Economic fundamentals and Eurozone sovereign spreads: will the good news continue?

Spreads between government bond yields in the Eurozone periphery and Germany have fallen to the lowest levels in 3 to 4 years. There are two major factors behind this. The first is the speech by ECB President Mario Draghi on 26 July 2012 promising ‘to do – within its mandate – whatever it takes’ and the ECB's Outright Monetary Transactions initiative of summer 2012. This has been successful in eliminating fears of an imminent Eurozone break‐up. The second factor is the improvement in economic fundamentals in the periphery countries, particularly in Ireland, Spain and Greece. Previous econometric work on the role of economic fundamentals at the country level has focused almost entirely on government debt and government deficit to GDP ratios. The true fundamentals have been obscured by market panics and by the fact that markets really only took full account of these fundamentals from the end of 2010. Before the middle of 2007, markets ignored the build‐up of stresses between Eurozone countries. Once amplification of perceived risks by market panics and the shift from inattention to full market attention are taken into account, a far more nuanced picture emerges of what country fundamentals really matter for sovereign spreads. In addition to excessive government debt, deteriorating competitiveness, excessive private debt, and housing market crises spilling into banking systems, have been especially prominent in the countries at the periphery. In Ireland and Spain, declining relative unit labour costs and the fading of the housing crisis have recently been important in narrowing spreads against Germany. The econometric model also suggests that good news on relative growth and inflation help narrow spreads. Prospects for further narrowing of spreads for Greece and especially for Spain look good. Once the current bout of falling spreads is over, the underlying picture suggested by the estimated model is less good for Ireland, Italy and Portugal and for the euro area core economy, France. In all four cases, the government debt to GDP ratio has been deteriorating, and for France and Italy, competitiveness has not improved significantly. For France, another factor is the rising level of the private debt to GDP ratio. For Ireland, scope is limited for the effect on the spread of further improvements in competitiveness and housing market recovery.     

Eurozone

All the signs are that Q2 will see Eurozone GDP growth exceed Q1's well above‐trend rise of 0.6%. In addition to the business surveys continuing to rise, quarterly industrial production and retail sales growth also probably accelerated in Q2, closing the previous gap between the surveys and hard data. This points to a robust rise in GDP of 0.7% to 0.8% in Q2     

The role of fiscal policies for external imbalances: Evidence from the European Union

We revisit the relation between budget deficits and current account deficits for 28 European Union countries from 1996 to 2019. We find that an increase in budget deficit of 1 pp of GDP results in a deterioration of the current account deficit of 0.318 pp of GDP, which supports the Twin Deficits Hypothesis. On the other hand, dynamic panel estimates partially corroborate the Ricardian Equivalence Hypothesis in the presence of a fiscal rules index. In addition: i) the relation between the two deficits is asymmetric and the negative impact of the recent Eurozone banking and sovereign debt crisis on the current account balance is observed; ii) with right-wing governments, the impact of the budget balance on the current account balance is mitigated; if the government is on the left, the impact of the budget balance on the current account balance is amplified; iii) after 2010, the budget balance positively affects the current account balance; and iv) the positive impact of the budget balance on the current account balance is higher in the cases of non-Eurozone countries, high budget deficit countries, and low exports countries, whereas it is lower in the cases of Eurozone countries, low budget deficit countries, and high exports countries.     

Europe

The Eurozone economy may have lost some momentum in the course of Q2, based on business surveys for the period. Admittedly, the falls in the composite PMI in May and June were pretty small and on past form the PMIs still point to slightly stronger quarterly GDP growth than the 0.2% recorded in Q1. But given the sharp falls in German, French, Italian and Spanish industrial production in May and subdued Eurozone retail sales figures for the first two months of the quarter we suspect that Eurozone GDP growth is unlikely to have picked up in Q2…     

The great rotation in global credit risks

• ? The pattern of global credit risks looks very different today than in 2007. Risks are now mostly centred in China and emerging markets. “Excess” private debt in China is as high as $3 trillion compared with $1.7 trillion in the US a decade ago. Yet some pockets of significant risk still exist in advanced economies, which not only implies vulnerability to rising interest rates, but also that the scope for rate rises may be limited.
• ? With policy normalisation underway in the US and the scaling back of asset purchases expected to start soon in the Eurozone, we focus on assessing vulnerabilities across global credit markets. This article explores the topic using a top‐down, cross‐country approach. We find that although private debt and debt service ratios look more benign in advanced economies than a decade ago, they have deteriorated markedly in many emerging markets in recent years.
• ? Based on a measure of excess private debt – comparing private credit‐to‐GDP ratios with their trend – China, Hong Kong and Canada are the riskiest. When comparing debt service ratios relative to their long‐term averages, risks are also mainly concentrated in emerging countries. But Canada, Australia and some smaller European countries also have high debt service ratios that have failed to drop since 2007, despite the slump in global interest rates.
• ? Overall, aggregate private debt indicators look less worrying than in 2007. We would also argue that the concentration of excess private debt levels in China reduces the risk of a sudden financial crisis based on massive credit losses, such as the one in 2007–2010. But with corporate debt levels in the US, Canada and some other G7 countries above their long‐term trend, investors need to be attentive to these considerable pockets of risk.

