Euroland: Country scoring in a monetary union

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This post is a guest contribution by Daniele Antonucci, Olivier Bizimana & Elga Bartsch of Morgan Stanley.

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.


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.

The imbalances in the periphery are larger than in core Europe, where the vulnerability scores in the former are higher than in the latter. What’s more, conventional wisdom has it that, in a monetary union, country members’ external imbalances are more sustainable than in a flexible exchange rate regime, as currency risk premia disappear.

So, the resulting increase in capital mobility might allow the financing of larger external imbalances. However, even in a monetary union, member states’ external imbalances need to be sustainable.

Why Just Looking at the Public Sector Does Not Work

For many investors, focusing on the eurozone fiscal picture is the obvious starting point when it comes to comparing strengths and weaknesses of the various member countries.

After all, the sovereign debt issues that are currently negatively affecting sentiment and growth prospects in the region are a prominent aspect of the eurozone crisis.

This approach has some merits – one of them being simplicity. Ranking the eurozone countries across a range of fiscal indicators, some related to solvency and some to liquidity (see Appendix in the full report), what emerges is a three-tiered Europe:

1. A first group of five countries (Austria, Finland, Germany, the Netherlands and France) that investors generally associate with core Europe – where solvency and liquidity risks are low or very low.

2. A second group of three countries (Spain, Italy and, to a lesser extent, Belgium) ranging from semi-peripherals to semi-core where liquidity risk is a factor and solvency risk, while not an imminent threat, could become a more material problem, if the perceived underlying issues are not addressed.

3. A third group of three countries (Greece, Portugal and Ireland), the smaller peripherals – now removed from the market in the sense that they don’t need to issue debt for several years, through the official lenders’ bailouts – where a liquidity crisis has already materialised and solvency risk is substantial even when looked on a short-term basis.

This purely fiscal-indicator ranking seems to make sense at first sight. Indeed, the correlation between our Fiscal Vulnerability Score (FVS) and 10-year government bond yield spreads seems quite high – at around 73%.

However, markets seem to differentiate even within the smaller peripheral group, while the FVS appears to assign the same score (and hence the same vulnerability) to Greece, Portugal and Ireland. The score indicates that Ireland is more vulnerable than Greece. We don’t think that’s the case. While Greece is the weakest link in the eurozone, Ireland has fared better lately, and Portugal too seems to be delivering on its adjustment programme, for now.

We think that what a purely FVS misses, at least in part, is the growth picture – which is mainly driven by structural economic factors in the medium term. Therefore, it does not capture factors that are at least as important as a country’s public debt and budget deficit to assess solvency risks. In our view, a broader set of indicators would be more appropriate to capture both the fiscal picture and other factors that are relevant from a market standpoint, ranging from private sector leverage to growth prospects. This is because what matters is a country’s ability to generate enough ‘growth dividends’ in the medium term to sustain a given debt burden.

As one would intuitively expect, the government bond market appears to correlate more closely with fiscal indicators (such as those that make up the FVS), while the equity market is more tightly connected with a wider range of indicators, which we summarise in the output of the E-MFR model. Still, we don’t focus on the goodness of fit of these basic regressions too literally, because some variables used in the FVS have more to do with (sovereign) liquidity – not solvency – risks.

But for Greece, Portugal and Ireland, which have already been removed from the market, funding comes from the official lenders’ (IMF and EU) bailout programmes – subject to conditionality. So, the FVS might provide a somewhat biased or perhaps irrelevant signal for the smaller peripherals, as a liquidity crisis has, in fact, already materialised for these countries.

Put differently, purely focusing on measures of a country’s borrowing requirements – even if embedded in a (somewhat broader) composite fiscal risk indicator – might be misleading for the smaller peripherals.

From a different angle, while market participants will of course assign different weights to these indicators over time, our framework assigns them the same importance and is meant to help investors think through the relative strengths and weaknesses of the various countries.

Key Themes

A broad-based approach to country risk might help investors better discriminate within the eurozone. Based on our ranking of eurozone countries’ economic fundamentals, we indentify five key themes, along with strategy implications.

1. A Multi-Tiered Europe

The core/periphery divide does not exist from an economic standpoint. Rather, by ranking the eurozone members along a wide number of dimensions, what emerges is that there’s a continuum of countries – from the strongest economies of Germany and Finland, to the weakest ones of Greece and Portugal. Yet, we think that investors might find it helpful to think in terms of four broad groups of eurozone member states (the composition of which can change over time depending on the individual countries’ strengths and weaknesses): strong-core, semi-core, semi-peripherals and weak-peripherals:

Strong-core: This group includes countries having, on average, very strong structural as well as cyclical fundamentals. In addition, they don’t have solvency and/or liquidity problems at this stage. These countries are Finland, Germany and Austria. They all have strong public finances, current account surpluses and better growth prospects than the rest of the eurozone.

