At the heart of most crises is a loss of credibility of policy institutions: This loss of credibility frequently, but not necessarily exclusively, arises from policy overreach. Such overreach may arise from policy institutions ‘abusing' their freedom in setting policy, or it may have been forced on them by developments elsewhere in the economy. Examples for the first case may be monetary policy that over-stimulates the economy with the result of inflation becoming too high; or fiscal policy running up too much debt. An example of the second case may be the public sector balance sheet having to absorb the consequences of excessive private sector leverage.
In turn, the restoration of credibility requires not just a policy retrenchment - that is, policy tightening. However decisive the change in policy direction, a true restoration of credibility necessitates policy to commit to return to a sustainable path. Ultimately, this is only possible if policy institutions are unable to repeat those mistakes: declarations of willingness will, in most cases, not suffice. Relinquishing ability, however, means impairing one's flexibility permanently and evidently - that is, it requires institutionalisation of the commitment to stay responsible. The inflation crisis of the 1970s provides an instructive example.
The Inflation Crisis of the 1970s/1980s
Policy overreach: After World War II, the Bretton Woods system of fixed exchange rates provided the cornerstone of macroeconomic - particularly monetary - policy for industrialised economies. Its demise in the early 1970s meant that monetary policy lost what is sometimes called its ‘nominal anchor' - a reference point to which to tether its own actions as well as the public's inflation expectations. High inflation in DM, caused at least partially by central banks over-stimulating the economy, was the consequence in the mid-to-late 1970s and early 1980s.
Policy retrenchment: Beginning from the early 1980s, monetary policy in various DM economies began reversing direction. Central banks, led by the Fed, raised interest rates sufficiently to induce recessions that ultimately wrung inflation out of their economies. The 1980s conquest of inflation that followed was painful, as it required recessions in most DM economies at one time or another.
Institutional change: To solidify the conquest of inflation, central banks were, subsequently, made institutionally independent - to insulate them from political pressure - and a new, different, nominal anchor was established: the central bank's own inflation forecast. With it came rules for the conduct of monetary policy. Roughly, such rules recommended raising policy rates if the inflation forecast was set to be above target, and vice versa. Societies discovered the "advantages of tying their own hands": by outsourcing monetary policy to an independent institution with the explicit mandate to keep inflation low, credibility in the monetary arrangement was re-established, inflation expectations declined and remained low, and inflation stayed well-behaved.
To summarise, in the 1970s the credibility of monetary policy was impaired through high inflation. It was finally restored through institutional changes which rendered central banks independent. The key was not just the freedom from political interference in monetary policy, but crucially the willingness of the policy authority to relinquish (some of) its flexibility by subjecting its policy-making to transparent rules.
Crises and credibility - the pattern: In short, crises follow the following pattern, in our view:
• Policy overreach, possibly combined with external events as catalysts lead to loss of credibility.
• Policy retrenchment, usually within the existing institutional framework.
• Institutional change completes, and cements, the recovery of credibility initiated by the policy retrenchment.
We believe that this pattern will apply to the current DM sovereign debt crisis.
The Ongoing Sovereign Debt Crisis
Policy overreach: An increasingly globalised capital market post Bretton Woods allowed both public and private sectors in DM to increase leverage substantially. Thanks to a constantly increasing supply of savings from the Middle East and Asia but also from DM savers, some DM governments were able to increase or maintain debt rather than having to make the unpopular decisions to cut spending or increase taxes. Elsewhere, private sector leverage meant the accumulation of contingent liabilities that were too large for the public sector to shoulder. In both cases, the Great Recession meant overreach for the public balance sheet, resulting in a loss of credibility of fiscal policy - namely, markets question the ability and willingness of governments to repay their debt. That is, most DM economies are now experiencing the consequences of markets' new-found ‘debt intolerance' - a phenomenon only EM policy-makers were familiar with so far. We think that the eventual restoration of fiscal credibility will follow the precedent of inflation and central bank credibility.
Policy retrenchment: In the near term, we believe that painful action is needed to effect a turnaround: fiscal austerity in indebted countries combined with debt write-downs for creditors (witness Greek ‘private sector involvement') - in short, the burden will have to be shared between debtors and creditors.
Institutional change: In the medium term, we think that fiscal consolidation in DM will be followed by institutional changes, which will limit the fiscal authorities' room for manoeuvre - fiscal rules, possibly enshrined in the constitution. Indeed, the IMF's experience with EM economies suggests that "fiscal rules are often introduced to lock in earlier consolidation efforts rather than at the beginning of the fiscal adjustment." Such institutional change is already underway in several European countries: Germany already has a fiscal rule embedded in the constitution, while Spain, Italy and France are following suit. More generally, the eurozone, being the epicentre of the crisis, is likely to see the most far-reaching institutional changes, as it needs to correct the flaws inherent in its design. This would mean a fiscal union - which in turn would necessitate a closer political union, not least to ensure that fiscal discipline is observed everywhere: after all, fiscal rules did exist already in the Eurozone - they just weren't followed.
