Is contagion risk overdone? Yes and No
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Is contagion risk overdone? Yes and No
Budget 2010 - a balancing act like no other
By Bevan Graham, Chief Economist AXA Global Investors
The EU/IMF Greece debt rescue package came not a moment too soon
Political dithering meant bond markets were starting to dictate the course of events, which is not healthy. Political realism saw through in the end. In our view, recent fiscal contagion has been more a political than an economic phenomenon. There are, however, still significant fiscal risks.
The Greece package is an appropriate mix of support with conditional austerity. This is only right and proper. Initial German reluctance to support the package reflected the fact that Greece had to play their part and, in short, it had to hurt. Otherwise others in a similar position may find EU/IMF support preferable to making (politically) hard fiscal decisions. The German parliament has now endorsed the package.
The Greek austerity plan is indeed austere. Cuts to public sector wages, pension reform and increases in taxes will all hurt. The plan is to have the Greek budget deficit under 3% of GDP by 2014. It was 13.6% of GDP last year (and still rising due to revisions to historical data).
“Contagion risks” are the order of the day. Concern has centred mostly on Portugal and Spain. Greece is a somewhat special case however. The global financial crisis was, as we have discussed before, a private sector crisis stemming from years of over-consumption and increased household indebtedness.
The Greek story is somewhat different: profligate spending was centred in the public sector. The graph below represents the GFC-starting position for household and central Government debt for Greece, Portugal, Spain and Ireland (the first country where fiscal risks were raised, but managed in a more orderly fashion). The US and UK provide a salutary reminder that fiscal risks are not quarantined to EU countries.
Pre-crisis, household debt in Greece was a relatively low 31% of GDP, yet public debt was already over 100% of GDP in 2008 and stood at 115% of GDP in 2009.
In most countries the GFC was centred in the private sector and has only more recently become a public sector issue as Governments have bailed out private sector institutions. In those countries the adjustment process is happening in households as well as the government sector. In Greece most of the adjustment process has to happen in the public sector, and the blame for that is being sheeted home to the Government. Public sector adjustment ultimately hits taxpayers and public sector workers. Rioting in the streets in Athens is perhaps understandable.
Greece is by no means out of the woods. Central government debt is now projected to hit 150% of GDP by 2014. Some form of debt restructuring in the future cannot be ruled out. But at least that can now happen in the fullness of time and in an orderly fashion.
Many developed markets are not yet completely out of the woods yet either. Budget deficits in many developed countries are structural (refer graph over the page) and public debt is rising sharply. The structural nature of the deficits means Governments cannot simply rely on economic growth to close the fiscal gap, at least not in the short-term.
Recent fiscal contagion has arisen out of political failure. In our view, further fiscal contagion will ultimately come back to individual governments articulating and swiftly implementing pathways back to fiscal sustainability. This goes beyond just a Greece/Portugal/Spain issue to every country with large structural deficits, including the UK and the US. Only by getting these deficits under control, and ultimately public debt trending down, can contagion be truly contained.
There are a number of broader question that fall out of recent events in Europe. For instance what it means to be a member of the European Union, and whether fiscal rules and accompanying checks and balances are strong enough. These questions will have to be addressed in the fullness of time.
Recent events vindicate our long-held concern about the extreme difficulty (both economic and political) that many countries will face in getting their fiscal houses in order, and our decision in March to increase our underweight to global bonds in the multi-sector portfolios.
By Bevan Graham, Chief Economist AXA Global Investors
The Global Financial Crisis (GFC) was fundamentally a private sector crisis. After the public sector had to bail out the private sector, many governments are struggling with the harsh realities of the post-GFC world: sharply higher budget deficits and public debt. For most, implementing some measure of fiscal austerity is the only pathway back to even a semblance of fiscal sustainability.
There is also growing realisation that big budget deficits in many countries are now structural in nature. This means simply relying on economic growth will not be enough, at least in the short-term.
This is the sobering global context for New Zealand’s Budget 2010 which is delivered this Thursday. We will be analysing the Budget from the perspective of a fund manager who takes a strategic view.
Our primary interest is the relative long-term health of the New Zealand economy compared to other economies we could be investing in.
In our Australasian share fund we currently have an overweight position to Australia, balanced by an underweight to New Zealand. That mix is based on our forecast that, over the next five years, Australian economic growth and corporate earnings will out-pace New Zealand.
That said, our economy is in relatively robust fiscal shape compared to many other countries. In Europe, for example, there is an increasing risk of sovereign default. New Zealand’s relatively stronger economic health is largely due to our fiscal reforms of the early 1990s. Those reforms, while difficult at the time, helped get the country’s fiscal house in order. This is why we have been better able to weather subsequent shocks, including global financial crises.
Last year, we forgave the newly elected National-led Government for a lack of vision in Budget 2009. Whatever plans they had were effectively derailed by the GFC and the imperative to demonstrate that the fiscal situation, as bad as it was, was not unmanageable.
This year, the challenges are different but no less important. All around the world, countries are struggling to come to terms with the twin post-GFC realities: expenditure has gone up as Governments try to support economic growth and maintain programs and entitlements, while at the same time revenue has dropped because the recession has bitten deep into the tax take. As a direct result, fiscal balances have deteriorated and public debt is now much higher.
The good news is that the global economic recovery has (finally) arrived though it is still fragile. While economic conditions are also improving here, it is generally accepted that the nascent recovery needs to be quite different from the past. This recovery has to be export-led, rather than consumption-driven.
For us, Budget 2010 must support the essential structural changes required within the economy. In this regard, the early signals are promising. Income tax cuts are back on the agenda but, in this post-GFC world, they need to be funded by other revenues, such as an increase in GST. It is positive to see moves away from taxes on income in favour of consumption tax (with appropriate compensation for those on low or fixed incomes).
This Budget will also be the first opportunity for the Government to formally respond to the recommendations of the Tax Working Group, by either adopting them or not. We liked many of their recommendations, with most in line with the concept of a low-rate broad-base tax system. Any changes that encourage investment decisions to be made on the basis of return, rather than their tax treatment, is positive.
The Government has promised to continue its focus on the quality of public spending. This sentiment should be applauded although the actual implementation will be judged by results. Each spending decision will need to be assessed on its merits which will require delicate political judgement.
We will also be looking for an understanding and appreciation of the longer-term fiscal trade-offs. Prior to the GFC, many developed economies, including New Zealand, were already facing significant long-term fiscal challenges. This was largely due to aging populations and the subsequent impact on pension entitlements and healthcare costs. Before the GFC we may have had some time to deal with the long-term issues. Today, that timeframe has shortened up considerably.
How the numbers looked in the December 2009 Half Year Fiscal Update
The underlying issue involves deciding the best balance between providing a range of programmes and entitlements (including retirement incomes at age 65) and other spending areas, such as more growth-enhancing infrastructure or greater support for the innovation system. This is the balancing act required in the Budget.
This year, many Governments will be judged on the credibility of their plans to restore fiscal sustainability. We are also looking for Budget 2010 to enhance New Zealand’s medium-term growth prospects. Only in that way can we go to our Australian colleagues and proudly declare an overweight to New Zealand equities.
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