Doing Business in Europe:
The Political &
Release date: May 25, 2011
Host: Vanessa Iarocci
Guest: Sage Newman, Eurasia Group
Running time: 21:36 minutes
Recently, concerns about contagion in the Euro zone have increased. In this episode of Strategy Talks, Eurasia Group's Sage Newman discusses the fast-changing European market for dealmaking.
Announcer: Welcome to Strategy Talks, the business podcast series by PricewaterhouseCoopers Canada. Hosted by Helen Mallovy Hicks, National Leader of PwC’s Valuations, Forensics & Disputes Practice, and Calum Semple, an Operations and Consulting Partner. This interview series, featuring new topics and guests every episode, is designed to valuable insight into some of today’s hottest issues affecting your business.
Vanessa: This is Vanessa Iarocci, your guest host on today’s edition of PwC’s strategy talks. I am joined today by Sage Newman. Sage is an Associate Director in the Corporate Advisory Services Practice of Eurasia Group. He received a BA with Honors in Government from Harvard University and has recently completed MA MBA at the Johns Hopkins University. Prior to joining Eurasia Group, Sage was a Legislative Analyst at the Rand Corporation where he managed congressional relations and outreach for Rand’s national security international affairs, terrorism and homeland security units. Welcome Sage.
Sage: Thank you Vanessa.
Vanessa: The topic of our broadcast today is Europe and we have been hearing a lot about Europe since 2008 but recently concerns about contagion in the Euro zone have increased after some public comments have been made about Greek restructuring. Can you comment on this a bit.
Sage: Sure and also thank you for having me speak today Vanessa. Yes, a lot of the markets have been concerned about different rumors about restructuring in Greece recently but another recent event that has spooked the market has been the recent release of the 2010 budget deficit, which is actually much higher than previously forecasted. The budget deficit was forecasted at 9.percent but now actually is showing at 10.5 percent#160; So this has caused the markets to be concerned, about potential contagion along with these other rumors as you stated early about the overall restructuring. Now if you look at Greece, these are just issues that are immediate just now but there are still other risks that are coming up on the horizon and if you look a couple of weeks ago that Greece had announced their new fiscal plan for 2012-2015.
This plan is calling for 23 billion Euros in austerity measures to be taking place over those three years and this is on top of the 3 billion Euros of austerity measures that already took place in 2011. Now this is something that needs to be done in order for Greece to get themselves back to economic growth and their fiscal house in order, but they also need to be looking out to generate revenue and one of the ways that they are trying to do this is moving forward with a plan to sell state assets and they have a plan to try to sell about 15 billion Euros worth of state assets by 2013 and try to raise about 50 billion Euros by 2015.
So there is a lot that needs to be done by the Greek government right now in order to get their fiscal house in order, but they are taking the right steps. I think that it’s interesting because this is a risk that is immediate and it’s going continue because the Prime Minister Papandreou needs to really introduce this reform to parliament and it needs to be adopted by parliament and this is gonna take a lot of political capital by the Prime Minister to push through. But the real concern is even if you were to push this through there is still a risk of dealing with implementation and this stems from the fact that if you look at the previous austerity measures they been very horizontal in nature and what I mean by horizontal in nature is that they been impacting groups across the entire citizenry or they been impacting groups that are very large like public sector groups. But now the austerity measures are gonna really be focusing on specific interest groups so now they’re going to be much more surgical; they’re going to be much more vertical in nature. And what you’re gonna start is to see is gonna be much more push back and its coming from these groups to try to negate any reform. So the risk stem from two different places, one they’re trying to get actually austerity measure passed through parliament and then get it implemented when they actually do get it approved.
Vanessa: So you know sounds like there’s definitely a risk to implementation for the restructuring? Does that mean were headed towards a bailout scenario or a default scenario?
