The NetherlAAAnds?

by: Shareholders Unite

The perception of the Netherlands is that it is generally a prosperous, well-run country, a sort of little Germany. But there are cracks appearing in that image. Citigroup's Jurgen Michels "expelled" The Netherlands from its exclusive club on the grounds that it "no longer seems to satisfy all of our other requirements for Core membership." What are these requirements? Well:

  • a relatively strong fiscal position in both the public and private sector
  • advocating strict fiscal and structural reform conditionality in return for support measures for weaker EA sovereigns and
  • relatively little reliance of the domestic banking system on Eurosystem liquidity
  • skepticism towards extraordinary ECB support for troubled euro area sovereigns and banks.

Although we're a little bemused by that fourth criteria, it seems the Netherlands isn't doing so badly on all of these, apart from the first. And even that is somewhat debatable, as public debt, at 66% of GDP is well below the euro zone average (88%). Not all is well though.

The Netherlands is the only AAA country that is in a recession and, as a result, the budget deficit, at 4.6% of GDP, is substantially above the 3% allowed by the Stability Pact. In fact, in order to get the deficit back to below 3%, some 16B euro of austerity measures are necessary.

First off, one can have serious doubts whether this is at all desirable in the midst of a recession. The Dutch recession isn't just any ordinary recession but in certain ways it is a lighter variant of the deep recessions (or, in some cases depressions) that plague much of the euro zone periphery.

The Dutch private sector is rather heavily indebted, the result of a housing boom and lax credit policies. This is akin to Ireland and Spain or Portugal. House prices are still falling (albeit in a moderate pace).

You see that by 2010, only Denmark had a higher level of household debt than the Netherlands. Austerity is likely to reduce growth, already negative, further. The negative implications for the balance sheets of households and banks shouldn't be underestimated.

Dutch banks, like Dutch households, have rather stretched balance sheets. They're also extremely large.

ING bank in the Netherlands is smaller than a number of U.S. banks, but given that the Netherlands economy is roughly 5% the size of the U.S. economy, it is huge relative to its home economy. In fact, ING has more assets than the entire GDP of its host country. [Jay Shambough, Georgetown University, NBER]

Where they worry in the US (and rightly so, we should add) about financial institutions being 'too big to fail,' relative to the size of the economy, Dutch financial institutions are massively bigger.

Trade balance
Unlike most of the euro zone periphery, Dutch competitiveness does not seem to be a problem. The Dutch economy basks in a rather large trade surplus. However, look closer and things are not so rosy. Unit labor cost have risen faster in the Netherlands than many other euro zone countries. Only those in Greece and Portugal have risen faster.

Also, a massive trade surplus isn't necessarily the good sign many take it for. It points to the country spending less than it earns. Not the public sector where there is an expected deficit of 4.5%. That necessarily implies, with the trade surplus in the order of 5% of GDP, that there is a private sector surplus of almost 10% of GDP.

That means that the private sector saves 10% more than it invests. That points to very weak domestic demand. This isn't a surprise as households are deleveraging as they are very heavily indebted with their main asset, houses, slowly reducing in value.

We're not at all sure that weakening demand further by embarking on a rather large austerity package to satisfy the Stability Pact is the way to go. Even Coen Teulings, the head of the official economic think tank, the Central Planning Bureau, has warned against this, as has the head of one of the two big employers organization.

Depending a little on the substance of the measures taken, but there is a real danger that we get some of the same phenomena plaguing the euro zone periphery, where austerity has deepened the crisis and increased debt/GDP levels.

A much better alternative would be if the country used this crisis to embark on necessary reforms in the housing market, in pensions, healthcare and the labor market, as two senior economist (Willem Vermeend and Rick van der Ploeg, together with 23 other economists) have recently argued.

The Netherlands probably has too much political capital invested in the Stability Pact, having constantly lectured the periphery about its importance, it's hardly in a position to renege itself. Apart from considerable image and influence loss there is also the real chance of having to pay substantial fines (up to $1B Euro) if the public deficit is still substantially above 3% by the end of next year.

And economic desirability is one thing, measures ultimately have to be taken by the slow moving political process which can't agree on the deep reform that is necessary. Nor is a 15 B euro austerity package a guaranteed outcome. The markets have taken notice.

Political stability
The worry of the financial markets seems to be about political stability. The country has a rather awkward government, depending on the support (but not participation in the Government itself) in parliament of the, in some areas rather right-wing PVV, the freedom party led by maverick Geert Wilders. The parliamentary majority is slim, just a single seat. And to complicate matters further, the PVV just had a prominent member splitting from the party, reducing the majority to zero.