     

The UK and the Eurozone: Sovereign Debt Management and Monetary Policy

Events in the wake of the ‘credit crunch’ can be understood only against institutional structures within which interdependent monetary and fiscal policy are administered. In the Eurozone, the attempt to keep a central monetary authority (together with its associated national central banks) independent from 17 diverse fiscal authorities was flawed. When sovereign debt approaches unmanageable levels, the Maastricht Treaty presents austerity as the single option. In the UK, the electorate has an opportunity to choose between monetary financing (inflation) and fiscal consolidation (austerity). Policy choices within the Eurozone and the UK are set against Keynes's focus on unemployment and more recent concerns to retain (or restore) price and/or financial stability.     

Pushing the limit? Fiscal policy in the European Monetary Union

Governments are confronted with the growing realization that they face fiscal limits on the size of debt and deficits relative to GDP. These fiscal limits invalidate Bohn's criterion for fiscal sustainability, which allows explosive debt relative to GDP, eventually violating any fiscal limit. We derive restrictions on a fiscal rule, necessary for the government to eliminate explosive behavior. These restrictions require that the response of the primary surplus to debt be relatively strong, and that the primary surplus be cointegrated with both debt and output. We test these empirical implications for a panel of eleven EMU countries, and find that they are satisfied, implying that fiscal policy does not create explosive behavior.     

Fiscal retrenchments and the transmission mechanism of the sovereign risk channel for highly indebted countries

We formalize sovereign and private sector default probabilities into a monetary model in order to test the hypothesis, which recently appeared in the literature, of whether the consideration of a sovereign risk channel affects the sign and size of output fiscal multipliers. The model is estimated for the most vulnerable Eurozone countries-characterized by high debt-to-GDP ratio-and stochastically simulated conditional on expenditure and revenue policy measures. We show that, conditional on specific fiscal shocks, the risk channel can operate in a pro-cyclical direction, amplifying the temporary contractionary effects of fiscal retrenchments. We show that both the relations between economic fundamentals and sovereign debt spreads and that between sovereign and credit spreads are weak. Therefore, the effectiveness of the risk channel for fiscal consolidations is small, irrespective of the direction of change in the sovereign default probability.     

Why big fiscal deficits and low inflation can coexist

• ▀ The surge in government debt caused by ballooning fiscal deficits is a necessary response to the coronavirus crisis. But we doubt this will lead to a burst of inflation in the advanced economies (AEs), let alone a debt crisis.
• ▀ Our fiscal forecasts assume AEs’ budget deficits averaged 20% of GDP or so in Q2. However, our deficit forecasts point to a sharp narrowing thereafter and for public debt as a share of GDP to peak in 2021.
• ▀ The risks around this forecast skew firmly towards deficits remaining wide, reflecting the balance of risks around our GDP forecasts and the possibility that governments allow some fiscal slippage.
• ▀ A slower narrowing of fiscal deficits than we forecast wouldn't automatically lead to a period of above-target inflation. Indeed, we wouldn't be surprised if larger-than-expected deficits were associated with weak inflation.
• ▀ High levels of corporate debt and weak labour markets raise the risk of private sector retrenchment ahead. In that case, large and sustained fiscal deficits may be needed to fill the vacuum and prevent GDP and inflation from falling. As has been the case in Japan over the past 25 years, large deficits over coming years could be associated with weak GDP growth and below-target inflation.
• ▀ If economies begin to overheat but governments keep fiscal policy loose, inflation could, of course, pick up. But central bank tightening would offset it. We believe the risk of sustained inflation overshoots is limited unless monetary policy were made subservient to governments’ own objectives. And we think the risk of central banks losing independence remains slim.

