FxPro Daily Forex Brief - Watching and waiting
Thursday, 16 February 2012 | 11:00
China’s politicised declaration that it would help Europe failed to have much sustained impact on market sentiment yesterday, with both traders and investors instead focused principally on the latest machinations in Greece (see below). Northern Europe has clearly lost confidence in Greek promises, while politicians in the latter calculate that the former will ultimately not be prepared to cut them loose. A Dow Jones story which surfaced late in the afternoon probably hit the nail on the head – Europe might offer Greece a bridging loan to enable it to repay bondholders on March 20th, and then reopen negotiations on the bailout after the Greek elections. However, there is also the possibility that Europe will decide that it is now its turn to have its own Lehman-like moment and let Greece go. This cannot be ruled out either, as reflected in recent comments from various German and Dutch politicians. This potential reality has hit the euro hard – overnight, it briefly fell below 1.30. Also affected were the bond yields of European fiscal miscreants, with both Spanish and Italian 10yr yields out by 20bp vs. comparable Bunds. Who will blink first?
Greece goes from bad to abominable. The Greek debt debacle increasingly looks like a game of Russian roulette between politicians and European leaders. Europe threatens no bailout without additional austerity, Greek politicians threaten default but sign off on austerity measures anyway and then signal their intent to renege almost immediately. And now Europe is contemplating delaying the second bailout package until after the next Greek general elections (while at the same time giving Greece enough money to avert a default in March). Meanwhile, Germany is still exploring the idea of placing any Greek bailout money into an escrow account (controlled by Europe), and northern Europe (Germany, the Netherlands and Finland) is, understandably, increasingly prepared to let Greece default altogether. Needless to say, it is very unlikely that Europe will sign off the second bailout any time soon, which raises the probability of at least a partial default come March 20th when Greece is due to repay a EUR 14.4bln bond that matures. Unsurprisingly, the euro has taken fright at this latest suggestion that the bailout might be months away. Leader of the New Democracy party Antonis Samaras has sent a letter to European leaders pledging his whole-hearted commitment to austerity, but unfortunately his remarks of earlier this week have shredded his credibility. No European leader can be blamed for harbouring serious doubts concerning his real commitment to the Stabilisation Program, especially if he is elected to power. Even if Europe did accept his assurances, such is the collapse of the Greek economy that another debt restructuring will probably be required before too long. Greece’s condition is terminal, and everyone knows it.
Asia’s increased resilience. Following developments in Asia focuses the mind on the extent to which this region can detach itself from what is going on in Europe. It has successfully de-coupled from problems elsewhere (in 2007-08), but does the water that has passed under the bridge since then make Asia more resilient or more vulnerable to the shockwaves from Europe? It’s a key question, especially with China again making noises about offering more solid assistance to the eurozone. As a reminder, it’s thanks to China and India that things have not been a whole lot worse over recent years. They alone accounted for more than half of global growth in 2008 and the majority in 2009. Since 2007, whilst developed market-growth has been almost flat, China has grown by 30% and India 35%. The reasons for this Asian resilience are numerous and come from both sides, in both the causes of the crisis (very much centered in the West), together with Asia’s turnaround from the late ‘90s crisis, into a region of savers and of greater intra-Asian dependence (intra-Asia trade growing far faster than trade with the West). The trade side of the picture is not a major threat to the growth picture in Asia, even if the eurozone enters a technical recession. China’s trade balance with the eurozone is around two-thirds of that of the US. For Japan, it’s one-third. Furthermore, the likely eurozone recession is going to be milder and less consumer-based than the US downturn of 2008-09. The real focus is the potential hit from the income account, i.e. overseas investors pulling out of Asia. History strongly suggests that more often than not this is the factor that is far more destabilising for emerging markets i.e. overseas investors disposing of assets over a relatively short space of time. Naturally, it is countries with current account deficits (making them reliant on overseas investors) that are more vulnerable, but the narrowing of the current account surpluses of both China and Japan cannot be ignored. In theory, this contraction could make them more vulnerable, given that a move into negative territory will change the dynamics of global trade patterns. But this is unlikely for both countries. Even though Japan is now running a trade deficit it continues to enjoy a far more stable position on the income account, the result of being the world’s largest holder of net external assets over the past 20 years. Overseas assets (especially Japan’s favoured fixed income) posted excellent returns last year, but this may not last, especially in the fixed income space. From this perspective Japan looks more vulnerable to a switch into a current account deficit than China, but it’s only a mild risk. China’s surplus looks set to rise over the next year as its long-held wish to rebalance away from investment towards consumption bears minimal fruit. Overall, despite these short-term trends, Asia has little to worry about in terms of capital flows in the face of the eurozone crisis. But the other trend that offers comfort is the diverging fortunes of sovereign debt between much of the West and Asia (Japan aside). The IMF sees the G7 debt/GDP ratio rising for each of the next five years. The same measure is seen falling by half (from 40% to near 20%) for developing Asian markets. Certainly the numbers may exaggerate this e.g. given the expansion of local debt in China but, even allowing for this, the divergent trends remain. Asia’s resilience, which was so important supporting the global economy a few years ago, should remain even stronger this time around.
Obama’s highly politicised budget. In what can only be described as a highly politicised budget, President Obama has sent Congress a document which lifts taxes significantly for the rich while at the same time raises government spending. Should this budget be enacted (zero chance), then the well-off will suffer the most financial pain, including the expiration of Bush-era tax cuts for those earning more than USD 250K a year, a minimum tax for those earning more than USD 1m per year and huge increases in tax on dividends for the wealthy (from the current 15% to 39.6%). Unfortunately, once again, there is absolutely no attempt to address America’s bulging fiscal obesity. The deficit this year is forecast to reach USD 1.33trln, representing some 8.5% of GDP. It will be the fourth straight year that the deficit is above one trillion dollars. Public debt is forecast to climb to USD 18.7trln by 2021, or 77% of GDP. Unsurprisingly, Obama’s budget has been slated by fiscal conservatives who at the same time recognise that these measures are very unlikely to ever see the light of day. Firstly, they will never be passed before the November 6th Presidential election. In any event, there are other pressing fiscal questions such as what happens to the automatic spending cuts worth USD 1.2trln that were already supposed to be enacted, or the issue of raising the debt ceiling which caused such an incredible fracas last summer. In sharp contrast to many European countries, America remains in fiscal denial, much to the chagrin of international investors. However, America continues to get away with it, in part because it is still the world’s major fiat currency.
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