The underlying problem that has spawned Europe’s sovereign debt and economic crisis is too much debt and too little economic growth. The end game for Greece came when its cost of borrowing rose to unsustainable levels, freezing Greece out of the capital markets, and into the arms of the European Union. The terms demanded that Greece lower its budget deficit to 3% of GDP by implementing severe austerity measures that have only deepened its recession and made it more difficult to shrink its deficit.
In recent months, Italy and especially Spain experienced an increase in their borrowing costs that looked like both were headed down the same path as Greece. To contain and reverse yields in Spain and Italy, the ECB announced its Outright Monetary Transaction (OMT) program. After receiving a request for assistance from a country, the ECB will buy unlimited quantities of that country’s bonds with maturities of less than three years. In return, the requesting country must agree to economic reforms that will surely limit some of its independence and control over its finances. And there, of course, is the rub for a country like Spain.
The unemployment rate in Spain is 25.1%, the economy is in recession, real estate values continue to fall and bad loans keep climbing. In July, the Bank of Spain reported that bad loans at Spanish banks rose to 9.8% of total assets. In June, Spain experienced a net capital outflow of more than $70 billion, according to the latest data available. This has caused the loan-to-core deposit ratio to soar to over 180% in July, forcing Spain’s banks to borrow $525 billion from the ECB.
In October, Spain needs to refinance more than $30 billion, and, without a backstop from the ECB, it could prove challenging to float that much paper without causing yields to spike. Spain has already pruned its budget in order to meet its budget deficit target of 3% in 2014. Last year’s deficit was 9.0% (barely higher than the United States’ 8.7% deficit), and a contracting economy will only make it harder to reach. Having already cut spending, Prime Minister Mariano Rajoy is reluctant to ask for the ECB’s help, since it will open the door for more cutbacks. That won’t bolster his political popularity, which is already falling. We don’t think he has any choice.
Europe is in recession and the ECB’s OMT program will not pull Europe out of it since it does little to spur growth. As we have noted previously, Italy’s average annual growth over the last 11 years is barely positive. Lowering yields in Spain and Italy will help postpone an immediate escalation of the crisis, but there are more chapters in this book.
The last chapter will likely be whether Germany chooses to backstop the rest of the European Union. A recent poll showed that 65% of Germans think Germany would be better off without the common currency, and 49% think Germany would be better off outside the European Union. However, if Germany was on its own, its currency would soar, significantly hurting its exports. As we noted in last month’s commentary, Germany’s Ifo Business Climate Index has fallen to levels that has preceded a contraction in German GDP.
As Europe’s recession gradually engulfs Germany, we’d wager the percent of Germans wanting out of the EU will increase.
China and the Potential for a Rise in Protectionism
Global growth has been slowing as we suggested at the beginning of this year. Monetary policymakers are concerned, which is why the ECB is launching OMT, the Fed is cranking up QE3, and the Bank of Japan has expanded its asset purchasing plans. These new programs would not be needed, if prior efforts had succeeded in establishing self-sustaining recoveries. Over the next 12 months, there exists a high probability that U.S. growth will remain under 2%, Europe will continue to flounder and growth in China may slip further. This is not a pretty picture, and could provide a fertile environment for protectionism, as politicians play on public sentiment and enact laws to protect jobs and garner votes.
This anti-trade movement is in sharp contrast to the last 40 years, when the combined total of imports and exports rose from 5% to almost 20% of global GDP at the end of 2011. This trend was built on the back of globalization and willingness from countries to open their borders and enter into trade agreements, fostering an expansion of trade throughout the world. Over the last 20 years at least one billion people have experienced an increase in their standard of living, lifted by global trade.
This remarkable record does not mean there aren’t a plethora of trade restrictions still in place. The U.S. has import restrictions to protect the sugar industry, so American consumers pay twice the world price for sugar, just to protect sugar industry jobs. The U.S. is not alone in this regard. We could cite every major country for using import or export restrictions or tariffs to protect a domestic industry. However, during difficult periods of slowing global growth, the temptation to use trade barriers has usually proved irresistible. As the Depression began to take hold in 1930, the United States passed the Smoot-Hawley Tariff Act in June 1930 to protect American jobs. This incensed other countries who responded with their own trade protections. Within 18 months of the passage of the Smoot-Hawley Tariff Act, world trade fell 40% and American imports and exports plunged by more than 50%, deepening the Depression.
Since China has arguably been the main beneficiary from trade growth over the past decade, and is the world’s largest exporter, we expect China to be the target of trade disputes in the next two years. We expect China to respond aggressively, which will escalate trade frictions, and lead to more “Buy American” and “Buy European” campaigns.
There is an old Chinese curse that seems appropriate for the situation: “May you live in interesting times.”
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