     

ECB tapering: beware of global consequences

• ? The ECB's scaling back of its QE programme in 2018 could be more disruptive to global financial markets than the Federal Reserve's ongoing balance sheet unwinding. ECB bond purchases led Eurozone private investors to inject a massive amount of funds into global debt markets over the last few years. As the ECB reduces its stimulus, Eurozone investors will gradually pare back the build‐up of their foreign debt exposures. The full unwinding of ECB QE will see investors rebalance toward domestic debt securities .
• ? We expect Eurozone investors to continue injecting funds into global debt markets as the ECB proceeds to wind down its QE, but they will do so at a much slower pace. Based on our projections, European purchases of foreign debt securities this year will total €200 billion – down by half from the average €400 billion over the last three years. Such a large reduction raises the risk of disruption in some markets.
• ? How did we get here? Spillovers from the ECB's QE were much more pronounced than during Fed's. European private investors that sold bonds to the ECB during its QE programme faced a commensurate shortage of domestic debt assets. In contrast to the US experience, ECB buying far exceeded new domestic issuance, inducing private investors to sharply increase purchases of overseas debt securities.
• ? Ultimately, we expect European investors to seek to restore the share of domestic debt securities in their portfolios to a level in line with the historical norm, after the proportion of their domestic debt holdings fell by 7pp since the programme began. The rebalancing is likely to start in earnest once the ECB stops buying (and eventually starts selling) securities. As a result, the global debt issuance boom is likely to lose steam, given the extent to which it has relied on the support of European investors.

     

The determinants of austerity in the European Union 2010–16

This paper aims at decteting what drove the adoption of austerity policies over the period 2010–16 in a panel of 28 European countries. Austerity is identified by year increases in the ratio between the structural primary balance and potential GDP. By means of principal component factor analysis we select the aggregate factors that might affect austerity, namely (i) fiscal consolidation (correction of high deficits and debts), (ii) market discipline (high sovereign spreads, low ratings), (iii) rule-based fiscal discipline (compliance with the Eurozone rules), and macroeconomic stabilisation (consideration for the cyclical position of the economy). Then we estimate a dynamic panel model with the system-GMM method. Results show that the most important contributions to austerity are provided by the market discipline and fiscal consolidation factors together with Excessive Deficit Procedures, with no significant role played by concomitant macroeconomic conditions. Overall, governments complied with orthodox fiscal principles and rules.     

ARE THE CURRENT ACCOUNT IMBALANCES BETWEEN EMU COUNTRIES SUSTAINABLE? EVIDENCE FROM PARAMETRIC AND NON‐PARAMETRIC TESTS

Using parametric and non‐parametric estimation techniques, we analyze the sustainability of the recently growing current account imbalances in the euro area and test whether the European Monetary Union has aggravated these imbalances. Two alternative criteria for the assessment of external debt sustainability are considered: one based on the transversality condition of intertemporal optimization, and the other based on the stationarity properties of the stochastic process of the debt–GDP ratio. Econometric sustainability tests are performed using the pooled mean‐group estimator and panel unit root tests, respectively. Variants of both test procedures with varying coefficients using penalized splines estimation are applied. We find empirical evidence suggesting that the introduction of the euro is associated with a regime shift from sustainability to unsustainability of external debt accumulation for the euro area. Copyright © 2012 John Wiley & Sons, Ltd.     

Europe

While the latest Eurozone activity news has by no means been all positive, it has provided enough grounds to suggest that the solid pace of GDP growth recorded in the first half of the year was maintained in Q3. Our GDP indicator points to quarterly GDP growth of about 0.4% last quarter.     

Estimating a common deterministic time trend break in large panels with cross sectional dependence

This paper develops an estimation procedure for a common deterministic time trend break in large panels. The dependent variable in each equation consists of a deterministic trend and an error term. The deterministic trend is subject to a change in the intercept, slope or both, and the break date is common for all equations. The estimation method is simply minimizing the sum of squared residuals for all possible break dates. Both serial and cross sectional correlations are important factors that decide the rate of convergence and the limiting distribution of the break date estimate. The rate of convergence is faster when the errors are stationary than when they have a unit root. When there is no cross sectional dependence among the errors, the rate of convergence depends on the number of equations and thus is faster than the univariate case. When the errors have a common factor structure with factor loadings correlated with the intercept and slope change parameters, the rate of convergence does not depend on the number of equations and thus reduces to the univariate case. The limiting distribution of the break date estimate is also provided. Some Monte Carlo experiments are performed to assess the adequacy of the asymptotic results. A brief empirical example using the US GDP price index is offered.     

