In view of the focus on the fiscal situation in DM, particularly in GIPS (Greece, Italy, Portugal, Spain), we have conducted an exercise on medium-term debt simulation in Central Europe. We want to emphasise upfront that these are mechanical simulations that should not in any way be interpreted as actual forecasts. Rather, they present plausible paths for the debt/GDP ratio under different scenarios. Our simulations are based on a traditional debt-sustainability framework. The ultimate path of government debt/GDP will depend on future nominal GDP growth, interest rate and fiscal outcomes. Note that a similar exercise done five years ago may have shown very different results.
We build three scenarios, based on subjective assumptions. In our base case, we assume unchanged policy in CE3, using the European Commission debt and primary balance forecasts for 2010 and 2011 as initial guidance. From 2012 onwards, we plug in our assumptions of ‘steady-state' real GDP growth, inflation, interest rates and primary balance. For the primary balance, we take the EC's measure of the CAPB (cyclically adjusted primary balance) for 2012 as a gauge of how the structural primary balance looks.
In order to smooth the profile, we also assume a three-year ‘transition' period from the 2011 primary balance to the cyclically-adjusted primary balance. The intuition is that we leave policy as it currently is and we give the cycle three years in order to return the primary balance to its steady state. Having done that, we see what happens to debt/GDP.
Under our baseline ‘no policy change' simulations, Hungary's debt/GDP is expected to fall from 81% currently, and stabilise at just under 80% of GDP. Of concern, debt/GDP for the Czech Republic and Poland are forecast to rise over the next five years and beyond, mainly because both countries are assumed to run a primary deficit over the analysis horizon, by virtue of the assumption stated above.
In order to maintain the government debt/GDP on a steady path beyond 2013, Poland needs to see its steady-state real GDP growth at 7.1% (model assumption: 3.5%) or steady-state primary deficit at 0.2% of GDP (model assumption: 3% deficit). For the Czech Republic, the steady-state real GDP growth needs to be raised to 9.2% (assumption: 2.8%), or the primary account needs to be balanced (assumption: -3.3%). These are by no means simple tasks, in our view.
We would highlight that, given our methodology, our base case is likely overly pessimistic on the Czech Republic and Poland (it assumes that policy does not get tightened) and overly optimistic on Hungary (our base case essentially assumes that the current tight fiscal stance holds ad infinitum). Of course, as stated above, assuming that fiscal policy is kept stable from 2011 onwards (‘tight' or ‘loose' at the 2011 level) may be a stretch, but this exercise is mechanic in nature.
Scenario Analysis on CE3
Our base case is probably too mechanistic. Therefore, in this section, we tweak our primary balance assumptions, and compare how our optimistic and pessimistic scenarios for CE3 compare with the base case.
We think it makes most sense to proceed on a country-by-country basis, rather than applying the same assumptions across all three countries. The reasoning is that Hungary has already tightened its belt a great deal over recent years, and now boasts one of the strongest structural (i.e., cyclically adjusted) positions in the whole of the EU. So, our ‘optimistic' scenario for Hungary broadly assumes that it maintains this discipline over the coming years.
For the Czech Republic and Poland, which have been far less proactive of the fiscal front, the optimistic scenario is that they actually take measures to correct the structural deficit. For all three countries, we use EU estimates to gauge the impact of age-related expenditure over the coming years, and assume that the impact takes place in a linear manner.
Czech Republic: As an optimistic scenario, we assume that the primary deficit improves by 0.5% of GDP every year, starting from 2012 (-3.1% of GDP versus -3.6% in 2011). This should bring the country to a primary surplus of 0.9% of GDP in 2020. In this case, debt/GDP increases from 41% in 2010 to around 55% in 2017, stabilising thereafter.
As our base case already assumes unchanged fiscal policy following the recent deterioration, we think that our pessimistic scenario should not deviate too far from the base case. For the pessimistic scenario, we assume that the primary deficit deteriorates by 0.1% of GDP per year, starting from 2012. Our model shows debt/GDP rising to 80% by 2020.
Poland: The assumptions used are similar to those for the Czech Republic. As an optimistic scenario, we assume that the primary deficit improves by 0.5% of GDP per year, starting from 2012 (-3.5% of GDP versus -4.0% in 2011). This should bring the country to a slightly positive primary balance in 2020 (which Poland last enjoyed in 2007, at the peak of the boom). In this case, debt/GDP increases from 54% in 2010 to around 68% in 2017, stabilising thereafter.
