Will Europe Break Up?

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Includes: BUND, FXE
by: Katchum

Lately, there have been more and more articles popping up about a eurozone break-up. James Turk recently suggested a eurozone break up on Capital Account. Let's objectively analyze if this concern is validated. To make it easier for me I'll consider the PIIGS (Portugal, Ireland, Italy, Greece, Spain) to be southern Europe.

The different aspects I will look into are the following (Source: all data from end 2010):

  1. Unemployment Rate
  2. Bond Yields
  3. GDP
  4. Debt
  5. Inflation Rate
  6. Current Account
  7. Government Budget

1. Unemployment Rate

In a previous article, I already pointed out a disparity between the north and the south of Europe. The south comprises the PIIGS. The north has strong countries like Belgium, Finland, Germany, Sweden, Luxembourg, The Netherlands, Austria.

If we take a look at the unemployment rate in the south, we see that unemployment skyrocketed from 2008 onwards. On average we have 15% unemployment residing within a range of 7%-21% (Chart 1). In the north we see an average of 5% unemployment residing within a range of 3%-6% (Chart 2). This is a huge difference. The north of Europe is much better of as opposed to the south of Europe. Compare this average to the United States' unemployment of 8% and China's unemployment of 4%. France is somewhere in between at this moment.

Note that unemployment rates have been going down historically for the north and have been flat since the economic crisis of 2008.

(Click charts to enlarge)

Chart 1: South Europe

Chart 2: North-Europe

Conclusion: Unemployment rate suggests a split between north and south.

2. Bond Yields

Bond yields in south Europe have been rising because of their increasing debt burden. The 10-year bond yield of the PIIGS is given in Chart 3:

  • Greece: 21%
  • Portugal: 11.5%
  • Ireland: 6.9%
  • Spain: 5.9%
  • Italy: 5%

Chart 3: 1 Year % Change in Bond Yields (South Europe)

Bond yields in the north of Europe have been declining. The 10-year bond yields of the strongest north European countries are given in Chart 4:

  • Belgium: 3.4%
  • France: 3%
  • Austria: 2.8%
  • The Netherlands: 2.3%
  • Finland: 2.2%
  • Sweden: 1.8%
  • Germany: 1.7%
  • Denmark: 1.7%

Note that all yields in northern Europe are lower than the yields in southern Europe.

Chart 4: 1 Year % Change in Bond Yields (North Europe)

Conclusion: Bond yields suggest a split of the eurozone between north and south.

3. GDP

The growth rate for the latest quarter of the southern countries was:

  • Ireland: +0.7%
  • Spain: +0.3%
  • Italy: -0.4%
  • Portugal: -2.8%
  • Greece: -7.5%

All of these are contracting or flat.

The growth rate for the latest quarter of the northern countries was:

  • Germany: 1.5%
  • France: 1.4%
  • Finland: 1.4%
  • Austria: 1.2%
  • Sweden: 1.1%
  • Belgium: 1%
  • Denmark: 0.5%
  • The Netherlands: -0.6%

Most of these are growing more than 1%, but have been in a declining trend. The Netherlands has started contracting just recently. Either way, the difference between north and south is obvious.

Conclusion: GDP growth suggest a split of the eurozone between north and south.

4. Debt

The government debt to GDP ratio for the southern countries was:

  • Greece: 143%
  • Italy: 119%
  • Ireland: 96%
  • Portugal: 93%
  • Spain: 60%

The government debt to GDP ratio for the northern countries was:

  • Belgium: 97%
  • Germany: 83%
  • France: 82%
  • Austria: 72%
  • The Netherlands: 64%
  • Finland: 48%
  • Denmark: 43.6%
  • Sweden: 40%

Notable is that the Scandinavian countries have significantly lower debt than other European countries. Surprisingly, Spain has only 60% government debt to GDP. These numbers are in line with the debt in the United States (100% debt to GDP).

Conclusion: Government debt doesn't give a clear picture between north and south.