A re-examination of housing bubbles: Evidence from European countries

This study uses data from six Eurozone countries and the United Kingdom between 1980Q1 and 2018Q4 to examine whether these countries had housing bubbles during the observed period. Whereas typical studies make strictly limited assumptions regarding interest rates, we make an unconventional argument for the necessity of testing the integration relationship between the price–rent ratio and the interest rate reciprocal to determine the existence of housing bubbles. To verify this study’s proposition, two housing bubble indicators were adopted to dynamically examine periods of housing bubbles in European countries by using a series of individual countries and panel data from Eurozone countries. According to the empirical results for individual countries, although the price–rent ratio indicates the occurrence of housing booms in the targeted countries, the evidence for housing bubbles is unclear. The dynamic bubble indicator revealed that housing bubbles occurred in France and Ireland within a short period in 1993Q3 and 2000Q2, respectively. Spain experienced two short-term housing bubbles in 1990Q1 and 2015Q1. The short-term bubbles signify that the housing markets were efficient. Once the price–rent ratio failed to converge toward the nominal interest rate, market traders’ rational behavior can immediately correct the short-term market divergence. The panel data of the Eurozone countries also reveals that simply using the price–rent ratio for examination may underestimate the correction of the housing markets. In conclusion, the results of this study demonstrate the importance of the interest rate in controlling the housing market.     

Eurozone

The Eurozone economy probably reached its peak velocity in Q2, when GDP rose 0.6% q/q. The figures available for Q3 provide something of a diverging picture between soft and hard data. The composite PMI – which has been the best predictor for quarterly GDP growth – averaged 56.0 in Q3, only slightly below the 56.6 seen in Q2. And the EC's Economic Sentiment Indicator was actually stronger in Q3 after reaching a new multi‐year high in September. But some of the hard data suggest that growth may be softer than indicated by the strong surveys. In particular, retail sales have been surprisingly weak despite high consumer confidence and strong employment growth, although we suspect weatherrelated factors have been at play.     

Europe

After two quarters of 0.3% GDP growth, the signs are that the Eurozone recovery moved up a gear in Q4 last year, with the latest industrial and consumer data pointing to buoyant GDP growth in the period. Meanwhile, in December, the composite PMI climbed to a five and a half year high, a sign that the recovery strengthened as the quarter progressed. For now, we have pencilled in GDP growth of 0.5%, which would match the gain recorded in Q1 2016.     

Forecast Overview

The ONS has made substantial revisions to the historical national accounts data which have brought it closer to the story told by the labour market and business survey data. GDP is now estimated to have been 2.7% above the early‐2008 peak in Q2 2014, up from the previous estimate of just 0.2%; this means that the UK's performance was similar to that of the Eurozone, though it remains well short of the recovery enjoyed by the US. We have long argued that the recovery was stronger than the ONS had initially reported and in producing our forecasts we had allowed for the likelihood that the data would be revised up substantially. As such, these revisions have little impact on our forecasts for future periods and we expect GDP to grow by 3.1% in 2014 and 2.7% in 2015…     

Fixed versus floating: vulnerability to rising interest rates

• ? Looking at different economies' exposure to fixed‐ and floating‐rate private‐sector debt reveals how vulnerable they could be to rising interest rates. Our analysis finds that Hong Kong, Sweden, China and Australia are potentially most exposed via floating rates to rising debt service costs. A 150bp rise in rates would also push several other countries' debt service ratios above the peaks of 2008. Less vulnerable economies include the US and Germany.
• ? High levels of floating‐rate debt imply a large and rapid pass‐through of rising interest rates to firms and households, with negative consequences. Exposure to floating‐rate debt as a share of GDP varies greatly: the highest levels are in Hong Kong, China, Sweden, Australia and Spain, with the lowest levels in the US, France and Germany.
• ? Growing shares of fixed‐rate housing debt in the US, Eurozone and UK mean the impact of higher interest rates may be less severe than a decade ago. Private deleveraging in countries such as the US, UK and Spain could also soften the impact.
• ? A rise of 100bp in short‐term interest rates would raise the debt service ratio after one year by around 2.5% of GDP in Hong Kong, with increases of 1.5–1.7% of GDP in Sweden, China and Australia. The smallest effects would be in the US and Germany.
• ? A 100–150bp rate rise would push debt service ratios in China, Hong Kong, Canada, France and the Netherlands well above their peaks of a decade ago. A similar rate rise would take debt service ratios in Sweden, South Korea and Australia close to, or above, previous peaks.
• ? The distribution of debt within economies, which our analysis does not cover, is also important. For example, there is some evidence that the US corporate sector has a high concentration of debt among borrowers with weak finances. Countries that are highly vulnerable to interest rate rises may see their central banks normalise policy rates more slowly than they otherwise would.

     

Europe

The Eurozone's resilience was tested again with another episode of political turmoil in Italy and financial market tensions related to the US government shutdown. But the region withstood the shock with only brief and very limited movements in financial markets. This stability suggests that the economic recovery is well established, albeit slow. We forecast 0.1% quarter‐on‐quarter in Q3 and with only a small improvement in Q4, 2013 as a whole should see Eurozone GDP contract by 0.3%.…