2. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
The most important question for investors over the next few years is whether Spain Spain’s euro departure would be another
will leave the eurozone. If it does, we should assume a Lehmans-style market Lehmans-style event
reaction, with equities plunging 50%, before rebounding strongly some three-to-nine
months later. Many banks across Europe may need to be nationalised. The world
will experience another global macro-shock. Africa and Asia will still grow, but
emerging Europe and Mexico will be hit hard. Investors will flee to US treasuries
and bid yields down to around 0%.
Of course none of these investment strategies are correct today. Rather the But we believe buying global equities is a
opposite. We don’t believe for a second that Spain will leave the eurozone in the good strategy today
next few months. So investors today should be gearing up for a somewhat better
global outlook going into 2013 – selling US treasuries in favour of EM/frontier
equities – and indeed, perhaps buying Spanish bonds too, as 2013 will likely see the
ECB step into the bond market.
Where we increasingly differ from the market is regarding the outlook for 2014-2015. It is 2014 where we differ from the market
Today, we read that some expect US treasuries to sell off aggressively that year,
ahead of a Fed rate hike in 2015, because US growth will be picking up strongly
towards 3.0-3.5%. If that is correct, then EM hard and local currency bonds will
become significantly less attractive. Instead of debt investors hunting yield – a hunt
that today has already created a global ‘hard’ currency bond bubble – the US
treasury market will itself begin to offer yield. Would the markets still over-subscribe
a debut Zambian eurobond more than 10x, at around 5.5% yield, if US treasuries
were offering 3-4% for 10 years? Would South African or Turkish or Russian local
currency bonds look so attractive at their low real yields? A more bullish outlook for
the US and world economy in 2014-2015 – while positive for EM growth – would
also have some negative impact on EM and frontier markets.
But it is 2014-2015 that we believe carries maximum deflation risk. The work we
have done below tells us to be increasingly worried about Spain’s ability to remain in
the euro over those years.
We will not make Spain’s departure from the euro our base-case forecast for any We will not make Spain’s euro departure
economy or stock. No other bank will. If we forecast the start of a sharp western the base case for our forecasts, even
recession in 2014-2015, then our earning numbers for shares, and our assumptions though we think it is likely
for currencies, would become radically different from the market’s, require a very
different ‘fair value’ for a share, and make us entirely useless for investors trying to
trade in 2013. In addition, there is still a good chance (albeit less than 50% as we
see it today) that something happens to surprise us positively. So we will stick close
to consensus for our US and European GDP forecasts, but will strongly doubt them.
But most importantly, our pessimism about Spain is rooted in assumptions about the The Spanish people may have more
level of pain that a population can take, and we may be wrong. The Spanish may fortitude and resilience than any other
prove to have more fortitude and resilience than any other society in history. society in history
Why have we shifted from 50/50 to 60/40?
This economist’s concerns about Spain are not new. A Spanish financial newspaper We have shifted from seeing a 50%
cited them back in September 2010, just months before moving to Renaissance chance of Spain staying in the euro to
Capital. Indeed, it was these concerns that were a push factor for the move to this 40%
emerging market investment bank. But until now, we’ve argued that Spain had a
50/50 chance of pushing through the tough reforms that Germany recommends, and
that the Spanish people endorsed with a landslide victory for the centre-right Popular
Party and Prime Minister Mariano Rajoy himself in November 2011.
The trigger for our change of view was the IMF’s World Economic Outlook forecasts Because no major forecaster sees jobs
of October 2012. The fund forecast that the maximum growth Spain could expect as growth in 2013-2014
late as 2017 is just 1.7%. That looked to us to be too low to create jobs in Spain, and
indeed, since at least 1981, Spain has not created jobs with growth of less than
2
3. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
2.4%. We would have to assume that the structural labour market reforms enacted
already in 2012 have lowered that growth threshold to 1.5-1.7% to believe that Spain
will see jobs created in 2015-2017. That is pretty heroic, so the implication is
Spain’s unemployment rate will keep rising.
Figure 1: GDP and employment data in Spain 1980-2017E
Employment % ch GDP % ch
Since 1981, Spain has
8
not created jobs
6 when GDP growth was
less than 2.4%
4
2
0
-2
-4
-6
-8
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: IMF World Economic Outlook
Very oddly, in our view, the IMF believes unemployment will fall, from 25% in 2012-
2013 to 24% in 2014 to as low as 20.5% by 2017. We strongly disagree that the
IMF’s forecasts for growth and unemployment will prove to be consistent. If it is right
on growth, we tentatively assume another 1.5mn jobs will be lost from 2012-2017
and unemployment will rise above 30%.
Figure 2: GDP % ch (rhs) and net job creation (000s, lhs) with Renaissance Capital forecasts for 2012E-2017E
GDP real pc change Net job creation (000s, Rencap forecasts 2012+, lhs)
1500 5.0
These growth rates don't
create jobs in Spain 4.0
1000 3.0
500 2.0
1.0
0 0.0
-1.0
-500 -2.0
-1000 -3.0
-4.0
-1500 -5.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: IMF World Economic Outlook, Renaissance Capital estimates
Indeed, the EU Commission and OECD have both now produced forecasts that
differ from this rosy IMF view. The EU Commission sees 26% unemployment in
2013 and the OECD sees 27% in 2014. These are more credible but may prove too
low.
