Eurozone: Painful Internal Devaluations Unavoidable
Financial markets seem to have a very short memory span when it comes to aligning with macroeconomic fundamentals these days. Though the release of housing sales numbers in the US today and the short-lived euphoria of China’s loosening of its exchange rate regime at the start of the week seem to have shaken up equities lately, Risk Watchdog can’t help but wonder whether all of that nasty ‘internal devaluation’ business in the externally least competitive eurozone economies is already being priced in.
Indeed, looking at the PIIGS in particular (Portugal, Ireland, Italy, Greece and Spain), I remain convinced that a painful deflationary cycle in these economies remains on the cards. My conviction is primarily based on the assumption that Southern eurozone economies (and Ireland) cannot exercise independent monetary policy, and will therefore need to undergo extensive internal devaluations to restore economic competitiveness. This has already been highlighted by sharply rising unemployment rates and falling output levels, and reaffirms Risk Watchdog’s belief that the eurozone economy will be a global underperformer in real GDP growth over the next few years!
Having been able to borrow at ECB rates for years, these economies have racked up household and public sector leverage, driving asset prices and wages higher, and ultimately eroding the competitiveness of their domestic economies. The PIIGS are now at a substantial disadvantage to compete on a global scale, at a time when external demand remains fragile to macroeconomic headwinds and wide scale deleveraging is well underway.
Euro Weakness Not Enough
Despite the over 18% drop in the value of the euro against the US dollar since November, this has done little to improve the competitiveness of PIIGS economies, which to a large extent rely heavily on eurozone demand for growth. In stark contrast, Germany’s economy, which was already extremely competitive to begin with, has benefitted immensely from the weaker euro, and will likely continue to do so.
My colleagues at Business Monitor have taken a look at the Harmonised Competitive Indicators (HCI) compiled by the Bundesbank, which is an index based on consumer price inflation and bilateral trade flows (including with other eurozone members). This serves as a good gauge of competitiveness in the eurozone. The accompanying chart shows how PIIGS economies remain highly uncompetitive vis-à-vis their German counterpart, which in a weak global demand context augurs poorly for their future growth outlook. Indeed, the superior competitiveness of the German economy has been remarkable for the past decade (see chart), highlighting the higher labour costs and wages in the smaller economies since euro adoption.
Meanwhile, the weaker euro has immensely helped to boost Germany’s competitiveness, by driving the HCI lower (see chart). To be sure, Germany has been well placed to benefit from euro weakness, having maintained an HCI below 100 for most of the previous decade.
In contrast, however, the sharp correction in the euro since the Greek sovereign debt crisis has hardly seen the Greek HCI move lower, which remained well above 107 in April. Greece’s economy has lost in competitiveness as the euro grew in strength, but so far has failed to regain any of it during the recent drop in the euro’s value against the dollar.
The Baltic Experience: Leading The Way
Given this dislocation of the value of the exchange rate (euro) and competitiveness of the PIIGS economies (i.e. labour costs and consumer prices), an internal devaluation is inescapable at this point. Indeed, the three Baltic economies of Estonia, Lithuania and Latvia are a case in point, having been undergoing painful internal devaluations since 2009. Fixed exchange rate regimes (ERM2) and a withdrawal of easy credit have led to sharp contractions in output and wages in recent quarters, as the economies seek to restore some level of competitiveness through a debt deflationary cycle.
In recent quarters, nominal hourly labour costs in the Baltic three have fallen sharply, with Lithuania experiencing an 11.0% year-on-year (y-o-y) contraction in the first quarter of 2010. Latvia’s nominal hourly labour costs fell 7.2% y-o-y, while Estonia’s dropped 5.5% during this period. Meanwhile, both Portugal and Spain experienced nominal hourly wage growth of 0.3% y-o-y and 2.0% y-o-y, respectively in Q110, and the euro area (EA16) saw nominal wages rise 2.1% y-o-y during this period.
This will likely change going forward – though union action and weak coalition governments may cause some delays. In particular, labour markets are set to loosen further over the medium term, with the situation having already taken a decisive turn for the worse in several PIIGS economies. This will put additional downside pressure on wages.
Looking at the construction sector, there are already seeing signs of housing bubbles being deflated. During the first quarter of 2010, Greece’s construction sector shrank by 19.7% y-o-y, and Spain saw construction output fall 12.9% y-o-y during this period.
Though a long way off the +40% y-o-y contractions seen in Latvia and Lithuania (see chart), I do not rule out the possibility of the decline in construction output gathering pace over the coming quarters, but most notably highlight that the ongoing deflationary spiral in the housing market – particularly in Spain and Greece – will likely persist over the medium term. Concomitantly, Risk Watchdog believes that a drop in nominal hourly labour costs will also be forthcoming as both private and public sector wage levels currently do not match macroeconomic reality – even with the euro being below US$1.2300/US$. Ouch!