Semi-core: These countries have relatively strong structural as well as cyclical fundamentals. Overall, they don’t face liquidity and/or solvency problems. Yet, they show some structural weaknesses compared to strong-core countries. France, the Netherlands and Belgium are in this group. The external sector is France’s main weakness, while non-financial private sector’s high indebtedness is the Netherlands’ main hindrance. High political uncertainty is a short-term negative for Belgium, as is its high public debt.

Semi-peripherals: These countries have weak structural and cyclical fundamentals, significant imbalances in parts of their economies that – if left unaddressed – might put solvency at risk over time and, to various degrees, difficulties in debt refinancing. Italy, Spain and Ireland belong to this group. Italy and Spain have poor economic prospects; Italy has to shoulder a significant public debt burden, but it also has a primary budget surplus and does not present other significant imbalances. Spain has a relatively low – but rising – public debt, a wider budget deficit and significant private sector imbalances. The Irish economy has stronger structural features and has gone through a significant adjustment, though the banking and housing crises are still leaving their marks.

Weak-peripherals: This group includes a couple of outliers from a fundamental standpoint, such as Greece and Portugal. While the latter appears somewhat stronger than the former – which one might put in a category of its own – both economies have very weak structural characteristics and a feeble cyclical outlook. In addition, they have heightened liquidity and solvency problems (Greece more than Portugal).

To sum up, we believe that putting the various eurozone countries into either the ‘core bucket’ or ‘periphery bucket’ is too simplistic an approach. It is more appropriate to think about the strengths and weaknesses of the EMU members in terms of a multi-tiered Europe, we think, where some countries might indeed have most (but perhaps not all) of the characteristics of a ‘typical’ core or peripheral country. Yet, most eurozone members will be somewhere in between.

2. France – ‘Typical’ Eurozone Economy

The French economy has almost the same characteristics of the northern core eurozone countries. In particular, its household and corporate sectors are solid and financially sound. In contrast to some peripheral eurozone countries, such as Ireland or Spain, the French economy did not experience excessive financial imbalances before the global financial crisis. This is because French banks usually impose strong conditions on borrowers, especially when it comes to housing loans (high collateral and affordability ratio of around 30%).

What’s more, the long-term prospects for the French economy are somewhat encouraging too, we think, with the working age population likely to continue to expand, thus supporting potential growth in the medium-to-long term. However, the French economy has some supply-side structural weaknesses, especially compared to other core countries. In particular, the balance of trade has deteriorated significantly since the start of the 2000s. France’s market share has declined, especially in emerging economies. This is due to various factors, including inadequate sector specialisation, small industrial base and high labour costs.

Put differently, as the median country in our ranking, France is the ‘typical’ eurozone country, in our view. It has strong economic fundamentals, but also structural supply-side weaknesses. Apart from a slowdown in the growth momentum, as in virtually all other eurozone countries, a crucial near-term concern of market participants, mainly because of the ongoing sovereign debt crisis, seems to be capital and funding of banking systems in core countries, particularly – but not exclusively – French banks. We believe that the persistence of the crisis might lead to a negative feedback loop among the sovereign, the banks and the real economy.

3. Belgium – Well within Core Europe

Perhaps surprisingly to some market participants, Belgium’s structural economic fundamentals are solid and comparable to those of other core countries. Private sector indebtedness is one of the lowest in the eurozone and Belgium has had a current account surplus over the past two decades almost one year after the other. Therefore, its net external position, i.e., the difference between what a country owns and what it owes, is positive and the strongest in the eurozone. This solid financial position is due to the large net savings of households and, to some extent, corporates, which tend to offset the deficit from the public sector.

The cyclical outlook looks robust as well, with Belgium having outperformed the eurozone average in 1H11. We expect this outperformance to continue for the remainder of this year and in 2012. Further, the labour market has improved at a faster pace than in most of other eurozone countries. The unemployment rate is below the region’s average and has declined significantly since last year. However, the high debt-to-GDP ratio and political uncertainty are important weaknesses. The risk is that the long-lasting political impasse may delay the fiscal consolidation effort.