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4. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 3: Unemployment rate forecasts (EU Commission, autumn 2012), OECD (2012, Volume 2), IMF
(October 2012)
Spain unemployment rate (%)
OECD IMF EU Commission
29
27
25
23
21
19
17
15
2009 2010 2011 2012 2013 2014 2015
Source: IMF World Economic Outlook, EU Commission, OECD Economic Outlook Volume 2
What this means is that Spain will have to endure an unemployment rate of 25% or Spain has managed one year of 25%
more for 2012-2015. So far, it has managed just one year. Even if you are as unemployment; it probably has to
optimistic as the IMF, Spain will need to manage an unemployment rate of 20% or manage three more years
more for eight years. So far Spain has managed just three, and voter anger was so
high in 2011 that the (then) ruling Socialist party suffered its worst-ever election
defeat in three decades at the local elections, before getting hammered in the
parliamentary elections.
Most damaging of all is the lack of hope that we believe will have engulfed Spain by Growth well above 2% is required to
2014. It is not just that unemployment will have risen to 27% if the OECD is correct, create a feel-good factor
or 30% if we are correct, but that there will be no feeling of hope of improvement.
Note that even if growth surprises on the upside before then, electorates do not feel
positive about growth of up to 2%. Former US President Bill Clinton famously beat
former President George H Bush in the 1992 election with the tag-line, “It’s the
economy, stupid”. Yet the economy was in a strong recovery mode in 1992 and
high-yield bonds were rallying hard. The electorate did not feel it. Only 3-4% growth
feels good to a developed market electorate. Spain will not have that in the IMF
forecast period even in 2017.
So having got worried about the unemployment outlook, we hunted around for data
to judge whether Spain can cope with this unemployment rate. The answer is very
discouraging.
What country can bear unemployment this high? And for
how long?
No economy (as far as we are aware) has ever sustained this unemployment rate Spain has had high unemployment
and maintained a peg to a fixed exchange rate. Since the Second World War, we before, but always with good reasons to
can find no example of a European country that has seen sustained unemployment hope it would decline
above 20% except Spain itself, with three years above 20% in the 1980s and five
years in the 1990s. But in neither episode did unemployment top 25%. In addition,
Spain then had a currency that the market could (and did) force weaker to help
produce jobs. Moreover, and we believe this was of huge psychological importance,
the 1985-1987 unemployment peak coincided with Spain’s entry into the EU which
gave many hope that life would improve. The 1993-1997 period coincided with Spain
being given approval to adopt the euro, which again provided hope of growth and
jobs. Indeed, private sector debt trebled from 70% of GDP to nearly 210% of GDP.
Both times, the population was right to be hopeful.
4
5. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 4: EU entry in 1986 and euro adoption (and a massive rise in debt) helped cut unemployment
previously – neither can help now
Spain
Private debt (% of GDP, lhs) Govt debt (% of GDP, lhs) Unemployment (% rate, rhs)
Spanish unemployment plunged as
300 private sector debt doubled. 30
How high will it rise in a
250 deleveraging scenario? 25
200 20
150 15
100 10
50 5
0 0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: IMF
Today, we see nothing to provide hope to sustain those unfortunate enough to be There is no hope provided by any major
unemployed. For households, wages are still likely to fall to boost competitiveness. forecast today
Households are deleveraging and defaulting, not borrowing more to fuel
consumption. We cannot see how the government can dramatically increase
spending, when the budget deficit in 2014 may still be 6% of GDP, double the 3%
deficit limit aimed for by eurozone member states. We do not expect companies will
decide Spain (over Poland, for example) is the best place to invest in for future
production. Meanwhile exports are too small to give Spain the chance to echo
Ireland’s recovery.
Figure 5: Spain: Key forecasts by OECD, IMF, EU Commission
2010 2011 2012 2013 2014
OECD Economics Outlook, Volume 2012 Issue 2
GDP (real % ch) -0.3 0.4 -1.3 -1.4 0.5
Unemployment (%) 20.1 21.6 25 26.9 26.8
Gen Govt budget balance (% of GDP) -9.7 -9.4 -8.1 -6.3 -5.9
C/A balance (% of GDP) -4.5 -3.5 -2 0.5 1.8
IMF, World Economic Outlook, October 2012
GDP (real % ch) -0.3 0.4 -1.5 -1.3 1.0
Unemployment (%) 20.1 21.7 24.9 25.1 24.1
Gen Govt budget balance (% of GDP) -9.4 -8.9 -7.0 -5.7 -4.6
C/A balance (% of GDP) -4.5 -3.5 -2.0 -0.1 0.7
EU Commission, Autumn 2012 forecasts
GDP (real % ch) -0.3 0.4 -1.4 -1.4 0.8
Unemployment (%) 20.1 21.7 25.1 26.6 26.1
Gen Govt budget balance (% of GDP) -9.7 -9.4 -8.0 -6.0 -6.4
C/A balance (% of GDP) -4.4 -3.7 -2.4 -0.5 0.4
Source: OECD, IMF, EU Commission
If we go back to the Great Depression that began in 1929, we find plenty of The Great Depression saw
examples of high unemployment in the mid-teens and ranging up to 33%, and in unemployment reach 33% in the
every case, the country involved dropped its adherence to the gold standard, Netherlands; one of the last to leave gold
devalued and/or imposed capital controls. Fed Chairman Ben Bernanke wrote a very
good paper on this, and we can all see that he has learnt a lesson from history1. The
benefits of leaving gold were not just the export boost (US exports were a very small
share of GDP) but also the freedom given to governments and central banks who no
longer had to maintain a costly peg via inappropriately high interest rates.