5. Inflation Rate

The inflation rate for the southern countries was:

  • Italy: 3.3%
  • Portugal: 3.1%
  • Ireland: 2.2%
  • Spain: 1.9%
  • Greece: 1.7%

The inflation rate for the northern countries was:

  • Belgium: 3.1%
  • Finland: 2.9%
  • Denmark: 2.7%
  • The Netherlands: 2.5%
  • Austria: 2.4%
  • France: 2.3%
  • Germany: 2.1%
  • Sweden: 1.5%

Conclusion: the inflation rate is almost the same for all European countries.

6. Current Account

The current account/GDP for the southern countries was:

  • Greece: -10.5%
  • Portugal: -9.9%
  • Spain: -4.5%
  • Italy: -3.3%
  • Ireland: -0.7%

The current account/GDP for the northern countries was:

  • The Netherlands: 7.7%
  • Sweden: 6.3%
  • Germany: 5.7%
  • Denmark: 5.5%
  • Finland: 3.1%
  • Austria: 2.7%
  • Belgium: 1.4%
  • France: -2.1%

All southern countries are exporting less than they import, resulting in a current account deficit. This will have impact on the debt and bond yields of their respective countries. The Netherlands is doing very well with 7.7%, while France is almost on the verge of joining the "F"-PIIGS.

Conclusion: the northern countries distinguish themselves from the southern European countries by maintaining a good balance sheet. They are more productive than the southern European countries. If there was no eurozone, the north would have a stronger currency than the south. If the current account gap between north and south were to widen, it would have political consequences (moral hazard).

7. Government Budget

The government budget/GDP for the southern countries was (2010):

  • Ireland: -31%
  • Greece: -10.6%
  • Portugal: -9.8%
  • Spain: -9.3%
  • Italy: -4.6%

The government budget/GDP for the northern countries was (2010):

  • France: -7.1%
  • The Netherlands: -4.7%
  • Austria: -4.4%
  • Germany: -4.3%
  • Belgium: -3.7%
  • Denmark: -2.6%
  • Finland: -2.5%
  • Sweden: 0.2%

Almost all countries are spending more on social security, pensions, medicare,..., than they receive in tax payer money. Notable is that the United States has a government budget deficit of 10%, which is larger than most of the European countries. Normally, if a country deteriorates economically, the government budget will turn into a deficit. This in turn will have its implications on the government treasuries. Borrowing costs should rise with higher budget deficits. Ireland is the champion in posting budget deficits as it bailed out its banks in 2010 (Anglo Irish Bank). The higher the budget deficits, the more turmoil on the streets we will see (Ireland and Greece had riots, Spain and Portugal will follow next)

Conclusion: the PIIGS have been posting higher budget deficits, due to the bailout of their banks. As most financial institutions are interconnected with each other (and given the fact that financial institutions [like Deutsche Bank (NYSE:DB)] are bigger than the GDP of the countries themselves), the government budgets will likely be interconnected too. The PIIGS will drag down the northern European countries as the latter will pay for the budget deficits through IMF bailouts.

Overall Conclusion

Several economic indicators (unemployment, bond yields, GDP, current account, government budget) show that there is a huge imbalance between northern and southern Europe. This supports the thesis that the eurozone will break up. At the same time though, all of these countries are interconnected through the IMF (government budget, inflation rate, debt to GDP, interfinancial connection). Each country in the eurozone has contributed to the emergency aid packages of the IMF and will continue to do so because the risk of interfinancial contagion is too big to ignore. This is apparent in the fact that some banks are bigger than the GDP of the country they reside in. The current account is the most important indicator to be monitored, because it shows clearly that northern Europe is subsidizing southern Europe. If this gap widens, moral hazards on the political front could be questioned. As a consequence, a break up of the eurozone could manifest itself.

As an investor, it is important to see the big picture. If a break up were to occur, several countries will leave the eurozone and go back to their former currencies. As an example, Greece could go back to the dragme, Germany could go back to the deutsche mark. In these cases it would be advisable to have your money in bonds of the strongest countries (Germany, Switzerland, Norway, Finland), because after a break up, you will be paid in cash denominated in the currency of that government bond. This is also why people are fleeing into German bonds. One of the ways to play this scenario is to buy the PIMCO Germany Bond Index ETF (NYSEARCA:BUND). As a figure of speech, you'll be standing on the top of the mountain while everything else is flooded away in front of you.

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

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