GREECE VS GERMANY
August 11, 2010 – 1:14 pm
One is the economic powerhouse of Europe and the other suffers from consistently low productivity and competitiveness, which are made worse by its inclusion in the euro.
Germany and Greece have garnered plenty of headlines in recent months, but while the former is considered the safest European sovereign along with non-European union nations Switzerland and Norway, the latter must now choose to either restructure its debt or direct a significant portion of its limited productive capacity toward servicing debt for several years.
Pierre Lapointe, global macro strategist at Brockhouse Cooper has been examining sovereign risk with country-by-country reports this month. The five key factors he is focusing on are economic strength, debt burden, debt dynamics, fiscal flexibility, and market access and costs of funds.
For Germany, he said the introduction of the euro exacerbated its competitive advantage over other European countries by making devaluation impossible. With the Germany economy set to grow at roughly 1.5% to 2.0% annually in the medium term, this may not be enough to grow out of debt, but it exceeds forecasts for other European sovereigns.
At an estimated 84% of GDP, Germany’s government debt burden is in line with most other European countries, which is relatively high. Meanwhile, the debt of German regions represent a liability of the sovereign, so the country’s central government provides a backstop for a number of other debt issuers in the country.
In terms of its debt dynamics, Mr. Lapointe said Germany is “markedly superior” to other European sovereigns. Its deficit is 4.5% of GDP, which compares favourably with its European peers.
German policy makers have also approved a “debt brake” that will require fiscal adjustment starting in 2011. “This is positive for German public finances and will limit the accumulation of debt,” the strategist said.
In terms of fiscal flexibility, Mr. Lapointe believes the country’s debt burden can still be reversed. Since interest payments account for 6% of government revenues, there is room for adjustment elsewhere. Germany also has access to plenty of low-cost capital given that it is a safe haven among European sovereigns.
Finally, its reputation, based on the large size of the economy and relatively sound public finances, makes Germany’s cost of funds very low. This facilitates its fiscal adjustment. “Credit markets view Germany on par with the United States,” Mr. Lapointe said.
Bottom line: “Despite a high debt burden, German policy makers are more averse to deficits and debt than some of their European counterparts. We think that investing in Germany entails only minimal levels of sovereign risk.”
He recommends maintaining a market weight position in European equities, but to be overweight Germany within the region.
As for Greece’s economic strength, with government spending accounting for nearly half of the country’s GDP, austerity measures for the next few years will be very damaging to employment. As a result, Mr. Lapointe does not think Greece will be able to rely on economic growth to reduce its debt burden.
In fact, before the recession, Greece’s debt-to-GDP ratio was above 100%. This situation demonstrates that highly indebted sovereigns are vulnerable to sharp and rapid increases in borrowing costs, which the strategist noted can in turn make the direction of debt unsustainable.
Calling Greece’s debt dynamics “extremely adverse,” Mr. Lapointe pointed out that it ran deficits of more than 5% of GDP before the recession. He estimates that the country’s low growth potential in the medium term means it needs surpluses of about 6% to 7% of GDP to stabilize its debt-to-GDP ratio.
“The difficulty in achieving debt stabilization could provide the incentive to a future Greek government, a few years from now, to seek to restructure its debt.”
The Greek government has lost almost all of its fiscal flexibility, Mr. Lapointe said, adding that it must now evolve under the scrutiny of other EU members. With 13% of government revenues currently used to service debt, he warned that this number will only rise further.
Finally, Greece’s access to long-term markets will likely be put on hold until after the €110-billion EU-IMF bailout package expires. If it is not extended further, Greece will resume funding itself at much higher rates, Mr. Lapointe said.
“Also, if Greece opts to restructure its debt, access to markets will probably be cut for at least a few years. The credit markets continue to assign a substantial probability to this event.”
Bottom line:
The current government has indicated it will use a significant chunk of its productive capacity for servicing debt in the coming years.
“This might change in the future if the sacrifices required to bring down debt levels prove to be unbearable for Greeks and if there is political gain in spreading the pain over to creditors.”
Mr. Lapointe recommends an underweight position on the Greek stock market.
(Financial Post)