1
http://www.nber.org/chapters/c11482.pdf
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6. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 6: The Great Depression: Policy changes on gold, capital controls and devaluation
Abandoned gold standard 1929-35
Suspension of Foreign exchange
with date, or abandoned full gold Devaluation
gold standard control
standard in 1931
Austria Apr-33 Yes Sep-31
Belgium Yes (1935) Mar-35
Denmark Sep-31
Estonia Jun-33 Yes Jun-33
Finland Oct-31 Yes Oct-31
France Yes (1936) Oct-36
(Jul 31 according to other
Germany Yes Jul-31
sources)
Greece Apr-32 Yes Sep-31 Apr-32
Italy Yes (1934) May-34 Oct-36
Netherlands Yes (1936) Oct-36
Norway Sep-31
Spain (not on gold) May-31
Hungary Yes Jul-31
Latvia Yes Oct-31
Poland Yes (1936) Apr-36 Oct-36
Romania Yes (1932) May-32
Sweden Sep-31 Yes Sep-31
UK Sep-31 Yes Sep-31
Australia Dec-29 Yes (1929) Mar-30
Canada Oct-31 Yes Sep-31
Japan Dec-31 Yes Dec-31
New Zealand Sep-31 Yes (1930) Apr-30
US Mar-33 Yes (1933) May-33 Apr-33
Notes: League of Nations, Yearboo, various dates; and miscellaneous supplementary sources
Source: http://www.nber.org/chapters/c11482.pdf
What is surprising is how long some countries lasted. Lightweights such as the UK This is roughly equivalent to 2014 for
managed two years of the Great Depression before coming off gold in 1931. The Spain
Netherlands held onto gold until 1936, by which time its unemployment rate had
reached 32.7%. This date – 1936 – will be roughly equivalent to 2014 for Spain2.
2
Note there are an absurdly large range of estimates for unemployment rates in the 1930s. To
take Sweden as one example, we have seen 30% cited in
http://www.ekonomifakta.se/en/Swedish-economic-history/From-War-to-the-Swedish-Model/
and 7% cited in http://www.tcd.ie/iiis/assets/pdf/Workshop25-26Feb2011-
Lindvahl_Responding_to_the_Crisis[1].pdf . The data source we have cited is perceived to be
reliable, but we should be aware of the variation.
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7. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 7: Unemployment rates, yellow to show departure from gold standard
Unemployment rates
1930 1931 1932 1933 1934 1935 1936 1937 1938
Belgium 5.4 14.5 23.5 20.4 23.4 22.9 16.8 13.8 18.4
Germany 15.3 23.3 30.1 26.3 14.9 11.6 8.3 4.6 2.1
Netherlands 7.8 14.8 25.3 26.9 28 31.7 32.7 26.9 25
Poland 12.7 14 15.6 16.7 16.3 11.9 11.8 12.8 8.8
UK 11.2 15.1 15.6 14.1 11.9 11 9.4 7.8 9.3
Sweden 12.2 17.2 22.8 23.7 18.9 16.1 13.6 10.8 10.9
Denmark 13.7 17.9 31.7 28.8 22.1 19.7 19.3 21.9 21.3
Norway 16.6 22.3 30.8 33.4 30.7 25.3 18.8 20 22
Switzerland 3.4 5.9 9.1 10.8 9.8 11.8 13.2 10 8.6
US (Lebergott) 8.7 15.9 23.6 24.9 21.7 20.1 16.9 14.3 19
US (Derby) 8.7 15.3 22.9 20.6 16 14.2 9.9 9.1 12.5
2008 2009 2010 2011 2012 2013 2014
Ireland 6.3 11.9 13.7 14.7 14.8 14.7 14.2
Greece 7.7 9.5 12.6 17.7 23.6 24 22.2
Spain 11.3 18 20.1 21.7 25.1 26.6 26.1
Portugal 8.5 10.6 12 12.9 15.5 16.4 15.9
Italy 6.8 7.8 8.4 8.4 10.6 11.5 11.8
Source: International Historical Statistics, Europe 1750-2000 by Brian Mitchell for 1930-38; EU Commission forecasts 2009-14, IMF estimate for 2008
Today we are in the equivalent of 1934, a year after 1933 when the US came off Countries that left gold last, suffered the
gold (unemployment was 21-25% depending on which measure you use) and three most
years after the UK had led a number of European countries off gold with it. These
countries, from Sweden to the UK, were the ones that suffered least from the Great
Depression. Those that devalued last, France, the Netherlands and Poland, suffered
for longer.
