European Debt Trap Ahead!
Investors' attention has rightly been on the US fiscal deficit, but rising tensions between Russia and Europe suggest that the fiscal situations of European governments may trigger a European sovereign crisis 2.0 sooner than in the US. A flashback to February 1992 and the notorious Maastricht Treaty is necessary. This treaty, which laid the foundation for the European Union and the euro, established four rules:
Deficit rule: A country is compliant if its general government budget balance is equal to or larger than -3% of GDP, or if any breach of the -3% threshold remains small (maximum 0.5% of GDP) and limited to one year.
Debt rule: A country is compliant if its general government debt-to-GDP ratio is below 60%, or if any excess above 60% of GDP has been decreasing by 1/20 on average over the past three years.
Structural balance rule: A country is compliant if its structural budget balance is at or above the medium-term objective (MTO), or if progress towards the MTO is sufficient (annual improvement of the structural balance equal to or greater than 0.5% of GDP, or the remaining distance to the MTO is less than 0.5% of GDP).
Expenditure rule: A country is compliant if the annual growth rate of primary government expenditure, net of discretionary revenue measures and one-offs, is at or below the 10-year average of the nominal rate of potential output growth minus the convergence margin necessary for adjusting the structural budget deficit in line with the structural balance rule.
Fast forward to 2024, France and Italy are major disasters in terms of the budget deficit rule. France currently has a budget deficit of 7%, while Italy's stands at 5%. France needs to reduce its deficit by a significant 4% of GDP. Neither Italy nor Greece should have been allowed in the EMU (European Monetary Union – Eurozone) originally. Greece's debt-to-GDP ratio sits at 170%, far surpassing the 60% target. Only the Scandinavian countries are currently in compliance.
On February 10th, away from the media spotlight as usual when it is about talking fiscal policies, the EU agreed to "Looser Fiscal rules to cut debt, boost investments." The revised rules permit countries with excessive borrowing to reduce their debt by an average of 1% per year if it exceeds 90% of gross domestic product (GDP), and by 0.5% per year on average if the debt is between 60% and 90% of GDP. Countries with a deficit exceeding 3% of GDP are mandated to halve it to 1.5% during periods of growth, establishing a safety buffer for anticipated challenges. Defense spending will now be factored into the Commission's assessment of a country's high deficit, a response triggered by Russia's invasion of Ukraine. Under the new rules, countries have seven years, extended from four previously, to reduce debt and deficit starting from 2025.
Fifteen or so years after the Euro area’s sovereign debt crisis, Europe faces another financial turmoil. France and Italy's high budget deficits for 2024, over 7% and 5% respectively, are warning signs. But these figures are symptoms of deeper economic stagnation. Germany, despite differing fiscal policies, also grapples with similar challenges. The collapse of Nicolae Ceaucescu's repressive but debt-free regime in Romania serves as a poignant reminder that the volume of debt alone does not determine sustainability. Rather, it is a state's ability to provide welfare and contentment while remaining financially stable. Politics, therefore, becomes the art of balancing these aspects continuously. Historically, the European model relied on oligopolistic industrial firms, heavily supported by favourable regulations and state-backed services. These firms, like those in the German automotive sector, enjoyed high profit margins and dominated the economy. This setup also shaped social policies, ensuring equitable distribution of benefits through fiscal transfers and labour market interventions. However, European companies now struggle to sustain profits and fund research. While government intervention historically fostered industries, prioritizing incumbents, the new digital revolution has also changed the nature of economic growth. With the lack of access to "cheap energy" since the start of the conflict between Russia and Ukraine, the German business model, relying on cheap energy to manufacture goods, has been structurally broken. In a nutshell, the growth engine of the European Union is broken and the weaker satellite like France and Italy will be first in line to pay the pay price of this new industrial reality.
Germany Industrial Production.
Zooming in, France is poised to be at the epicentre of the impending European Ice Age, as its fundamentals have been deteriorating since the 2008 Global Financial Crisis. With a government spending to tax revenue ratio of 0.5, France has persistently lived beyond its means, and the looming recession is expected to worsen this situation, potentially pushing the ratio even lower than during the peak of the Covid pandemic.