4. Italy and Spain – Same Outlook…for Different Reasons

The semi-peripherals, such as Italy and Spain, exhibit some (admittedly few) features of the semi-core countries, while having quite a few things in common with the smaller weak-peripherals. Yet, from a fundamental standpoint, both the Italian and Spanish economies are more robust than, say, Greece and Portugal. However, their market access looks impaired and, while they can still issue government debt, official support seems crucial to ensure that they can still fund at a reasonably low interest rate. We think that Italy and Spain share the same medium-term outlook, i.e., they’re unlikely to become quick turnaround stories and their economies are likely to grow at around the same pace over the next couple of years, but for different reasons:

• Back in 2010, we argued that Italy, while not yet part of core Europe, was moving towards the more robust eurozone countries (see Inching into the Core, March 15, 2010). Clearly, slower growth in Europe and beyond, along with a weakening domestic economy due to fiscal austerity, suggests that the Italian economy might well fall back into recession next year. This has refocused markets on Italy’s high public debt burden (see Growth Coming to a Standstill, August 17, 2011) and, while the ECB has so far supported Italy’s bond market – and the enhanced EFSF might well do the same if Italy continues to do its homework – refinancing risk remains a key concern. A still unresolved political situation might have further exacerbated investor worries. Political events have exerted a substantial influence on Italian financial markets over the past several decades. For example, econometric analyses suggest that, in the two weeks before and after a government collapse, the cumulative rise in interest rates is about 24bp. Similarly, equity markets fall by around 5% over the same period (see On the Return of the Political Risk Premium, September 20, 2010). Yet, Italy is inherently different from the weak-peripherals in many respects. The Italian government has been running primary budget surpluses for almost two decades excluding the crisis period and, virtually alone in the eurozone, should have a 1% primary budget surplus this year – likely to reach 3% next year. What’s more, Italy has low private sector indebtedness and high wealth, along with neither a major housing boom-bust unfolding nor external imbalances that would make it overly dependent on foreign capital.

• Spain, too, while weak across a number of dimensions, seems better placed than the smaller peripherals to eventually rebound. In particular, we have argued that the Spanish economy has started to fix itself in various areas (see Spain: On the Mend, March 7, 2011). We are still of the opinion that visible progress has been made in some important respects – although a lot of work still lies ahead. For example, the Spanish government is implementing a labour market reform that could, over time, help reduce the unemployment rate (which is still stuck at over 20%). What’s more, a number of pension changes have been enacted – although they could have been more far-reaching. And, mainly courtesy of a substantial belt-tightening at the central government level, Spain seems almost on track to meet its budget deficit target of 6% of GDP this year and public debt, while rising, is still below the eurozone average; the requirement of a balanced budget in the constitution is also a positive development. Other recent pieces of legislation, from the Services Directive to the Sustainable Economy Law, should modernise Spain’s regulatory framework. Yet, there are several risks ahead, with the two ‘known unknowns’ being the fragilities of the banking sector and public finances at the sub-national level. More broadly, after the hangover from a credit-fuelled housing and consumer boom-turned-bust, economy-wide deleveraging continues. This rebalancing process needs time to unfold. While it lasts, economic growth will stay subdued, we think.

5. Ireland – Turnaround Story, but Starting from Behind

If there is a eurozone country that can meet the challenges posed by the current crisis, it is probably Ireland. True, the challenges are also somewhat bigger than elsewhere – notably in the banking sector. But Ireland is among the few eurozone countries that have historically managed major turnarounds in fiscal policy and the wider economy. Ireland is already showing signs of the smart cyclical upswing in 1H11, which offers some protection against the slowdown that likely lies ahead in the eurozone.

In our view, Ireland is fundamentally different from most other eurozone countries in that the structure of its economy is more flexible and less regulated (see Ireland: Mastering the Challenges Ahead, September 13, 2010). Being more of a free market economy, Ireland went through a drastic adjustment process, which saw the economy shrinking sharply. The deep recession also brought meaningful price and wage cuts, which have allowed Ireland to regain most of the competitiveness it had lost during the boom years.

More than any other country in the periphery, Ireland has seen a far-reaching adjustment in house prices (down more than 50% from the peak), construction activity (down to 5.7% of GDP from more than 20% at the height of the boom) and price competitiveness (due to deflation causing a real depreciation of around 7% against the eurozone).

The fact that the Irish current account balance is about to swing into positive territory underscores the extent to which the domestic savings and investment imbalance has been corrected, in our view. With the banking system being the main cause of investor concerns about the Irish sovereign, the results of the April bank stress test and the subsequent policy actions taken by the government could well mark a turning point for Ireland, we think.

In our full report, we show a summary of the main strengths and weaknesses of France, Belgium, Italy, Spain and Ireland, along with our core strategy views. We mainly focus on the semi-core and weak-peripheral groups, rather than on the benchmark (Germany) and the smaller peripherals (Greece, Portugal), because these countries still have market access and are currently viewed by investors as those with more uncertain prospects in both directions.

Many market participants, on the other hand, tend to agree with our call of the need of a more far-reaching restructuring in Greece, whose prospects are then less uncertain – but rather more difficult (we have analysed these issues elsewhere). And Germany, being the benchmark for government bond markets in the eurozone, still benefits, at least at this juncture, from safe-haven status.

Source: Daniele Antonucci, Olivier Bizimana & Elga Bartsch, Morgan Stanley, October 14, 2011.

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