Figure 8: GDP % ch, 1929-1938, yellow for suspension of gold standard, blue for devaluation
1929 1930 1931 1932 1933 1934 1935 1936 1937 1938
Australia -1.0 -4.9 -4.5 3.8 5.7 3.8 4.1 4.8 5.7 0.8
Austria 1.4 -2.8 -8.0 -10.3 -3.3 0.9 1.9 3.0 5.3 12.8
Belgium -0.9 -1.0 -1.8 -4.5 2.1 -0.8 6.2 0.7 1.3 -2.3
Canada -0.1 -3.3 -15.4 -7.1 -7.1 10.6 8.1 5.4 9.4 2.6
Denmark 6.7 5.9 1.1 -2.6 3.2 3.0 2.2 2.5 2.4 2.4
Finland 1.2 -1.2 -2.4 -0.4 6.7 11.3 4.3 6.8 5.7 5.2
France 6.8 -2.9 -6.0 -6.5 7.1 -1.0 -2.5 3.8 5.8 -0.4
Germany 1.2 -6.1 -10.2 -9.3 10.5 7.7 9.1 10.5 6.0 7.7
Italy 3.3 2.7 -7.9 3.2 -0.6 0.4 9.6 0.1 6.9 0.7
Japan 3.1 -7.3 0.8 8.4 9.8 0.2 2.8 7.3 4.8 6.7
Netherlands 0.8 -0.2 -6.1 -1.4 -0.2 -1.8 3.7 6.3 5.7 -2.4
New Zealand 3.6 -4.3 -8.5 -2.5 6.6 5.0 4.7 18.6 5.4 7.0
Norway 9.3 7.4 -7.8 6.7 2.4 3.2 4.3 6.1 3.6 2.5
Sweden 6.1 2.1 -3.6 -2.7 1.9 7.6 6.4 5.8 4.7 1.7
Switzerland 3.5 -0.6 -4.2 -3.4 5.0 0.2 -0.7 0.6 4.8 3.8
UK 2.9 -0.7 -5.1 0.8 2.9 6.6 3.9 4.5 3.5 1.2
US 6.1 -8.9 -7.7 -13.2 -2.1 7.7 7.6 14.2 4.3 -4.0
Note: US
Source: International Historical Statistics, Europe 1750-2000, Brian Mitchell
The Great Depression tells us not to worry too much about Ireland or Portugal, and Unemployment in Ireland, Portugal and
that we should relax about Italy. Their 2012 IMF estimated unemployment rates of Italy have not reached unprecedented
14.8%, 15.5% and 10.6% are just not high enough to warrant the same concern that levels
we have about Spain and Greece.
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8. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 9: Unemployment rates: EU Commission data, average for 1992-2008 and then annual from 2009-2014
Ireland (unemployment) Greece (unemployment) Spain (unemployment)
Portugal (unemployment) Italy (unemployment)
30
25
20
15
10
5
1992-2008 2009 2010 2011 2012 2013 2014
Source: EU Commission
Departure from the gold standard or euro will be hard to
forecast six months ahead
One key lesson to take from leaving a fixed exchange rate is that they are very The departure from a fixed currency
unpredictable even three months ahead of time. Former US President Franklin D regime is hard to forecast even months
Roosevelt did not campaign in the 1932 election on the promise of leaving gold. But ahead of time
he enacted the policy quickly after coming to office, when the dire economic
situation forced a policy response.
The UK in August 1931 had just formed a new national coalition cabinet with the Public sector wage cuts forced the UK off
strength to push through harsh budget cuts required by the gold standard and the gold in 1931
markets. Yet it was cuts in public wages, leading to a naval mutiny (exaggerated by
the media) in September 1931, which forced the UK government to abandon gold. It
was a humiliating retreat for a country that had seen its return to gold in 1925 as
indicative of its global strength and imperial longevity. We should not for a moment
assume that officials found it easier to leave the gold standard than Spanish leaders
may find it to leave the euro.
The most recent example we are all more aware of is of course Argentina in 20013. Argentina was considering dollarisation
The country was still seriously considering full dollarisation in 2000. Harsh austerity in 2000, and did a big debt swap in 2001,
measures were still being advanced in 3Q01 supported with new IMF money. While just weeks before abandoning the dollar
the opposition won mid-term elections in October, the government was still peg
functioning and in November 2001 was able to enact significant debt swaps to
reduce the debt burden. Yet a bank run that began on 30 November, amidst 18%
unemployment, led to riots and chaos. In December 2001, Argentina was ruled by
four successive presidents4.
What timeline could we expect from Spain?
Having just argued that the end of the euro will be quick and unpredictable in its Spanish politics meant eurozone
precise timing, we are still foolish enough to make a stab at forecasting the date. We departure was not a threat in 2011-2012,
have not been worried for the past year, because in 2011, the Spanish had a chance and probably not in 2013
to vent their rage at the incumbent Socialist government and elected PM Rajoy with
a large majority, despite his promise that the road ahead would be painful and filled
with tough reforms. Few would cope well with the cognitive dissonance of taking to
3
http://www.guardian.co.uk/world/2001/dec/20/argentina1
4
http://fpc.state.gov/documents/organization/8040.pdf
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9. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
the streets to protest against a man who has delivered harsh tough reforms which
you have just voted for.
Figure 10: Support for the main establishment parties has fallen from 84% in 2008 to 54% in the latest
November 2012 poll
Socialists People's Party Plural Left
50
45
40
35
30
25
20
15
10
5
0
2007 - local 2008 - 2011 - local Nov-11 Aug-12 Sep-12 Oct-12 Nov-12
general general
Source: Wikipedia
Even taking to the streets in Rajoy’s second year (2013) will prove a little difficult to
reconcile with having voted for him in 2011. Yet already there are murmurs of
discontent, that Rajoy has been unable to keep his promises.
We assume that by 2014, the Spanish will be able to justify to themselves that Rajoy We believe 2014 could be the crunch year
has failed them, and that his reforms have failed to deliver prosperity. People may
then take to the streets and demand change.
There is a chance that the Rajoy government survives until a heavy defeat in It is hard to believe in an unchanged
parliamentary elections in December 2015, but it seems hard to believe the policy stance until elections in December
electorate will be that patient. And today no large party exists which offers the 2015
Spanish a choice. That will change. No-one outside Greece had heard of Alexis
Tsipras before May 2012, yet by June he was seen as a plausible prime minister.
For both Greece and Spain, we tentatively assume that summer is more likely for
political unrest than winter, given the example set by Argentina (summer is in
December), and many other countries.