France: Ratio of government spending to tax revenue.
In a "bureaucratic communist" country like France, where the government plays a dominant role in generating GDP, investors would be wise to focus on the ratio of government debt to the GDP generated by the private sector, representing real economic activity. At 198%, the French government's debt-to-private-sector-GDP ratio has reached levels comparable to those seen in Argentina before experiencing a collapse of their sovereign debt.
France: Ratio of government debt to GDP generated by the private sector.
This rings particularly true when considering the inflation rate for everyday people, often referred to in France as the "Gilets Jaunes" in reference to the 2018 social unrest sparked by working-class individuals. This inflation index encompasses energy, food, and housing costs which are the costs that matter for the average employee. Since the onset of the Covid pandemic, the rising prices of these three basic necessities have surpassed the average wage increase for French workers. Consequently, the quality of life for the average French worker has significantly deteriorated since the pandemic's onset whatever the ambient narrative prevailing among the elites.
Average wage per capita in France (black line); ‘Gilets Jaunes’ Inflation Index (1/3 Food; 1/3 energy; 1/3 housing) (red line).
France faces the challenge of refinancing EUR273 billion in 2024, EUR262 billion in 2025, and EUR278 billion in 2026, totalling EUR813 billion of its EUR2.766 trillion debt over the next 36 months. The current weighted average coupon of the French debt is 1.61% compared to the French 10-OAT yielding at 2.9%. Given the current fiscal situation, smooth refinancing seems unlikely.
So, France, like many European countries grappling with deregulated immigration are on the brink of a social revolution. Additionally, France is entering a dire ‘debt trap’. As a matter of fact, France is in a more precarious situation than Italy in the impending sovereign debt crisis, one can examine the spread between Italian and French 10-year yields, which is at its lowest level since 2015. This suggests that Macron may have recognized the need to divert financial markets' attention from the dire state of the French economy by adopting a more aggressive stance among NATO leaders. Historically, wars have often been a catalyst for governments to default on their debt.
Spread between Italy and France 10-Year Yield.
Currently, the financial markets are not pricing in the risk of a sovereign debt crisis in France or Italy, evident from near-decade-low CDS spreads. However, a reassessment of "European government risk" would likely trigger capital outflows from the region and significantly weaken the EUR/USD forex rate.
France CDS (blue line); Italy CDS (green line); Spain CDS (purple line) & EUR/USD FX rate (axis inverted; red line).
On March 21st, the European Council President urged Europe to transition to a war economy, emphasizing job creation as a significant benefit. Charles Michel's endorsement reflects Europe's extensive history of conflict, with the Russia/Ukraine NATO war being just one of many, marking the 487th military conflict in Europe over the past 2000 years. Europe's increasing reliance on China and the US for security, coupled with its dependency on Russia for energy, suggests that capital outflows are likely to intensify in the coming months as geopolitical tensions escalate on the ground. Consequently, Europe may be tempted to impose capital controls, as most Emerging Markets have done during previous financial crises.
Rates ALWAYS rise during war because governments print money like never before, and inflation skyrockets, forcing them to put capital controls, wage controls, price controls, and rationing in place. This time will not be different, and Europe is moving first in this direction.
In this context, given the Eurozone's bureaucratic tendencies, it's no surprise that it has begun tightening regulations on cryptocurrency. This move primarily targets private wallets, aligning with the ECB's preparations to launch a CBDC. This initiative likely forms part of the European Union's strategy to increase taxes for financing defense efforts and to implement capital controls more efficiently than emerging markets have done in the past. The ECB's presentation from March 2024 outlines a timetable for the Digital Euro, with development and implementation set to begin in November 2025 after the legislative process is completed. This aligns with the EU's plan to issue digital identity cards to all residents by 2030 for government identification and citizen tracking.