Note that institutions created in the aftermath of the ‘previous' crisis may not necessarily be useful for the ‘next' crisis: a weapon that was created to fight the previous war may no longer be adequate for the next one. For example, many observers in markets and academia think that the Bank of Japan is perhaps excessively inflation-averse. This may have resulted in several policy errors (the premature exit from its Zero Interest Rate Policy in 2006 being a prime example) that entrenched deflation in the economy. In addition, the BoJ may be too independent in the sense of it being insufficiently accountable - with the consequence of it not taking enough action against deflation (see Robby Feldman, Deflation: Will the US and Europe Follow Japan? September 6, 2010).
Similarly, the ECB being explicitly forbidden by treaty to fund governments is a problem in the current constellation as it has exposed even solvent sovereigns to the possibility of a self-fulfilling run. In our view, a solution to this situation requires the ECB to be mandated to act as a lender of last resort for sovereigns (see EuroTower Insights: Fiscal Union Needs Monetary Back-Up to Solve Crisis, September 22, 2011).
This is essentially a problem of institutional design. If the institutional set-up/rule is too rigid, it will not provide sufficient flexibility when the environment within which policy operates changes. If the rules are too lax, credibility is not restored, or is restored insufficiently. The art of good policy design consists of striking a balance between such considerations. Yet, whatever the future holds, one thing seems certain: we are likely be just as unprepared when the next crisis comes, and we are again likely to have to scramble to change our institutions in response.
Country Factors - Do They Matter at All?
Before the eurozone economic and financial crisis, investors underestimated differences in country vulnerability. The risk of lending to, say, Finland (strong economic structure, prudent fiscal policies, etc.) was perceived to be similar to lending to the eurozone's weakest link: Greece. Indeed, sovereign spreads were so compressed during the decade prior to the crisis that they didn't really make much difference from a macro standpoint. Put differently, market discipline did not work, i.e., it wasn't efficient enough to punish fiscal slippages or structural weaknesses of the eurozone economies.
But country heterogeneity matters a great deal now. Measured by either the government bond yield spreads against Germany, or by looking at CDS premia, investors have started to discriminate between countries inside the EMU to a much greater extent since the inception of the financial crisis and subsequent economic fallout. We think that this trend will likely continue as long as Europe deals with the twin debt and banking problems. And even after the emergence of a more durable solution to tackle the current situation, we believe that markets will pay a lot more attention to the many eurozone countries' idiosyncrasies.
Growth discrepancies within the eurozone are now at a very high spread of 11pp, with growth ranging from around +5% in Austria to -6% in Greece (4-quarter year-on-year averages). This is not unprecedented - given the economic outperformance before the crisis and underperformance after the crisis of Ireland, Greece and Spain. Yet, such a wide range of growth outcomes is quite unusual and only happened once before (late 1999 and early 2000). What's more, the discrepancy among the various countries has been on the rise for the past year or so - courtesy of a massive country rotation within the eurozone. This adjustment process, painful as it is, is crucial to the functioning of the region - especially in the light of the macro imbalances that have built up in the past.
Much of the past growth divergence (and thus the ongoing correction of imbalances and misalignment of business cycles) reflects a one-off adjustment after the start of the monetary union. Back then, the poorer periphery was catching up with the core, the former were converging to the lower interest rates of the latter and investors were diversifying their portfolios away from the low-return core and into higher-yielding peripheral sovereigns.
Put differently, capital mobility within the eurozone - by and large a desirable feature of EMU integration - resulted in wider current account deficits (and piling up of foreign debt) and surpluses (and building up of foreign assets) in peripheral and core countries respectively. However, an oversupply of bank funding, inadequate risk management and excessively low interest rates in the core have contributed to a build-up of imbalances and resulted in an inefficient allocation of the capital flows within the region.
The upshot is that investors need a framework to think through the implications of country heterogeneity within the eurozone. In turbulent times like these, investors re-discover country risk analysis. While this time is no different, we think it's time to go beyond the few typical indicators everyone looks at and take a more comprehensive approach. Thus, this report should provide an answer to the many requests we received recently from investors for key risk indicators for all eurozone economies.
While we believe that our country risk ranking produces plausible results, one need to be aware that, as any ranking tool of that type, it is highly sensitive to the selection of indicators employed. For example, developed countries can probably sustain higher external vulnerability indicators than emerging markets; high values for a few metrics can represent a strength or a weakness depending on a given state of the world (e.g., stable versus turbulent markets, or economic expansion versus contraction); and some eurozone statistics are possibly misleading, given that there is a monetary union.