Democracy is immortal in Greece and Spain
While we believe the 1930s is a valid template when considering economic policy 7,000 data points tell us democracy is
options, it is totally invalid to suggest that democracy is under threat. As we showed immortal in southern Europe
in the Revolutionary Nature of Growth (click here), no country has lost democracy
with a per capita GDP above $9,800 in 2005 PPP dollars, and it is very rare to lose it
above $6,000. Spain ($27,600 in 2009) and Greece ($27,300 in 2009) are hugely
above this figure. As PPP dollars do not collapse like nominal dollar comparisons
do, we can see no way in which democracy would be threatened in either Spain, or
indeed Greece.
In the 1930s, those countries with a per capita GDP of $5,000-6,000 (in 1990 Spain and Greece in 2009 were 8x richer
international Geary-Khamis dollars, so not quite the same) such as the UK, the per capita than Germany in 1933
Netherlands and Switzerland maintained democracy; Germany lost democracy with
a per capita GDP of $3,500 in 1933.
9
10. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
What about Greece?
Greece is in a very similar situation to Spain, but is further advanced on the road to Less than half of Greeks supported pro-
euro exit. A coalition government even before elections meant the electorate did not euro bailout parties in the June 2012
want to vote for either of the major status quo parties in 2012. The two dominant election
parties, New Democracy (ND) and PASOK, failed to get even 50% of the
electorate’s votes in either the first May election, or more worryingly, in the second
election of June 2012. Ahead of the second vote, the Greek population was
effectively told by the EU that EU loans would cease unless they voted for pro-EU
bailout parties. Only 42% voted for ND or PASOK. Fortunately, the Greek electoral
system gives bonus seats to the largest single party (the ND), but Greece’s
population is no longer a country committed to the euro.
And little wonder. Unemployment is also above 20%. The EU sees it rising from Greece’s GDP decline is frighteningly
23.6% in 2012 to 24% in 2013. The IMF sees it rising from 23.8% this year to 25.4% similar to Great Depression declines
in 2013. GDP is already down 17% from the 2007 level and will be 20% down from
the 2007 level in 2013. Of 17 countries during the Great Depression, only four
experienced a bigger decline than Greece has already experienced, and all major
forecasters assume the situation will get worse in 2013.
Our assumption is that the Greek government will fall in 2013, quite possibly also It will surprise us if the Greek
involving a further splintering of PASOK and ND too. Opposition leader Alexis government survives 2013
Tsipras will be very well placed to take power, having correctly told the electorate in
2012 that a vote for PASOK and ND would produce more pain. We assume his
premiership would take Greece out of the euro.
This might delay (or even prevent) similar happening in Spain. The experience of Greece’s euro departure might (initially)
many countries when they first devalue and default is one of financial and economic deter the Spanish from following
chaos – see Russia in late 1998 or Argentina in 2001-2002. Greece will look very
messy from the outside and feel worse from the inside. Assuming Greece leaves the
euro in 2013, many Spaniards may be deterred from following in late 2013 or early
2014.
However, by late 2014, Greece’s export recovery should have begun and the strong
growth and job creation in 2015 may prove to be as tempting to Spain, as the UK or
German boom of the mid-1930s was to the Netherlands and France in 1936.
We do not believe the market will react for too long to a Greek euro exit. Investors Global stock markets may fall 10-20%
have largely divested their exposure to Greece. French banks have taken large upon Greece leaving
losses to shut down their operations. Companies are moving their stock market
listing out of Greece. A 10-20% fall in markets over one-to-three months is as much
as we expect from this. We assume a fall, because Greek departure is not yet priced
in. Interestingly 80% of 56 fund managers in a recent Reuters’ poll expect Greece to
still have the euro by the end of 2013.
The Spanish and Greeks want to keep the euro
We have no doubt that those with jobs and savings would like to keep the euro. Spanish and Greek household saving
However, this no longer reflects the economic interests of many Greeks or structures are now very different from
Spaniards5. Our estimates suggest that most Spanish households now have more Germany’s
debt than cash or bond savings. Since the Greek bond default on the private sector,
and capital flight, we assume the same for Greece. It is ironic that by adopting the
euro, and greatly increasing personal debt levels, it is likely that Spain has moved
from being a country with a net savings structure that was well aligned with
Germany’s preference for low inflation and a strong currency, to becoming a debtor
5
for more detail on this – click here for Thoughts from a Renaissance Man, Who supports
inflation/deflation, 20 June 2012
10
11. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
country like the UK where society is more likely to favour a weaker currency, and
inflation to erode away that debt. Italy by contrast, remains a country where most
households should favour deflationary policies.
Figure 11: Household cash and bond savings minus household debt, as a % of GDP (2007-12 data)
140
120 US savings structure shifting
100 Deflation should be politically away from inflation preference
popular in these countries while Greece shifts towards inflation
80
60
40
Inflation should be politically
20 popular in these countries
0
-20
-40
Greece (2007)
Greece (2012)
US (2006)
US (1Q12)
Japan
China
Austria
Germany
Spain
UK
Indonesia
Russia
Hungary
Romania
Turkey
France
Italy
Czech Rep
Poland
Ukraine
Portugal
Source: IMF, various national sources
The Germans won’t allow the euro break-up – we disagree
We think the market makes two fundamental errors when it analyses Germany’s
attitude to the euro. These errors are rooted in market beliefs about Germany’s self-
interest in having a weak euro and its commitment to a political project.
First, the market assumes the Germans can’t afford a euro break-up because the
residue euro, or Deutschemark if it comes to that, would strengthen to excessive
levels and destroy German competitiveness. We could not disagree more.
