European Budget Positions

Clay Smolinski, portfolio manager of the Platinum European Fund, dissects the current fiscal positions and policies of the governments of Greece, Italy and Spain.

Over the past two years the European stock markets have danced along to a recurring pattern. The steps have been:

1. the market sells down on the latest evolution of the European sovereign crisis,

2. investor panic intensifies as European policy makers publicly disagree on an appropriate solution, and

3. eventually a substantial policy response is agreed upon and the stock market goes on a massive relief rally.

Having seen this sequence play out in February 2010, August 2011 and most recently in May 2012, investors are pondering whether the latest funding plan by the European Central Banks (ECB) signals a turning point that will break this pattern of crisis escalation.

The ECB’s offer is essentially this – they will provide unlimited low cost funding to a country in need, IF that country makes a written agreement to execute a deficit reduction plan supervised by the International Monetary Fund (IMF). This is a very powerful tool, as it completely removes the doubt over long-term financing. With financing taken care of, the key issue that will determine the future of the Euro is whether the peripheral governments can balance their budgets without disenchanting their public to the point they vote to exit.

Readers have probably noted the financial press is fairly poor in communicating any real detail of what the governments have actually achieved in reducing their budget deficits; instead we generally just get lots of emotive articles about the lack of spending cuts etc. Therefore, in order to make a judgment on what the path to fiscal redemption will look like, it is worthy to lay out the basic facts around the government’s current budget positions, what action they have taken, and what further they need to do. For this exercise we will concentrate on Greece, Italy and Spain.

Greece

Greece makes an interesting case study; as the first country to be engulfed by the crisis it has been working on its fiscal adjustment programme for the longest.

The first thing you will notice here is the oft repeated view that the Greek government has 'done nothing' to fix its budget is a myth. Points to note:

1. The government has not been able to increase its overall revenue take in the face of a rapidly shrinking economy. The government has raised taxes and improved tax collection (note how revenue has grown as a percentage of GDP) but this has been offset by a lower income base to tax.

2. They have been able to implement large cuts to spending, and this has not just been limited to the less politically sensitive areas like the purchase of third party goods and capital expenditure. The public sector wage bill and welfare payments are down -20% and -12% respectively since 2009.

3. Since 2009, Greece has seen its economy shrink by -16%, its government cut spending by -25% and its unemployment rate increase to 23%. While the election was close, despite this environment the citizens have voted to remain in the Euro.

All up the Greek government is close to achieving a primary balance (revenue minus all non-interest expenditure); however, if we include their interest bill they still need to find another €16 billion to balance their books. To do this without growth in revenue would mean the government needs to cut its non-interest spending by another -20%, which is simply unrealistic. You can see why there is more serious discussion at the European level around a stimulus plan to restart economic growth in Greece, and we would not be surprised to see Greece seek further forgiveness of interest at some stage.

Source: Greek Ministry of Finance and IMF

Italy

It is clear the position of the Italian government is far better than the news headlines suggest. They are on track to record a €44 billion primary surplus by the end of this year.

Points to note:

1. The majority of the adjustment by the Italian government to date has been via increased taxes. They have successfully pushed through tax increases to the tune of €51 billion, while the economy in nominal terms has grown slightly.

2. The government has done little in the way of reducing expenses. They have made cuts to the usual ‘easy' areas of capital expenditure and other sundry expenses.

3. Welfare costs have increased by €24 billion, whilst the wage bill and purchases of third party goods and services are flat. Total non-interest expenses have fallen by only -€5 billion since 2009, a reduction of less than 1%.

All up, the Italian government is in a fairly strong position. They need an adjustment of €43 billion to show a fully balanced budget, and even if the whole €43 billion was achieved via spending cuts, this would only account for a -6% reduction to total non-interest spending. Historical precedents tell you this is far from an unrealistic goal, and if the Italians have modest success executing on the new deficit reduction plans issued by the current Monti government, it is highly likely that they will have balanced budget by 2014.

On this basis the fear around Italy looks over-played.

Source: Italian Ministry of Finance and IMF

Spain

The position of the Spanish government is far weaker than their Italian compatriots. Despite some success in increasing taxation revenue and having already cut non-interest spending by €45 billion to date, they still need to find another €75 billion to be able to deliver a balanced budget.

One positive is that the Spanish government has a relatively low tax take as a % of GDP which would point to further leeway to increase taxes. The negative is that Spain has already aggressively cut capex and spending on third party goods – further progress requires them to go after the difficult areas of wages and public welfare.

The Spanish cannot be accused of ignoring the need for action and in response; the Rajoy government has released an enormous budget reduction plan. On the revenue side, VAT increases, higher taxes on fuel, alcohol and tobacco and removal of corporate tax breaks are expected to net €20 billion. Another €20 billion of expenses will be cut in the form of reducing government subsidies for prescription drugs and surgical procedures, teaching hours and classroom sizes will be increased in education, and 500 overlapping government departments are scheduled to be closed.

More importantly for the long-term health of the economy, these cuts are being accompanied by deep reform of the Spanish labour market. The power of industry-wide collective bargaining agreements are being removed, the conditions for fair dismissal of employees has been significantly broadened and once the fair dismissal conditions have been met, employers have far more flexibility to alter working hours and pay as a first option rather than automatically firing staff. In addition, if lay offs must occur, the maximum redundancy payments have been reduced. All of this will help the Spanish labour force improve competitiveness versus its European peers.

Overall, despite some good work the reality is the sheer size of the adjustment needed means Spain will remain the focal point of the crisis for some time to come. €75 billion represents close to 20% of current non-interest spending. As a benchmark, if most of this is achieved via spending cuts, this would mean Spain would have cut its total non-interest spending by -30% since 2009. Greece has shown reducing spending by this level is not impossible, but with a starting climate of 25% unemployment the path to doing this is guaranteed not to be smooth.

Source: Spanish Ministry of Finance and IMF

So returning to our initial question, is the ECB funding plan the turning point towards the resolution of the European sovereign crisis? The ECB funding plan in a basic sense is another extension of the bailouts we have already seen for Greece, Portugal and Ireland; funding is provided on the condition that the government balances its budget. The difference this time is that the funding is coming from a politically independent body and given the ECB's ability to print money, the size and duration of the bailout is credible.

The success the Spanish government will have in adjusting its budget and the political will of its voters remains to be seen. However, we see both parties taking a pragmatic approach. No doubt the Spanish will fall short of their initial targets, but as long as some progress is being made the ECB will continue to provide funding, and allow the adjustment to be made over a longer timeframe to soften the blow on the overall economy. If we get evidence the Spanish are making headway with their budget, it will be fair to say this ECB plan is indeed a turning point towards a final resolution of the crisis.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.