For the Eurozone, much hinges on self-discipline and self-interest

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1 For the Eurozone, much hinges on self-discipline and self-interest Author: Jonathan Lemco, Ph.D. Will the Eurozone survive its severe financial challenges? Vanguard believes it is in the interests of both have and have not members to preserve the European Union, but this will be possible only with far greater fiscal discipline. When long-simmering fiscal woes in Greece first captured headlines and unnerved global financial markets last year, calm was temporarily restored and the damage appeared to be contained. Greece negotiated a package of unpopular but necessary austerity measures to qualify for a financial rescue by the International Monetary Fund and European Union (EU) members in spring Since then, the breadth and depth of the challenges faced in other peripheral European countries leading, for example, to a junk rating for the sovereign debt of Ireland, the former Celtic Tiger have again shaken global markets. And speculation has mounted that the euro may not survive as a common currency, and that the EU may break up. The backdrop: The global recession of exacerbated long-term structural economic issues in several peripheral Eurozone countries, leading to recent bailouts, a crisis of confidence, and plunging stock markets. The question: Can the Eurozone survive amid serious ongoing economic challenges? Vanguard conclusion: We expect the European Union to survive, but the road will be bumpy. As always, investor portfolios should be diversified across both developed and emerging markets. Amid swift-moving currents and market gyrations, it can be difficult to maintain perspective. However, regardless of what the current headlines may be, we offer four observations regarding the short- and longer-term outlook for the Eurozone: The Eurozone crisis is likely to continue well into the foreseeable future. Our best guess is at least two more years, possibly much longer. Whether Greece, or Portugal, or another country actually defaults is less important than how the default takes place and what follows it. We believe it is unlikely that Greece or any other member would decide to leave the EU. For the longer term, there are two broad scenarios for the possible fate of the EU. We believe the more likely scenario is that the EU will evolve toward a much more disciplined fiscal union within a decentralized constitutional structure. If such a fiscal structure cannot be negotiated, then we believe an EU collapse becomes more likely. Austerity measures and strict enforcement of budgetary policies and guidelines must be accompanied by economic growth and investment, although spending cutbacks will be a drag on growth. Vanguard Investment Perspectives > 1

2 Figure 1. The Eurozone sovereign-debt crisis: Rising costs of default insurance The credit default swap spread can be viewed as the relative cost of insuring a debt security against a default or restructuring event. This chart shows CDS spreads for the six peripheral countries versus Germany, considered one of the soundest issuers in the region. The wide spread for Greece illustrates rapidly eroding confidence in the country s ability to repay bondholders. Spreads of 5-year sovereign CDS relative to Germany: January 2, 2009 August 18, ,000 2,500 Basis points 2,000 1,500 1, Jan July 2009 Jan July 2010 Jan July 2011 Greece Portugal Ireland Italy Belgium Germany Spain Source: Thomson Reuters Datastream. Rising borrowing costs, falling confidence, and more bailouts Since early 2010, there has been tremendous uncertainty regarding the outlook for the economies and sovereign debt of peripheral Eurozone members, notably Greece, Portugal, Ireland, Spain, and Italy. Belgium could be added to this list as well, because of its political uncertainty and growing fiscal burden. The global recession of exacerbated longterm structural and economic issues in these countries, including: public sectors that were excessively large in relation to the overall economy, unsustainable social entitlement programs, and fundamental misalignments in wage and price levels relative to more competitive members of the currency union. In spring 2010, the situation came to a head in Greece. This was followed by a global retreat from the debt of the peripheral EU countries and by soaring interest rate spreads on their bond yields and credit default swaps (CDS) relative to German bunds (Figure 1). After a period of calm, spreads widened again. They spiked dramatically in mid-july 2011 before the second Greek bailout was negotiated, then fell back. The spread of 5-year Greek sovereign CDS rates relative to Germany peaked in July at about 26 percentage points. Since spring 2010, supranational authorities and policymakers in the Eurozone and elsewhere have engineered major responses first to rescue Greece, then more recently to rescue Ireland, Portugal, and Greece (again). Figure 2 summarizes the various bailouts, standby programs, and policy actions addressing the crises. A notable feature of the second Greek bailout arrangement is that some bondholders will shoulder part of the cost. 2 > Volume 10