Germany is a saving nation. Like Japan or Switzerland, and more recently China or The Germans can cope with an
the Czech Republic, this means its currency will appreciate over time because a appreciating euro/Deutschemark
saving nation will run current account surpluses. Those savings provide a cheap
source of funding for the banking system, and therefore the corporate sector, which
invests to become more efficient over time. In the 10 years after former US
President Richard Nixon took the US off gold, the Deutschemark appreciated from
DEM3.6/$ to DEM1.8/$. This did not destroy the German export base. In the
1980s, the Deutschemark appreciated from DEM3.2/$ to DEM1.5/$ and Germany
survived that too. Today, were it not for the euro, Germany might well have a
currency at DEM1/$ instead of DEM1.5/$, but we see no reason to believe that
German industry could not cope with it.
11
12. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 12: Deutschemark has appreciated for 40 years against the US dollar – and still we buy German
goods
DEM/$
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
1-Jul-74
1-Jul-79
1-Jul-84
1-Jul-89
1-Jul-94
1-Jul-99
1-Jul-04
1-Jul-09
1-Mar-71
1-Nov-72
1-Mar-76
1-Nov-77
1-Mar-81
1-Nov-82
1-Mar-86
1-Nov-87
1-Mar-91
1-Nov-92
1-Mar-96
1-Nov-97
1-Mar-01
1-Nov-02
1-Mar-06
1-Nov-07
1-Mar-11
1-Nov-12
Source: Bloomberg
Since 1971, both Switzerland and Japan have coped with a similar appreciation. Yet Switzerland and Japan both run C/A
both record current account surpluses and have massive FX reserves. Germany will surpluses despite massive FX
be in a similar position if it ever left the euro. Yes, Germany would suffer a little, but appreciation since 1970
in the long run, the deflationary bias of an ever stronger currency, is something
which German industry has always been able to cope with, and which German
households’ saving structure says the population should support.
Figure 13: Swiss franc has appreciated for 40 years and still the world’s 20th Figure 14: Japanese yen appreciates for 40 years and still their FX reserves
biggest economy runs the 9th biggest C/A surplus are among the largest in the world
CHF/$ JPY/$
4.5 400
4.0 350
3.5
300
3.0
250
2.5
200
2.0
1.5 150
1.0 100
0.5 50
1-Mar-71
1-Jun-73
1-Sep-75
1-Dec-77
1-Mar-80
1-Jun-82
1-Sep-84
1-Dec-86
1-Mar-89
1-Jun-91
1-Sep-93
1-Dec-95
1-Mar-98
1-Jun-00
1-Sep-02
1-Dec-04
1-Mar-07
1-Jun-09
1-Sep-11
1-Mar-71
1-Jun-73
1-Sep-75
1-Dec-77
1-Mar-80
1-Jun-82
1-Sep-84
1-Dec-86
1-Mar-89
1-Jun-91
1-Sep-93
1-Dec-95
1-Mar-98
1-Jun-00
1-Sep-02
1-Dec-04
1-Mar-07
1-Jun-09
1-Sep-11
Source: Bloomberg Source: Bloomberg
Second, the market assumes an open-ended German commitment to a political
project, but forgets the deal that Germany made. Germany agreed to sacrifice the
euro only if other countries were prepared to do the structural reforms required to
make the single currency work without massive federal transfers between countries.
Governments from Spain to Portugal, Italy and Greece said they would do these
reforms when necessary. Their elites believed that only the euro strait-jacket could
deliver the long-term prosperity that Germany enjoyed, and keep their populations
from following the devalue-and-inflate model they had adopted previously. They did
not do these reforms when times were good. Germany did, enacting the Harz IV
reforms of the mid-2000s.
12
13. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 15: Germany did harsh reforms when the world was growing – unemployment rates %
Germany Greece Ireland Italy Portugal Spain
Germany cannot afford large transfers to
30 Spain
Germany did Harz IV reforms
when times were good
25
20
15
10
5
0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: IMF
Today Germany is prepared to support governments on the reform path support, via
the ECB, but it cannot keep doubling down on the bets it is making. If pessimists
about Target-2 contingent liabilities are right, Germany’s public debt could rise from
80% of GDP to around 110% of GDP. Even if they are not right, Germany’s long-
term pension obligations and poor demographics mean it cannot endorse
significantly more fiscal transfers to Spain. We do not expect Germany’s late 2013
election to change this. Spain is largely on its own.
The ECB can step in and help out
Up to a point. Let’s optimistically assume the ECB piles into the Spanish bond ECB intervention is unlikely to create
market in January, and cuts yields on 10-year debt to 3%. If you are a Spanish jobs in 2013-2014
corporate, able to borrow at, let’s say 4%, and the economy will not grow faster than
1.7% by 2017, would you 1) invest your cash in the bond or 2) invest in a slow
growth economy. Or if you have a job in Spain, will you 1) borrow money or 2) save
money, when your wages are falling, house prices are falling, the economy is
shrinking and private sector (household and corporate) debt levels above 190% of
GDP are among the highest in the world. If Spanish bond yields were cut to zero,
then we would get a little more optimistic. What Spain really needs, and what any
country needs when its economy is weak, is interest rates in negative territory in real
terms. This is not likely. ECB support is closer to an aspirin, than a cure.
Spanish productivity has improved sharply – it has become much more
competitive
What all economists are looking for is a sharp improvement in Spanish and Greek
productivity and this is under way. However, the improvement in unit labour costs
partly reflects a fall in wages, but also the surge of unemployment to 25%. If
unemployment rose to 50%, the figures would probably get better still, but this is not
politically sustainable. Spain needs job creation and urgently. That is not in the
ECB’s mandate, although the maintenance of the euro may require it.