In European matters, the PVV is rather fierce anti-EU and anti-Euro. They even had a report commissioned, written by Lombard Street, arguing that the Netherlands would be better off if it left the euro zone altogether. While the Netherlands has a long tradition in coalition politics and balancing interest, the situation is particularly delicate right now.

Mr. Wilders is, by Dutch standard, no ordinary politician, and his party not one like any other, it's basically a movement, rather than a political party. Mr. Wilders rules it as he sees fit (there is little to no inner party democracy), and the fact that he isn't actually in the Government itself gives him a degree of freedom and leverage that other politicians don't enjoy.

This means that for implementation of '"euro zone measures" like embarking on austerity, the Government often has to lean on the left-wing opposition, which have little incentive to support the Government.

Clearly, this political fragility isn't conducive to taking big economic decisions, and this is exactly what the market are sensing.

The upshot, is the Netherlands triple A rating in danger?
Well, it's not the likes of Citibank that decide on that, but the ratings agencies, even if they have similar criteria as Citibank's. That can hardly be a surprise, there are only so many ways in which one can slice and dice creditworthiness. So what are these? Standard & Poor looks at five criteria:

  • The effectiveness, predictability and stability of the political process. We covered this above and this is in danger of turning negative for the Netherlands.
  • The economy. On the positive side are the above average GDP/person (36,500 euro per head in the Netherlands, the euro average is only 27,000 Euro), but negatives are the high private debt, the decline in the housing market and the fact that it's the only core country in a recession. Also weak are internal demand but export demand is also lagging.
  • Monetary affairs. While these are the domain of the ECB, what is notable is that Dutch banks have been relying rather heavily on the ECB (see figure below)
  • Normally S&P would consider the stability of the currency, but with the euro being a common currency this doesn't reflect on the Netherlands (and the euro has been remarkably stable, considering all the turmoil with the euro zone crisis)
  • Budgetary policy. Definitely a weak point with the public deficit considerably above the 3% norm of the Stability Pact and the economy in recession, which makes improving this figure that much harder. The political situation (see above) doesn't help either.

We're not quite at a downgrade yet, but markets are clearly starting to worry (see figure below). Both the economic as well as the political situation can only be described as fragile. This year, the economy will shrink by 3/4% and only moderate growth is projected for the years after that.

Dutch 10 year bond yield
Red line: Dutch 10 year yield
Blue line: Spread with German 10 year yield

This growth is too slow to improve the budgetary situation, quite the contrary. Without measures, the deficit will stay at 4.6% and the debt/GDP ratio will increase to 76% by 2015, leading to more interest payments and a possible loss of its triple A status (which could lead to yet more interest payments). Clearly something needs to be done.

A decisive market reform program with long-term measures to control spending in health care and pensions would have our preference, as that is least likely to reduce economic growth further and increase the problems. It would also probably be enough to stop the rot in market confidence in the Netherlands.

Some investment suggestions
A decisive reform package seems an unlikely outcome, considering the delicate political situation. Some austerity package will come forward, but whether this is enough to stop the rot remains very much to be seen. The Dutch stock market has had a nice run the last months, even if we came of the highs a little bit in the last two weeks.

The retreat could continue if things get worse. The only country ETF listed in New York is the iShares Netherlands ETF (EWN). Its top ten holdings:

  • Unilever NV (UN): 20.07%
  • ING Groep N.V. (ING): 13.04%
  • Koninklijke Philips Electronics NV (PHG): 7.42%
  • Koninklijke (Royal) KPN NV (OTCPK:KKPNY): 6.27%
  • ASML Holding NV (ASML): 4.74%
  • Akzo Nobel NV (OTCQX:AKZOY): 4.59%
  • Koninklijke Ahold NV (AH): 4.56%
  • Heineken N.V. (HINKY.PK): 4.55%
  • Reed Elsevier NV (REN): 3.24%
  • Aegon NV (AEG): 3.13%

Now, the problem is, these are all big international conglomerates for which the Netherlands isn't their main market. However, should the Dutch economy continue its present recession and political gridlock, confidence will erode further and the Dutch stock exchange will, to a certain degree, suffer as well.

Shorting a Dutch bond ETF would be a better idea. However, even after an extensive search uncovering a whole universe of rather exotic ETFs, there doesn't seem to be such a Dutch bond ETF. A pity, that. With some fantasy one could invest in the "flight to safety" trade, that is, invest in German bonds. There is a German bonds ETF, the ProShares German Sovereign/Sub-Sovereign ETF (GGOV).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.