free Fall
• Syriza most likely to win in the June elections given momentum
• Syriza will try to play hardball to get concessions on the MoU. Someone will have to
blink…
• A renegotiation of the Memorandum would set a precedent that the Troika might
not be willing to accept
• A marginal renegotiation won’t make a difference as Greece is in free fall, and will
damage Syriza’s popularity…political risk and instability continues
• …Greece exits in an amicable divorce fashion

Better an end with horror, than a horror without end.
– Sophie Scholl


The Pain in Spain
Primary Balance Gap


The Pain in Spain
Resource Gap Analysis, Debt Stabilization at 2011 Levels


What’s Needed (Beside Official Money)
1. More realistic fiscal consolidation pace for the periphery
2. Room for additional monetary easing by and independent ECB
3. A gradual weakening of the Euro
4. Recapitalize banks early and properly
5. Slower pace of fiscal consolidation, German policies to boost domestic spending
6. Financing infrastructure spending for the EZ periphery
7. Continue structural reform

8. Fiscal union and debt mutualization process as economic and political union deepens
9. A plan for an orderly divorce of EZ members who cannot grow without exiting the EZ


What’s Ahead for the EZ
• (More) Defaults and exits of insolvent countries – GR and PT

• Structural reforms and ambitious fiscal targets (austerity) in Italy and Spain that imply
sharp contractions and worsening of debt ratios

• Continued balance of payment crisis

• Risks of loss of market access for Italy and Spain

• Risk of restructurings in Italy and Spain

• Political/Fiscal union? Debt mutualization? EZ wide banking supervision, regulation,
deposit insurance? Reduction in the power of national sovereigns?


U.S. Macro: Better, But Not Done/Started Deleveraging

• After ending the year with a 3% real GDP growth rate in Q4, the United States is shining
in terms of macro performance, at least with respect to the EZ.
• Better economic data in the U.S. have contributed to a significant improvement in
sentiment throughout Q4 2011 and the beginning of 2012.
• Labor markets have ended 2011 and started 2012 on a very encouraging footing, which
could eventually lead to stronger labor income growth and put the economy on a positive
feedback loop.
• There might be a significant fiscal policy drag ahead and a Fed that might act too late: ie
policy mistakes


Slack in Labor Markets
1.02

1.01
Employment Peak Payrolls = 1

1

0.99

0.98

0.97

0.96

0.95

0.94

0.93
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50
Months Since Employment Peak

2007 2001 1990 1980-81 1974


Housing Matters…
25% 6%

20%
4%
15%

10%
2%
5%

0% 0%

-5%
-2%
-10%

-15%
-4%
-20%

-25% -6%
Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09

Growth in US Household Net Worth, Y/Y (Lhs) Growth in US Real GDP, Y/Y (Rhs)


Central Banks Coming to the Rescue

BOJ Balance Sheet Expansion Fed Balance Sheet Expansion
35000 2400000

30000 2200000
2000000
25000
1800000
20000 1600000
15000 1400000
1200000
10000
1000000
5000
800000
0 600000


10
12

-4
-2
0
2
4
6
8
1/1/1990
1/1/1991
1/1/1992
1/1/1993
1/1/1994
1/1/1995
1/1/1996
1/1/1997
1/1/1998
1/1/1999
1/1/2000
1/1/2001
1/1/2002
1/1/2003
1/1/2004
1/1/2005
Japan Fiscal Balance (% of GDP inverted)

1/1/2006
1/1/2007
1/1/2008
1/1/2009
1/1/2010
-4
-2
0
2
4
6
8
10
12

1/1/1999

1/1/2000

1/1/2001

1/1/2002
Signs of a Very Long Deleveraging Ahead?

1/1/2003

1/1/2004

1/1/2005

1/1/2006

1/1/2007
US Fiscal Balance (% of GDP inverted)

1/1/2008

1/1/2009

1/1/2010
29

Central Banks Coming to the Rescue (sort of…)
US Japan



Central Banks Coming to the Rescue
US Japan



Getting a Handle on the Problem
• China’s surge in investment from 2008 coincided with a decline in its marginal product of
capital and a massive increase in its debt-to-GDP ratio.

• Its marginal product of capital fell from an average of 1.0 in the first seven years of the
decade to 0.75 from 2008 through 2010.

• After accounting for off-balance sheet and shadow bank lending, we estimate that China’s
outstanding domestic debt increased from 164% of GDP in 2008 to 210% in 2010.


Getting a Handle on the Problem
• Switch from export-led to investment led growth model

• Reinvesting 50% of income persistently in a productive way is mission impossible

• Mismatch between return horizon from infrastructure investment and maturity profile of
liabilities (bullet loans)

• NPL problem waiting to surface in the 2014-2016 period

• Financial repression and bailouts can kick the can down the road further, but rebalancing
might be more costly later… you can turn off the investment led engine quite fast, but you
cannot turn on the domestic demand and open the capital account as fast…


Precedents Suggest Chinese Slowdown
• Where I/GDP has peaked, growth has slowed
• China is near this structural turning point
Growth • Current account surplus and financial repression
Country Peak Year Before Growth After
will prevent liquidity crisis but not domestic banking
Hong Kong 1997 4.9 1.3
problems
Indonesia 1996 7.1 0.4

Malaysia 1995 9.3 5.0

Thailand 1995 9.0 0.6

South Korea 1991 9.7 7.3

Japan 1990 5.1 1.5

Singapore 1984 8.7 5.8

Philippines 1983 4.6 0.0

Source: National Statistics, Gapminder, RGE.
Note: average growth rates 5 years before/after

Conclusions
Deleveraging cycles need to be managed and offset by policy
The path of growth is policy dependent as balance sheet repair continues and the private
sector comes back
Balance sheet repair implies a rebalancing in the global economy that will see growth rates
much slower than the boom years
Understanding rebalancing dynamics is key – not every country is in deleveraging mode: need
for a holistic approach
Understanding policy and political risk is key: potential high impact on productivity
Understanding demographics is key


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Bracing for Balance Sheet Repair Mode - Presentation: Christian Menegatti, Roubini Global Economics - Elite Summit

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Bracing for Balance Sheet Repair Mode - Presentation: Christian Menegatti, Roubini Global Economics - Elite Summit