Note also that productivity booms were very obvious during the Great Depression
too. To cite one example we found last week, Belgium’s iron and steel sector saw
huge productivity improvements from 1930 until 1935, when Belgium finally left the
gold standard, and began to create jobs again.
13
14. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 16: Belgian productivity rose until it left the gold standard in 1935, (tonnes per man per year)
Smelting Crude and semi-finished steel
800
700
600
500
400
300
200
100
0
1930 1931 1932 1933 1934 1935 1936
Source: The Unbound Promotheus (1969), David Landes
Spanish exports have risen and the C/A deficit has disappeared
Among the reasons we have turned more pessimistic is that Europe’s double-dip The good news of Spanish export growth
recession has wiped out what was a potentially better story for Spain. Exports of has disappeared
goods (in euros) were up 20% in early 2011, but the latest data show this has
collapsed to nothing.
Figure 17: Spanish export growth (% ch in euros) - not exceptional in 2010-2011 has disappeared
Exports Imports
50
40
30
20
10
0
-10
-20
-30
-40
Jan-96
Jan-01
Jan-06
Jan-11
Sep-92
May-94
Nov-96
Sep-97
May-99
Nov-01
Sep-02
May-04
Nov-06
Sep-07
May-09
Nov-11
Sep-12
Jul-93
Mar-95
Jul-98
Mar-00
Jul-03
Mar-05
Jul-08
Mar-10
Source: Bloomberg
Exports of goods, services and income are now 35% of GDP, barely up from 34% of Total exports are a small share of GDP;
GDP in 2011 or 32% in 2001. And GDP is down 15% since 2007. This is a broader unlike Ireland or the Baltic states
measure than we would ever normally look at, purely to emphasise how unlikely it is
that Spain is to emulate the Irish or Baltic economic recoveries. Do click here to see
Thoughts from a Renaissance Man – why the Latvian model is not valid for Greece
(26 October 2011) – which highlights trade comparisons and that Latvia in 2011 was
3x richer than in 2000, even after its 2008-2011 austerity.
14
15. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 18: Exports of goods, services, and income do not look high enough as a % of GDP
Exports (Goods, Services, Income) as % of GDP Imports (Goods, Services, Income) as % of GDP
45
40
35
30
25
20
15
10
5
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: Bloomberg
The improvement in Spain’s current account to around 2% of GDP from deficits of The C/A improvement is due to no
10% of GDP looks good, but is due to a collapse of internal demand. Admittedly this domestic demand
means Spain is no longer seeing cash flow out of the country, but no export growth
means we are not seeing inflows either. On the FDI side, 2012 has seen more
inflow than any year since 20036, but we are sceptical this will be sustained.
Figure 19: The improved C/A and net FDI balances do not look good enough to warrant optimism
Outward net FDI Inbound net FDI C/A % of GDP Net FDI as % of GDP
8
6
4
2
0
-2
-4
-6
-8
-10
-12
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: Bloomberg
A massive depreciation of the euro to the $0.65/EUR levels seen in the mid-1980s
could save the day. It does not look likely, although the last year has seen some
belated Asian currency appreciation against the euro which will help Germany.
6
Among deals cited earlier this year, French energy management company Schneider Electric
is moving to buy Spain’s Telvent for EUR1.4bn; the IT sector and Barcelona geographically
have attracted investment in 2012 http://www.fdiintelligence.com/Trend-Tracker/Spain-takes-
larger-share-of-global-FDI-in-2012?ct=true
15
16. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Figure 20: $/EUR rate since 1975 -- Spain would benefit it we saw 1985 levels
1.8
Inflationary German
1.6 1970s re-unification
1.4
1.2
37-year average is 1.19/EUR
1.0 Volcker's
high interest
rates Tech bubble
0.8
deflates
Plaza accord
0.6
Jan-75
Jan-76
Jan-77
Jan-78
Jan-79
Jan-80
Jan-81
Jan-82
Jan-83
Jan-84
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Source: Bloomberg
The Spanish unemployment data are misleading – the black market will save
Spain
We totally agree Spanish unemployment rates may be misleadingly high. Even at Spanish unemployment numbers may be
the peak of the Spanish boom, there was still an 8% unemployment rate, which is far overstated – but are still far too high
higher than in other over-heating economies. But even assuming the real rate was 4
ppts lower, this still implies that Spanish unemployment today is around 21%. And
the unemployment rate is higher than it’s ever been and it is likely to rise further.
We also have no doubt that there is increasingly reliance on the black market in Growth of the black market is a negative
Spain – but this means less taxes for the government and therefore more austerity for government finances
from the public sector. In addition, wages are likely to be lower, which will make
servicing mortgages more difficult. Not paying taxes may help some manage for a
year or two, but it is not a sustainable long-term strategy.
The Spanish can emigrate
We hear many anecdotes about people leaving periphery Europe for jobs Spanish unemployment figures suggest
elsewhere, and are aware that many Spanish worked in France during the 1980s. less emigration is happening than in
However, we are more convinced by the anecdotes that the Portuguese, Irish and Italy, Portugal or Ireland
Italians are leaving – the boom in Angola is making it easy for the Portuguese to
move and the Irish are famous for their willingness to move (is there a capital city
without an Irish bar?). When we read that the Spanish Chamber of Commerce in
Brazil, the world’s sixth-largest economy, receives 100 CVs a month from Spaniards
looking to find work7, it does not take long to work out that if every one of them gets
a job, it will only be another 5,000 years before there is no Spanish unemployment.
More obvious still are the unemployment rates in those countries, which are 40-60%
lower than in Spain or Greece, suggesting emigration is helping Ireland and
Portugal, but it is not solving Spain’s unemployment problem.