3 Figure 2. Key responses to the Eurozone debt crisis Response Date Amount Description Bailout of Greece May billion 80 billion from Eurozone members and 30 billion from the International Monetary Fund (IMF). Second bailout July billion 59 billion from Eurozone members and the of Greece IMF. An additional 50 billion is expected to come from the private sector. Bailout of Ireland November billion 17.5 billion from Ireland (National Pension Reserve Fund and the state s cash reserves) billion from the IMF billion from the EFSM (European Financial Stability Mechanism) billion from the EFSF (European Financial Stability Facility). Bailout of Portugal May billion 26 billion from the IMF and 52 billion from Eurozone members. European Financial May billion The EFSF can make loans funded by floating- Stability Facility (EFSF) rate debt that is guaranteed by Eurozone member states. The EFSF is a temporary mechanism that will be replaced by the European Stability Mechanism (ESM) in June Expansion of EFSF July 2011 Increased to The EFSF s lending capability was boosted, 780 billion and it was given authority to intervene in the secondary debt market. European Central Bank Ongoing billion The ECB purchases the debt issued by (ECB) bond purchases since the program Eurozone nations as part of its open-market was launched in operations. May 2010 Bank stress tests and July 2011 Of 90 banks, These tests aimed to assess the ability of recapitalization 8 failed the stress the European banks to withstand financial tests: 5 Spanish, shocks. Those that failed the test were 2 Greek, and required to present recapitalization plans 1 Austrian. by September 31, 2011, and to be ready to implement them within the following three months. Source: Vanguard. The root cause of the problems in Greece and, to a lesser extent, in Portugal, Ireland, Spain, and Italy is spending beyond their means. As a precondition to membership in the European Union, countries pledged that their budget deficits would not exceed 3% of gross domestic product (GDP) and that sovereign debt would not exceed 60% of GDP. Over time, however, with lax enforcement, budget deficits have become far greater especially in Greece, where the deficit as a percentage of GDP turned out to be far worse than we were led to believe: 15.4% for full-year 2009 and 10.5% in 2010 (see Figure 3, on page 4). Vanguard Investment Perspectives > 3

4 Figure 3. Fiscal retrenchment in the Eurozone These key figures show the need for fiscal adjustment in the Eurozone. The deficit reduction targets are listed in each country s Growth and Stability Program, a document that EU members must submit annually. The targets are based on cyclically adjusted GDP, meaning that the economic recovery is already built into assumptions about government revenue. Germany and France, the largest members of the Eurozone economy, also have fiscal retrenchment targets to meet, meaning that the overall adjustment for the region is substantial. Country s Real GDP growth Debt-to-GDP 2010 share of rate (Q ratio (debt as budget deficit European Union versus Q1 2010, percentage of (percentage GDP (2010) annualized rate) GDP, 2010) of GDP) Germany 20.4% 2.7% 83.2% 3.3% France United Kingdom Italy Spain Belgium Greece Portugal Ireland Sources: Eurostat (the statistical office of the European Union) and Bloomberg. Short-term outlook: Deep fiscal cuts with serious implications for growth The governments of Europe s peripheral economies have shown notable commitment to addressing their budget imbalances. As shown in Figure 3, several countries budget deficits far exceed the membership targets. In accordance with the European Union s Growth and Stability Program, most members have now set a target of reducing their deficits to 3% of GDP the original EU standard by However, the essential fiscal austerity programs that have been announced and implemented to achieve that goal are a double-edged sword. Instead of spending and engaging in fiscal stimulus to support economic activity, governments across the Eurozone are being forced to reduce spending and cut stimulus programs, creating negative shocks to spending and growth, with serious near-term implications for the fragile European economic recovery. In our view, the impact of these simultaneous austerity measures is likely to reverberate across the entire euro area in the short run. Even if the cutbacks are spread out over several years, the overall fiscal adjustment is large. And with GDP growth already slowing significantly in Germany, France, and elsewhere, we are cautious about the near-term outlook for the Eurozone as a whole. As stated earlier, we think it is reasonable to expect the region to remain troubled for the foreseeable future, most likely for at least two years and conceivably for much longer. A sovereign default? For some time, the bond market has signaled an expectation that Greece will default on its sovereign debt. Greece s ratio of total debt to GDP (143% in 2010 see Figure 3) is several standard deviations worse than that of other peripheral European countries except Italy, which has the notable advantage of being a more broadly diversified and export-oriented economy, the third-largest in the EU. 4 > Volume 10