As our base case already assumes unchanged fiscal policy, we think that our pessimistic scenario should not deviate too far from the base case. For the pessimistic scenario, we assume that the primary deficit deteriorates by 0.1% of GDP per year, starting from 2012. Our model shows debt/GDP rising to above 90% by 2020.
Note that we have only assumed fiscal tightening in Poland in the optimistic scenario. Even in the optimistic scenario, debt/GDP is projected to breach the 60% threshold. This result underscores the mechanic nature of the analysis: Poland's constitution forbids it from running any deficit once debt/GDP hits 60% of GDP. Nevertheless, one conclusion still stands: barring a change in the constitution or a redefinition of debt (say, to exclude pension liabilities of the second pillar), the Polish adjustment will have to be really quite severe over the next few years.
Hungary: Unlike Poland and the Czech Republic, Hungary has implemented significant fiscal tightening since 2008. Our optimistic scenario is therefore fairly similar to our base case: we assume that the primary surplus improves by 0.1% of GDP per year, starting from 2015 (1.1% of GDP versus 1% in 2014), and reaches 1.6% of GDP in 2020. In this case, Hungary's debt/GDP is expected to fall towards 75% in 2020, from 81% currently.
The pessimistic scenario assumes that the primary deficit deteriorates by 0.3% of GDP per year, starting from 2012, reaching -2.6% by 2020 (basically, almost as bad as the fiscal position in the first half of the decade). In this scenario, debt/GDP heads towards 100% of GDP in 2020.
Polish 5y5y versus EUR Too High?
As fiscal deficit and debt/GDP levels make up two of the four Maastricht criteria, we think that convergence probability of Hungary and Poland should be reflected in the 5y5y spread to EUR, to a certain extent. A high fiscal deficit and debt/GDP level tends to result in increased issuance, which pushes the long-end yields higher, thus implying a lower chance of convergence, and vice versa.
Since March 2009, the HUF 5y5y spread to EUR (currently around 270bp) has recovered from the high of 400+bp, bottoming twice at around 180bp, which is just 40bp shy of its five-year low of 140bp. On the contrary, the PLN 5y5y spread to EUR did not recover like HUF 5y5y did, despite the rally in the risky markets. In fact, it widened further over the past year, and is now at 180bp, close to the all-time high of around 210bp (low was at around 20bp in 4Q08).
This divergence in 5y5y trend reflects the different routes the Polish and Hungarian governments took in 2007/08. The Hungarian government had to tighten its fiscal policies in order to comply with the IMF's restrictions. On the other hand, the Polish government loosened its fiscal policy over recent years in order to stimulate growth, and managed to steer the economy away from a recession, outperforming its CE3 neighbours. Relaxing fiscal policy at the peak of the cycle was a risky strategy on Poland's part (see also Complacency Breeds Trouble, September 27, 2007), and it meant that the fiscal position was much weaker than the headline numbers suggested.
Based on our analysis, while the government debt/GDP is higher in Hungary, the pace of increase should be much slower than Poland's. If one assumes that policies remain broadly stable from here, Poland's government debt/GDP is projected to catch up with Hungary's around 2020 if our base case materialises. Of course, that assumption has many drawbacks, as discussed above, and significant tightening kicks in as the debt ratio approaches 60%.
In addition, Komorowski's win in the Polish presidential election should be viewed as a positive for the fiscal reform, in our view, though probably it is of limited impact over the next few months. This could put a ceiling on the PLN 5y5y spread to EUR, although we cannot discount the spread reaching new highs if the fiscal situation remains unresolved for an extended period of time.
Comparisons with GIPS
Compared to GIPS, the situation in CE3 seems relatively contained. According to the European Commission, by 2015, Greece could see its government debt/GDP rise from 137% currently to over 160%, if we see an unsuccessful consolidation.
Government debt/GDP levels in Spain (64% to around 90%) and Portugal (84% to around 110%) should also experience a steep upward trajectory due to their large primary deficits. Although already at 118% now, Italy's government debt/GDP profile is the least concerning out of the four, where the EC projects the debt/GDP to stabilise at around 120%.