The welfare state and being richer than our grandparents
In our view, the most important differences between the 1930s and now are 1) the The welfare state may be the single most
development of the welfare state and 2) the vast increase in wealth in Western important factor that could keep Spain in
Europe relative to the 1930s. Some would argue that the welfare state is partly the the eurozone
cause of Europe’s budgetary problems. But more important today is that the welfare
state means that unemployment is probably sustainable at far higher levels than
ever before, and for far longer than ever before.
7
The Future of Spanish Business, Financial Times, 30 November 2012
16
17. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
In addition, the personal stored wealth of an individual and their family, is far greater
than in the 1930s. Virtually all in the West have more savings and/or more
possessions than their grandparents had at the same age, again potentially giving
more resilience in the face of an income collapse. There is an offset to this of
course. Many of us also have far more debt, and also higher expectations regarding
their standard of living, meaning they may in fact struggle to cope with a sustained
loss of income. The West may actually be less resilient. We will find out in which is
true through Spain’s experience in the coming years.
So where’s the upside?
Spain’s euro departure would of course be messy, as in Greece, but the upside Export profits could treble if Spain leaves
would come swiftly. In the past 12 months, exports of goods, services and income the euro, on the currency effect alone
were worth 35% of GDP. Let us assume that profits are 10% of this, and are worth
3.5% of GDP or roughly EUR35bn. If the peseta devalued from ESP1/EUR to
ESP3/EUR, then exactly the same volume of exports would now deliver ESP105bn
of profits, giving more corporate tax revenues to the government and more cash for
companies to invest in Spain. Yes, peseta GDP would inflate too, but not as quickly,
and at first the benefits would be very significant. Exporters would boom once the
global macro shock began to fade.
Moreover volumes would rise too. Germany’s Volkswagen Spanish subsidiary,
SEAT, would see exports soar, perhaps at the expense of French and Italian
models. Domestic sales would benefit due to import substitution. Spain, already one
of the world’s most popular tourist markets, would gain a competitiveness boost
relative to France, Italy and Turkey.
Spanish companies in the Ibex 35 now make 61% of their revenues outside Spain8. Overseas profits would also help greatly
In pesetas, this would grow hugely, giving Spanish companies liquidity, and
producing corporate taxes that would again help close the Spanish fiscal gap.
Santander alone gets an estimated EUR5bn of its total EUR7bn profits from
overseas – though its adverts suggest its exposure to Spain is even less than this.
We would expect Spanish companies and Spanish corporates to bring money home
after devaluation.
This Spanish boom would lead to job creation, leading to more government budget
revenues, investment as well as higher domestic demand. For some years, the
boom could be self-sustaining even without a well-functioning banking sector.
Continuing rows with the rest of Europe over the Spanish default would last years,
but each year would give Spain more growth, and budget revenues and therefore
scope to reach a deal that satisfied its most important partners.
And Portugal, Italy, France?
It is hard to see how Portugal could remain inside the euro if Spain left. The far more
important question is could France and Italy remain inside? On that we have no
strong view.
Conclusion
We believe Greece is likely to leave the euro in 2013 and believe Spain may leave
by the end of 2014. The timing of each will be determined by domestic political
unrest and unlike for example, the chances of democracy surviving (100%), we find
this impossible to quantify. We cannot know how much pain the Spanish and Greek
people will be prepared to take. However history suggests staying in the euro with
unemployment at these levels would be an unprecedented achievement.
8
The Future of Spanish Business, Financial Times, 30 November 2012
17
18. Renaissance Capital Thoughts from a Renaissance man 11 December 2011
Positive surprises that would make us re-evaluate our views would include 1) any We need to see growth to turn more
sign that structural labour reforms already enacted have lowered the growth rate positive on Spain remaining inside the
needed to create jobs, 2) a significant euro collapse to well below parity to the dollar, Euro
which would boost European growth, 3) a huge shift in northern European thinking in
favour of GDP growth, 4) any sign of global growth accelerating hard which may lift
Europe’s prospects and 5) a massive Spanish default on private and public debt,
cutting the total debt load by perhaps 150% of GDP or EUR1.5trn, paving the way
for renewed borrowing by both.
Given the poor prospects for the eurozone in coming years, we continue to believe
that emerging and frontier markets are the better place for investors who hope to
see capital appreciation in the short and long term, and an income stream too. The
domestic demand we see in Russia, parts of emerging Europe (especially Turkey),
and Africa, fed by the likely rise in bank lending from systems that are less inter-
twined with the European banking system, means these markets can grow.
In addition, we see evidence across from Russia to Turkey and Nigeria to South Our key markets are preparing well for
Africa, that the public and private sectors are preparing well for Spain’s euro Spain’s euro departure
departure. Nigeria is targeting a 20-25% lift in FX reserves to over $50bn, Russia’s
budgetary plans aim to reduce the dependence on energy so that a commodity price
fall will be less damaging, South Africa is maintaining low interest rates and a
competitive currency so that growth might be sustained even in this scenario, while
Turkey is re-orientating trade towards the Middle East. Many governments and
companies are pushing out the duration of their debt, to avoid refinancing problems
in 2013-2015. We assume a commodity price shock would be short-lived, as growth
in Asia would continue and a global shock would limit new investments in supply.
All recognise that markets will be severely disrupted by departures from the
eurozone, but their levels of preparation for this are improving every month.
Nonetheless, we’d expect their markets to be hit hard in 2014 if Spain does leave
the euro, before bouncing back strongly in 2015
18