5 Although it appears unlikely that Greece can avoid default, what matters more is whether the default will be orderly that is, somewhat predictable and orchestrated by EU leadership or disorderly, with surprises and unexpected contingencies. A disorderly default could trigger an even more widespread and severe sell-off in global stock and bond markets, and would be more likely to spread to the bonds of fiscally healthier European countries. Note that the same analysis would apply regardless of which beleaguered country defaults. The EU Constitution allows a defaulting member to voluntarily leave the union, but does not require the member to do so. We believe that if Greece or another country defaults, it will be in that nation s interest to remain within the EU even though the national economy might benefit from the resulting devaluation of the local currency, which would make exports more competitive. If Greece, for example, severed ties with the EU, its government would need to be ready for an immediate run on Greek banks, a substantial decline in the standard of living absent EU financial support and access to credit markets as an EU member and other serious implications. Long-term outlook: Fiscal union, or collapse? In mid-august, French and German leaders proposed a carrot-and-stick approach to reward countries that effectively address their budget gaps. At the same time, the prospect of an effective fiscal union which might ultimately lead to a centralized budgeting and taxing authority appeared to gain credence at least among investors, as indicated by pricing and spreads in the market for credit default swaps. Another idea that has been discussed is the issuance of Eurobonds, which would be joint obligations of all EU members. Senior leaders of core EU members do not embrace the notion of a fiscal union, for reasons that include reluctance to relinquish fiscal sovereignty and aversion to further bailouts of reprobate members. And the EU Constitution would have to be amended before a fiscal union could be set up. However, if the goal is to preserve the considerable benefits of the EU including trade efficiencies arising from a common currency there appear to be few alternatives. As a possible first step toward fiscal union, we believe it is highly likely that meaningful enforcement mechanisms will be put in place, sooner rather than later, to encourage all members to adhere to budget targets and to penalize them if they don t. A logical next step, and one that probably will be resisted by politicians, would be establishing a bureaucratic structure for making and enforcing budget and spending decisions. Absent a move toward strict enforcement of fiscal discipline, a partial dissolution or even a total collapse of the EU would appear more likely. Muddling through with haphazard and idiosyncratic political decisions that fail to address long-engrained habits is no longer a viable option. Growth must accompany austerity Gaining control over budgets and spending is a necessary but not a sufficient condition for fiscal healing. Economic growth is also essential and is even more challenging to achieve in the face of sharp cutbacks in spending. The key to economic growth is meaningful investment by domestic and international investors, who must gain confidence that Greece and other nations are making genuine, tangible progress in getting their fiscal houses in order by cutting back on public services, reducing tax-avoidance, and other measures. Progress will take time, especially as the global economic growth engine seems to be stalling again. Meanwhile, investors should be mindful of the potential for high volatility in both equity and fixed income markets, including wide movements in bond yields over short periods. We encourage investors to diversify their portfolio holdings among developed and emerging markets, making sure that the proportions of each are consistent with risk tolerance and investment objectives. Vanguard Investment Perspectives > 5

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