From an investment perspective, it's impossible for this catastrophe to have no repercussions for various economic actors. However, as always, these effects will take time to manifest. Insurance companies, for instance, guarantee future risks and maintain reserves to cover them, typically invested in government bonds, real estate, and minimally in stocks. With real estate also declining due to rising interest rates, they've incurred a 40% loss on these reserves. Meanwhile, the costs of the risks they've insured have risen due to inflation, prompting them to significantly increase prices. This will reduce the profitability of insured businesses and lower individuals' standards of living, exacerbating the impending recession. Commercial banks, much like insurance companies, have their mandatory reserves heavily invested in government bonds. With these bonds declining, along with their capacity to absorb defaults, banks are likely to halt lending. Already, there's a virtual freeze on new loans, particularly in real estate. Pension funds, which cater to complementary pensions, typically allocate about 50% of their reserves to various investments.
Investors should not be swayed by the prevailing narrative suggesting that all is well for the European banking system, as indicated by the current state of CDS. Instead, it's crucial to recognize that the banking system, especially in France, is poised to endure substantial losses from the impending sovereign debt crisis in the region.
Taking a closer look behind the curtain, at loans provided by Monetary Financial Institutions (MFIs) to Euro area financial corporations other than MFIs and ICPFs (Insurance Corporations and Pension Funds), which essentially encompass loans made by Euro area banks to non-banks, including investment funds and securitization structures, reveals an intriguing trend. While there has been an overall decrease in loans across the European banking system in recent years, this specific category of loans tends to rise during periods of heightened liquidity and economic financial circumstances.
Recent history provides ample evidence of this phenomenon. For instance, in early 2007, as the world began to grapple with the unfolding subprime mortgage crisis, there was a notable increase in loans provided by Euro area banks to non-bank financial corporations. Similarly, a similar trend was observed in December 2009, preceding the onset of the Greek debt crisis.
Indeed, history repeats itself, and we witnessed similar events once again in January 2018, when dollar funding became scarce, leading to liquidity issues worldwide. This trend resurfaced in February 2022, following Russia's invasion of Ukraine and the resulting disruptions to energy supplies, which impacted the European economy. Therefore, the increase in loans from European banks to non-banks serves as a reliable canary in the coal mine, signalling the looming possibility of a credit event brewing behind the scene.
To provide context, the current value of loans from European banks to non-banks stands at EUR 1.3 trillion, a significant sum within the global banking sector. This represents a 5.7% increase since August 2023. Conversely, loans from banks to households have either remained stagnant or decreased, reflecting tightened liquidity and a pessimistic economic environment.
This trend serves as a warning sign that a crisis may be looming beneath the surface in Europe. While the exact reason for the increase in loans to non-banks is not definitively known, clues suggest a potential connection to the commercial real estate problem in Europe. The latest Financial Stability Review from the ECB has highlighted this issue, indicating that it may be contributing to the uptick in loans to non-banks.
In its 2023 annual report released two weeks ago, UBS highlighted the downturn in commercial real estate as one of its "top and emerging risks." This concern arises from high interest rates and a decline in demand for office space, impacting the sector. UBS expressed apprehension about adverse effects on valuations due to higher interest rates and the structural decline in demand for office and retail space. The bank emphasized the potential broader impacts stemming from material balance sheet exposure to the sector by both bank and non-bank lenders. The bank defines "top and emerging risks" as those with the potential to materialize within one year and significantly affect the group. Other risks highlighted in the report include inflation and geopolitics. Notably, commercial real estate did not feature among its top risks in the previous annual report.
Lagarde has already been quite clear that the first interest rate reduction will come in June, as she mentioned at the latest ECB meeting on March 20th. This view has been widely endorsed by many members of the Governing Council, including the most hawkish among them.
With stagflation already present and the banking system facing uncertainty, it's unsurprising that the ECB has adopted a more dovish stance compared to the ‘politically correct’ FED. Given the ECB's heightened political sensitivity compared to the FED, it's anticipated that the ECB will be compelled to cut rates ahead of the June European election to lure electors to support the war agenda of current heads of states and to avoid dealing with rising nationalist parties. This prospect is likely to serve as another catalyst for the EUR to weaken against the USD in the months ahead.
Spread between FED & ECB interest rate cut probability (blue line); EUR/USD FX rate (axis inverted; red line).
Read more and discover how to position your portfolio here: https://themacrobutler.substack.com/p/european-debt-trap-ahead
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