Sage: This is what’s concerning the markets. It’s a very good question - and what’s going to happen is to see if first of all they can pass it through parliament and if they can’t pass it through parliament it’s an immediate red flag for the markets, and it’ll probably lead to new elections for the government. If they are able to pass through and it gives the Greece government more time to really focus on these measure and really trying to work through the political dynamics of trying to implement the plan, but you have to understand this is also in a larger backdrop of a very difficult macro economic situation. This is the third consecutive year of contraction going on in Greece - which is very bad. Besides that, if you look at unemployment in the country it’s at about 15 percent across the entire country, and if you look at the youth employment its around 37 percent, so you know Greece has a lot of specific concerns and risks that they’re gonna have to look at not only now but across the horizon.
Vanessa: Right and you alluded to the weak macro environment, so are there even options for a Greek bailout? Is there a lender of last resort?
Sage: I think that you know what is interesting when you look at the different facilities that are actually out there right now to help on out for bailing out sovereigns, the facilities that are out there are what’s called EFSF, which is the European Financial Stability Facility, and then off for 2013 there’s gonna be a new facility called the ESM which is the European Stability Mechanism. When the ESM is up and running, the EFSF is gonna be a passive vehicle. But there’s a lot of issues actually to the funding of theses different vehicles. And I can go into that in detail if you’d like.
Vanessa: Yeah, if you could just highlight how the vehicles would be funded and who are they investors?
Sage: Sure, if you look at EFSF this is the primary bailout vehicles for sovereigns right now, but there’s two major issues there dealing with this vehicle. The first one stems around the fact that the actual amount that this actual facility will have in order to support bail outs and restructuring. That number has been decided in principal to be 440 billion Euros; it’s quite a lot. The issue stems from the fact that it only has 250 billion Euros as a capital base and they have to maintain that capital base right now to maintain the Triple-A rating - so there is a shortfall of 190 billion Euros. So where’s that coming from? Well, you see that a lot of these Sovereign states they do not wanna be adding more capital, and the reason is if they do so it’s gonna be impacting their debt to GDP ratios, so they’re very hesitant to do so what you have now is just guarantees on this 190 billion, which is really I would say not allowing the facility to be as flexible and strong as could be. The other issue with EFSF is when you look at the flexibility of the organization to respond to different crises. What it cannot do is actually be preemptive, what mean by preemptive is it cannot buy debt on the secondary market. It can only buy debt on the primary markets, and this is a big issue because it leads to much more flexibility of the fund helping out different sovereigns when they get into crises.
What you’re starting to see and what has been going is the ECB which is the European Central Bank, they have been acting as this lender you could say last resort, adding a lot of liquidity into these market places, uh when they needed bail-outs. It’s pretty interesting, when you look at the ECB, ECB’s core mandate is not to help struggling sovereigns or banks, um you get bailed on out because of what’s going on in the market place via these extra-ordinary interventions that they are doing.
What their core mandate is price stability or dealing with inflation, so you know they are injecting all this liquidity, or at least what they are doing very intelligently is working with domestic banks to say you need to increase your reserve ratios to sterilize you know that new liquidity into the market place. And therefore you know counter-act any inflationary impact. But you have this other dynamic where the ECB is also looking to try to address its core constraint of inflation. It’s moved its overall core rate about 25 basis points…. Net 1.25 percent and it’s looking to try to move it up probably another 50 basis point by the end of the year. So this is going to be counteracting any inflationary pressures but what it’s going to do is also going to be stymieing some of the growth that’s gonna be necessary in both Southern and peripheral parts of Europe. So it’s interesting dynamic of what’s going on right now with the ECB because of the lack of power EFSF has.
Vanessa: Interesting! So we have bailout mechanism and potential inflation! How does Angelo Marko feel about this, and how is she going to survive the election?
Very interesting question! The Germans have an interesting role in this. Let me jump back because I think we want to just touch upon what’s called ESM, which is called European Stability Mechanism, and the Germans are very involved in this process as well. This ESM is gonna be the permanent vehicle after 2013 to help sovereigns with restructuring and bailouts.