Enter the Euro Macro-Financial Ranking Model
The Euro Macro-Financial Ranking (E-MFR) compares eurozone countries based on a broad set of economic, fiscal, financial and institutional variables capturing different macro and micro aspects. The E-MFR model includes five blocs:
1. Economic strength: This category reflects the structural features of eurozone economies as well as their cyclical outlook, based on our forecasts for 2012.
2. Fiscal vulnerability: This group of indicators focuses on medium-to-long-term government debt sustainability and funding needs, i.e., solvency and liquidity risks.
3. Financial conditions: This set of variables consists of measures of non-financial private sector leverage, banking sector liquidity and the importance of asset markets.
4. External dependency: This category has to do with external solvency (current account, FDI, household savings and the net external position).
5. Political uncertainty perception: This group of indicators reflects our subjective perception of the political outlook, along with how far away the next election is.
Methodology
The E-MFR model is loosely inspired by some of the criteria used by rating agencies, although the final selection of the various indicators is based on our own judgment of what's relevant from a market standpoint. So, our ranking is not meant to predict the next country to be downgraded, or fall under speculative attack. Rather, it is an attempt to compare and contrast eurozone countries across a number of dimensions, with a view to the most relevant factors for both fixed income and equity markets.
Clearly, quantitative methodologies such as ours cannot capture swings in investor confidence, which depend on policy-makers' responses to the ongoing crisis, among other things. Indeed, financial markets usually move well ahead of rating changes. Yet our ranking exercise provides a useful framework to disentangle eurozone countries' fundamental strengths and weaknesses relative to each other. The ranking methodology follows three steps:
1. Rank eurozone countries across each variable, e.g., 2012 GDP growth forecasts from high (better) to low (worse).
2. Take the mean ranking within each category, e.g., 2012 GDP growth, inflation and unemployment rate forecasts in the ‘cyclical outlook' category.
3. For each country, average out the rankings across all the main categories to get the final ranking.
The relevant factors might well change over time, as well as the importance that market participants might attach to them. Still, we think that the various categories featuring in the E-MFR model are a fair representation of the concepts that investors would use in their own assessments. There are several potentially useful indicators, but we tried to include our preferred variable for each concept, i.e., only indicators that tell a different story made it in the final selection.
Another guideline we followed in our methodology was to keep the ranking tool itself as simple as possible: we wanted to provide enough granularity to analyse the eurozone members' fundamentals, but also have a manageable number of indicators per country.
Furthermore, apart from the 300 time series or so that we have crunched to build the E-MFR model, the Appendix at the end of our full report presents a couple of other indicators that are still worthwhile to monitor.
The weights that one would use in these ranking exercises are, by their very nature, subjective - and can only be based on someone's assessment of their relative importance in the current environment. With this caveat in mind, we have tried to be as objective as possible and refrained from arbitrary weights. Investors can of course assign a different importance to the various factors and variables presented in detail in the Appendix of the full report.
Overall Results
The five blocs included in the E-MFR model point to considerable heterogeneity within the eurozone. In particular:
• Core countries, unsurprisingly, compare favourably to peripherals in terms of economic strength, because of both stronger structural features and a better cyclical outlook. Yet, Ireland's trade openness, large manufacturing base and non-price competitiveness - while price competitiveness has improved visibly in recent quarters - measure well versus most countries.
• In terms of fiscal vulnerability to the Eurozone, peripheral countries - with higher government indebtedness and interest expenses relative to their revenue base, as well as a limited ability to grow out of their debts - show worse fundamentals than core Europe. But Italy's relatively small budget deficit, long average maturity of the debt and high domestic debt ownership stand out in the eurozone and make it less subject to a sudden buyer's strike.
• High non-financial sector leverage - both across households and firms - is a key fragility in both core (Netherlands) and peripheral (Spain, Portugal, Ireland) countries, where a credit-fuelled housing and/or consumer boom-turned-bust has generally taken place. However, limited bank liquidity seems more of a problem in southern Europe and Ireland.
• External dependency shows that there generally is a north/south divide, with southern countries (Greece and Portugal) as well as Ireland having current account deficits and higher foreign liabilities than assets; northern countries (Germany, the Netherlands and Belgium) have current account surpluses and higher foreign assets than liabilities. France and Italy are somewhat in between.
• Our perception of political uncertainty, either because we are close to an election or because the government appears to have somewhat limited parliamentary support, suggests a still unresolved situation - for different reasons ranging from election proximity to diminishing support - especially in France, Italy, Spain, Belgium and Greece.
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