International Economic Outlook: April 2013

Cyprus and the Eurozone
 
The fragility of the Eurozone crisis has once again captured the attention of the world as the citizens of Cyprus come to terms with recent events.  Until recently Cyprus had a thriving economy with a prosperous tourism and shipping industry as well as a reputation for a tax haven that attracted Russian investors.  As at the end of 2011, Cypriot banks held around €50billion in deposits, more than twice the country’s GDP.  But the banks were not safe custodians of these funds and instead invested roughly 50% of their deposits into Greek sovereign bonds.  In February 2012 Greece received a lifeline from the troika (the ECB, The EU and the IMF) to save its banking system from collapse but a condition of the deal was for private bondholders to accept a 53.5% reduction in the value of its bonds.  From the moment this deal was announced, Cypriot banks were effectively insolvent and had been relying on the ECB’s Emergency Lending Assistance ever since.   
 
Cyprus is a small country and so none of this would have necessarily made the headlines of major news broadcasts around the world had it not been for the unusually hardline taken by the troika.  In exchange for a €10 billion package, the troika were demanding that Cyprus come up with €5.8billion.  Unlike previous banking bailouts where governments (taxpayers) had met the cost of saving the banks (and/or unsecured creditors had been forced to accept a write-off of the amount lent), the Cypriot government came up with a deal whereby depositors with savings over €100,000 would stand to have around 60% of their balance converted into bank equity and the remaining 40% will be frozen until authorities feel confident enough to lift restrictions on banks. 
 
The deal is significant on many levels.  Firstly, it recognises that banking losses need to be shared by investors rather than by taxpayers alone.  While generally you would expect unsecured creditors to take a haircut before depositors, in the case of Cyprus this would have raised only a fraction of the funds required due to the limited amount of unsecured debts. 
 
Secondly, Germany is sending a clear signal that it is reluctant to fund bailouts indefinitely.  This in turn raises the question as to whether or not the ECB is still willing to do ‘whatever it takes’ to save the Eurozone given the increasing reluctance to support weaker EZ members. 
 
Therein of course lies the fundamental problem as while the Outright Monetary Transaction bond buying program has been successful in restoring confidence in the region since its introduction, a number of countries (including Portugal, Spain, Italy and Ireland) remain on an unsustainable debt and deficit trajectory.  One or more of these countries may ultimately be forced into a debt restructuring deal in coming years.  The Cyprus experience may well cause nervous bank depositors in these countries to withdraw their funds at the first hint of any such restructuring, which once again has the potential to test the resolve of the global banking system. 
 
The United States
 
The outlook for the United States remains encouraging.  The very supportive monetary policy conditions that have resulted in significant currency depreciation and very low interest rates have provided a boost to the business sector and increased household disposable income.  This in turn has fed through to modest improvements in consumption and employment.  This self-perpetuating cycle of growth has also started to trigger renewed growth in the housing sector that collapsed during the sub-prime crisis.  These developments of course are very favourable as the US now has a lean and profitable corporate sector supported by a resurgent consumer.  Nevertheless, recent wars coupled with the very high cost of bailing out the banking system has left the US with an enormous government debt problem that needs to be addressed before it too becomes unsustainable.  The requisite reduction in government spending and associated increase in taxes will provide a drag on future growth prospects for many years to come but is absolutely necessary to restore sustainability once more. 
 
China
 
After several quarters of deceleration, economic conditions in China have continued to improve.  The economy grew by 2% in the December quarter to be 7.9% higher over the year.  The recovery was aided by mid-year stimulus measures that included significant railway infrastructure investment that has spurred a recovery in steel production and associated commodity prices of iron ore and coking coal.  Furthermore, a modest recovery in the real estate sector coupled with moderate rates of domestic consumption continues to underpin the recovery.  Conditions in the manufacturing sector though remain more benign in line with the more challenging global outlook.  Overall China’s economy should continue to grow moderately throughout 2013 but, as we have mentioned before, the large investment in infrastructure in recent years is not sustainable and is likely to result in losses for financiers (including developers, state owned enterprises and local governments) given that utilisation rates in many instancesremain poor.  In all likelihood we foresee a situation where lower fixed asset investment coupled with subdued global demand will result in lower medium term growth outcomes (2014 onwards). 
 
Conclusion
 
Improved short term growth prospects in both China and the United States should facilitate a modest improvement in global conditions over the rest of the year.  Yet risks in the Eurozone periphery remain elevated as debt and deficits continue to grow.  The IMF is predicting global growth in the order of 3.5% through 2013 and 4.1% in 2014.
 
Martin Fowler is a director of Moore Stephens Sydney Wealth Management where he provides financial advice to high net wealth individuals and conducts research into the social impact of economic policy. He is also a director of Whitefield Limited, an investment company listed on the Australian Stock Exchange.
 
Martin can be contacted via email at Mjfowler@Moorestephens.Com.Au or alternatively by phoning +61 2 8236 7700.