Now, the Germans have been very involved with this process because if you actually look at the actually look at the limit for this mechanism it’s at $800 billion, but the inpaid capital right now is only $80 billion, so now there’s a gap of $720 billion, and as I stated earlier with EFSF countries don’t wanna be adding more capital because its gonna impact their debt to GDP ratios. So what you have is not only guarantees on this $720 billion but you also have what’s called callable capital, this mean you have board members… they’re gonna create a board for ESM. They’ll be able to go to sovereign capitals and immediately call upon capital to be distributed into ESM so that they can allocate that to help out any struggling sovereign. But the Germans, here’s when the Germans get involved…. The Germans don’t want actually this type of power to exist with ESM and you have different parliamentarians that are in the Bundestag, which is the lower house of the German Parliament, that are saying this needs to be subjected to a vote. What they are effectively doing is neutering the strength and the flexibility of ESM to really address different types of sovereign debt threats that happen in the future because it needs to be subjected to a vote in a domestic capital.
So the Germans are really pushing back on that. And I think, getting back to you on your second questions, what about the Germans and what is their view on this. It’s quite interesting, you have to look at this from a German perspective, more hazard perspective, The Germans have been engaging in very difficult structural reforms in the last 10-15 years, and they said this is what’s gotten them into the very good economic position they are in today. But if you look at the Southern countries in Europe and if you look at periphery as well they’ve not engaged in the same sort of difficult reform and they now have had to pay for the price of economic malfeasants, but the Germans are saying well they’re not paying the price for economic malfeasants it’s the German taxpayers that will be paying the price for economic malfeasants, because they are going to be the ones funding both these vehicles, EFSF and ESM the most. So they have been very hesitant to try to stand up these two vehicles. It’s quite interesting, and they been moving forward with more of this incrementlist approach, so they been dragging their feet to stand these institutions up so the market pressure can be placed on these other Sovereign nations in the periphery and in the South to push them to make sure they are moving forward with structural reform. So when you look at it from perspective it’s quite interesting.
Vanessa: Interesting, and so we’ve spent some time chatting about the two big players, Greece and Germany. What about some other countries such as Portugal and Spain, what’s going on and what’s the outlook?
Sage: Sure, and I mean Portugal is an interesting story, I think what I can do is provide a little bit of background by having a timeline, as what’s happen and where is it going in the future. If you look back to late March, The Prime Minister, José Socrates, he was trying to push through parliament a very strong package for austerity measures, but this was rejected by parliament. And because it was rejected he resigned. Which was then gonna be forcing new elections to come up, I think it’s going to be happening sometime in June. From then till now a few things have happened. They have actually created a new caretaker government, where the caretaker Prime Minister is again Socrates, but the other thing they’ve done is formally requested for a bailout.
What’s currently taking place now is there’s negotiations moving forward between what’s known as the Troika, which is the European Commission, European Central Bank, and also the IMF, as well as with government officials and political party leaders in Portugal, and what they’re doing is trying to negotiate the details surrounding the bail-out package. And what we think is that which information has not really been disclosed of what’s going on during discussions, what we think is gonna happen is that the two main parties which is the Popular Party and the Social Democratic Party, are gonna be supporting any new bailout package once the new government is formed. If they were to come into government they would also be supporting the package, as well we’ve heard some statements coming from other right of center parties that said that they will not be blocking and therefore also supporting any sort of bailout package that comes through parliament when new elections happen sometime in June.
What you hear on the other side of the spectrum is that the Green the Communists and also the Left Bloc who make up a lot of the parties on the left center part of the government said that they will not be supporting austerity measures, and they said that Portugal should not even be talking to any International Institutions. But if you look at polling data right now, they only represent about 15 percent. So they really are not gonna have too much of an impact. So when you look for the bail-out coming out in the future, looks like it’ll be passed by the government.
Vanessa: Interesting! There’s been a little bit of noise on Finland interfering with that? What’s your opinion on that?
Sage: I think that it’s a bit more noise right now. And the True Fins getting into government right now, everyone’s concerned about that. What’s going to happen is there will be work arounds, weather its gonna be work arounds by the Fins to make sure that they’re gonna be supporting any package moving forward, or work arounds by other actors to make sure that they would be supporting of bailouts, I don’t think that a true threat. It’s just more noise.