If these countries follow a successful fiscal consolidation programme, the EC expects the government debt/GDP levels to fall or stabilise, except in Portugal, which should still see a rise in its government debt/GDP level.
Debt-Sustainability Analysis on EM Countries
Extending the debt-sustainability analysis to other EM countries, we find that most countries in Asia and LatAm should continue to reduce government debt/GDP, albeit at variable speeds. In Asia (India, Indonesia and Malaysia), the government debt/GDP reduction is expected to be driven by high real GDP growth, despite running a primary deficit of between 1.3% and 1.8% of GDP. Our Asian economists are forecasting 5-8% long-run, steady-state growth beyond 2013 in these countries.
Even though the real interest cost burdens are expected to be higher in the LatAm countries than in Asia, government debt/GDP reduction is still possible, thanks to steady-state real GDP growth of between 3.5% and 5.5%, coupled with primary surpluses of 2-3% of GDP. The only exception is Mexico, where government debt/GDP is expected to stay fairly constant at around 34% (mainly due to our expectation of a small primary deficit).
Real GDP growth in the CEEMEA region is expected to be the weakest, with steady-state real GDP growth at 4.5% or below. CE3 and Russia are expected to underperform the rest of the countries in the region. The three countries in CEEMEA that are assumed to run a primary deficit over the analysis horizon are the Czech Republic, Poland and Russia.
Russia should see its debt/GDP doubling from 9.5% to 18% over the next five years, but we would emphasise that this move is from a low base, as Russia currently has the lowest government debt/GDP among all the EM countries, and the debt-service costs should be relatively easy to fund.
The real GDP growth or primary balance required to maintain the government debt/GDP on a flat trajectory beyond 2013 serves as a good comparison, particularly for countries with rising debt/GDP profiles.
We can see that the CE3 countries need to increase real GDP growth by 0.3-6.4% to stabilise debt/GDP, or increase the primary surplus by 0.5-3.3% of GDP. For Russia, in order to stabilise debt/GDP at around 15% beyond 2013, the long-run real GDP growth needs to be at close to 14% per year (model assumption 3%), or the primary surplus needs to be at 0.2% of GDP (compared to our steady-state forecast of -1.5% of GDP).
Mexico needs to see its real GDP growth at 3.8% (versus 3.5% assumed) or running a primary deficit of 0.2% of GDP, in order to maintain a steady debt/GDP profile beyond 2013. With a relatively low debt/GDP level (28%), Indonesia's situation is one of the least severe among the countries with a rising government debt/GDP profile. However, it can still stabilise the debt/GDP profile by increasing real GDP growth by 1.5% to 7.8%, or moving its primary deficit from 1.8% of GDP to 1.3%.
Putting it All Together
We plot the current level of 5y CDS against debt/GDP in 2011. On a relative value basis, Indonesia, South Africa, Turkey and Colombia appear cheap versus Peru, Malaysia and Brazil, while Russia, Mexico, India and Hungary appear fairly valued. The results seem consistent when we plot 5y CDS against debt/GDP in 2013 (where the steady-state assumptions start). We have excluded Argentina and Israel from the plots as their current CDS levels distort the charts significantly.
Argentina's 5y CDS is very high at around 900bp, and should be treated separately from the other countries in this analysis. At 80% of debt/GDP, Israel's 5y CDS is around 200bp lower than Hungary's. Several factors that contribute to the difference are: 1) A better fiscal and growth outlook for Israel; 2) Israel is A rated while Hungary is BBB rated; 3) The absence of balance sheet problems/FX loans in Israel's banking sector; and 4) The availability of the US-guaranteed loans to Israel.
Next, we compare the local debt valuation versus debt/GDP. The most relevant measure is the asset swap spread (ASW) on the 5y debt (note that the regression fit for ASW is not as strong as the fit for CDS versus government debt/GDP). Turkey, Colombia, Peru and South Africa appear cheap versus Russia, Indonesia, Mexico, Malaysia and Brazil. Similarly, the results seem consistent when we plot 5y ASW against debt/GDP in 2013.
Aggregating both the comparison results, the countries that stand out as cheap on a relative value basis are Turkey, Colombia and South Africa, while Malaysia and Brazil appear expensive. As fundamentals continue to improve in Turkey and Colombia, we think that it makes sense to favour Turkish and Colombian government bonds. However, we would caution against selling/going underweight Malaysian government bonds as the fundamental improvements could justify the premium embedded in these bonds.