Vanessa: Interesting… and Spain?
Spain is an interesting situation too, because Spain is a big economy first of all, I mean if you look at Spain, it represents 12 percent of Euros own GDP in comparison to 6 percent for Greece, Portugal, and Ireland combined, so you know Spain if it were to turn South it would be a big problem. What you’re getting right now is some noise around Spain in the market place. This stems from what’s going on with Greece and Portugal. If you look at yields on 10 year debt for Spain, back in October 2010 it was at 4 percent, now it’s at 5 percent. It is going up and does have an impact. However Spain is really been moving forward robustly with reforms. They’ve been engaging labor reforms, and they been really trying to address their fiscal deficit. So if you look the true risks that are in Spain, they are around the financial sector.
The Bank of Spain right now has been working with different financial entities throughout the country to come up with a new restructuring plan and strategy, and they’ve approved this and they are gonna be injecting some capital into the struggling entities. The real risk is if these entities come back and say we need more money, and if they come back and say more money, then the markets become very very concerned, what does this mean?! And you’ll see bond spreads and yields trying to get even wider, and then it can be leading to more potential thoughts and risks for contagion. But right now I don’t think were there at the moment.
Vanessa: Fascinating! So so many moving parts, do we have any historic precedence for this scale of Sovereign default? I shouldn’t’ say default. Do we have any historic precedence for this scale of Sovereign crisis?
Sage: I think that in Europe this is one of a kind right now, and when you look at what’s being done, and what will continue to be done, I think we’re going to be writing history as we move forward.
Vanessa: It’s a real unknown!
Sage: It is a bit of an unknown, it’s one of these situations is the more you look under the hood the more you start to get concerned. This is why I think you really need to put a line underneath the crisis. And I think that you know what we had previously talked about these two vehicles to support any Sovereign bailout and once you get those stood on up, I think the markets will start to come on down but were not there yet but as we get closer to EFSF really becoming a passive vehicle moving to the full standing on up of ESM which will be the permanent vehicle hopefully things will be resolved by then, if not then were in uncharted territory.
Vanessa: And is a Euro zone breakup plausible? If we go there…into uncharted territory?
Sage: I think no, I think the consequences for a break up, and someone leaving the Euro zone, are catastrophic - and I think most people recognize that fact. There’s a whole set of different risks that’ll occur and I think people are gonna be doing everything they can to make sure that doesn’t happen. When people talk about if you are going to the one of the responsible countries such as Germany leave or you going to see one of the irresponsible counties such as Greece leave so they can really start to manipulate their overall exchange rates, in order to try to make it more easy to export their way out of the problem. It’s not gonna happen. And I think that’s a consensus across the entire Euro zone um so if anyone talks about that, my assessment is its still just noise.
Vanessa: OK, one last question, which is a little bit of a loaded question! S&P recently warned on US debt profile. Is the US headed down a similar path?
Sage: I think when you look at the United States, it’s interesting. I think one of my colleagues coined this term: when you look at the new emerging markets or what’s called the “sub-emerging markets,” those being a lot of the developed countries, and including the United States it is a situation where you are seeing right now that the debt ceiling right now needs to be raised, and if it’s not raised its will be once again a complete uncharted territory, and what this means is how the financial markets are gonna react, however what the United States needs to do is they always need a crisis to happen before they really act.
And right now they are allowing this crisis to happen because there are political gains to be made, and the Republicans are gaining from the fact that the deficit is so high and they are trying to put pressure on the budget so they could really reduce it and using this as an opportunity to do so. So when you look at the United States will it really move forward with the a strict default, I don’t believe so because I think everyone understands you know the catastrophic impact of this, and the United States will make sure that they do what they need to do before that happens.
Vanessa: Fascinating stuff! For more information or to download our joint report with Eurasia Group entitled Evolving Outlook for Business in Central or Eastern Europe, visit our website at pwc.com/ca/emdeals.
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