Another observation is that Peru local bonds appear cheap, while Peru CDS spreads are too low. Therefore, one interesting trade is to buy the Peru local bonds, and long Peru CDS. Indeed, our LatAm strategists are currently recommending long Peru Soberano bonds (see Peru: Buy 5y Soberano, Rogerio Oliveira and Juha Seppala, June 16, 2010).
Please see the Appendix of EM Profile: An Exercise in Debt Sustainability, July 19, 2010, for details on the methodology and assumptions.
The Global Growth Debate
The over-riding theme of this week's MPC, in our view, will be the ongoing developments in Europe and their likely impact on South Africa. The SARB appears to have been more bearish than the markets about European growth and fiscal developments as far back as March, when it surprised the markets with a 50bp rate cut and expressed significant concerns about the sustainability of burgeoning fiscal deficits and government debt ratios in the US and Europe. In our opinion, its bearish outlook has now been confirmed, and the key issue now is whether it turns significantly more bearish at the July 22 MPC meeting or not. We believe not.
Quite rightly, SARB Governor Marcus in a recent speech on July 7 warned that, although peripheral European exports account for only 5% of South Africa's exports, Europe as a whole imports a third of South Africa's manufactured exports, and a slowdown in the euro area would not be entirely inconsequential for South Africa. We agree. However, we also note that, in the same speech, the governor mentioned that the SARB still expects growth to average around 3% this year (i.e., no downgrade to its earlier growth forecast of 2.7%, which we believe will in fact be raised to 2.9% at the next MPC meeting, thanks to largely to an upside surprise in 1Q10); she was also careful to highlight that some of the major European countries like Germany are likely to report stronger growth if they are able to increase productivity and take advantage of the weaker euro.
We also could not help but notice that in its latest World Economic Outlook (a report often cited by the SARB) on July 8, the IMF highlighted downside risks to global growth but left its forecast for 2010 European GDP unchanged at 1%. At this stage, therefore, while we believe that the SARB will likely maintain a negative outlook on global growth, we are not of the opinion that its stance will change dramatically enough to warrant a change in policy rates locally. If anything, it may adopt a wait-and-see position that is likely to see it leave policy rates unchanged but with a relatively dovish statement that allows it to pull the trigger by September if things were to turn materially worse.
The Manufacturing Sector Debate
Second, we expect the MPC to spend a fair amount of time discussing domestic growth prospects vis-à-vis the extent to which further policy stimulus is warranted. There is no doubt that the SARB, like ourselves, was somewhat caught off-guard by the timing of the recent synchronised decline in global PMIs - especially with South Africa's PMI now having dipped below 50 index points and pointing towards a contraction in manufacturing output in the months ahead. For the record, we did not expect the PMI to dip below 50 before 3Q10.
However, as easily inferred from the governor's speech, the sustainability of South Africa's manufacturing sector hinges not only on local demand conditions, but also on demand conditions offshore - particularly in Europe. And it appears that the current slowdown in manufacturing is driven more by what the SARB refers to as "weaker macroeconomic conditions in certain euro member countries" than by a renewed contraction in final domestic demand (final demand rose from 1.2%Q in 4Q09 to 4.9%Q in 1Q10, and is likely to have remained buoyant in 2Q, thanks to the World Cup). Our analysis shows that monetary laxity has little influence on manufactured exports to Europe (see South Africa: Gauging Susceptibility to the Vagaries of European Growth, June 21, 2010). Therefore, we do not believe that engineering easier money is necessarily the right policy response to the ailing local manufacturing sector. Instead, productivity-enhancing measures such as cost control, more flexible labour markets, a more liberal trade policy that allows for cheaper intermediate inputs and an easier tax regime will deliver better medium-to-long-term results.
The Inflation Debate
Third, although the SARB remains an inflation targeter, we believe that the inflation argument will carry the least weight in the July MPC meeting's decision function. This is simply because not much has changed on the inflation front: Although the most recent inflation readings surprised marginally to the downside, it is becoming increasingly likely that the 0.1%Y print in May food inflation signaled the trough in annual food inflation; and that although food prices are unlikely to rise significantly going forward, the disinflation effect from lower food prices could be drawing to an end as technical base effects unwind in the coming months.
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