European Central Bank (ECB)’s president Mario Draghi announced last month an unlimited bond-buying program to save the Eurozone and its debt-loaded countries. The United States Federal Reserve is also buying more bonds after it announced a third round of quantitative easing. Investors sighed with relief and markets reacted positively. The United States’ ‘fiscal cliff’ still looms, however, with massive, legally mandated tax increases and spending cuts coming into effect at the beginning of 2013 if no budget-balancing deal is found. For insight on these and other issues, Executive sat for a one-on-one with Paul Donovan, global economist at UBS, while he was in Beirut last month.
Draghi recently announced an unlimited bond-buying program whereby the ECB would acquire short-term government bonds of countries in distress. Is this a band-aid or leap forward for solving the Eurozone sovereign debt crisis?
It’s not a band-aid. I would say it is step forward; leap forward is a bit too far. It demonstrates that the ECB will not allow Europe to fail and that monetary union will hold together. Draghi is going as far as he can legally go at this stage. More will need to be done in the future to make the euro work properly but it possibly needs treaty changes. For now, this is an important step.
What is missing for the Eurozone to work properly?
For the euro to work, a banking union, a single bank supervisor, is needed. We are moving toward that and I think something will be established by the middle of next year. Secondly, we need some degree of fiscal integration. At UBS we prefer the term fiscal confederation, as it sounds more Swiss. Switzerland is a very good model with its highly independent cantons that share limited fiscal policy. We also need competitiveness in Europe and structural reforms.
Doesn’t Germany, which is highly dependent on exports, benefit from a weak euro? It wouldn’t want to see a breakup of the Eurozone as that would mean the Deutschmark would explode.
There is no question that Germany benefits from the existence of the euro. If the Eurozone were to break up, we have done a rough estimate that it would cost Germany 25 percent of its gross domestic product in a year. Germany’s main export market is Europe. Its banks would collapse as they hold French, Italian and Spanish bonds, which would become worthless; it’s chaos for the banking system. So Germany does benefit from a weak euro but the negatives of what is happening now are greater than the positives. Europe, Germany’s main export market, is very weak and German banks are weaker than they would otherwise be because the bond markets are weaker, which is why growth is likely to be below 1 percent this year.
Is a breakup of the Eurozone likely, in your opinion?
Anything is possible. Politicians do silly things from time to time. Our view is that if a country like Germany would lose 25 percent of its GDP in a year by leaving the euro then it would cost Greece maybe 50 percent of its economy in a year. It would be absolutely devastating. If Greece goes, Spain, Portugal and Ireland would leave within six weeks. It is bank runs that cause the collapse of monetary unions. Only four monetary union breakups took place in the last century, aside from when a country got completely destroyed like Germany after the [second world] war: the Austro-Hungarian Empire which broke up between 1919 to 1921, the US monetary union between 1932 and 1933, the former Soviet monetary union in 1991 and the Czechs and Slovaks in 1994. The trigger for the breakups, with the exception of the Soviet Union, was bank runs. The good news is that political leaders in Europe, the ones that matter, understand this, and that’s why we had the Draghi plan. Don’t get me wrong; the euro should never have been created, as it doesn’t work. Now that we’ve got it, it’s the Hotel California. You can check out but you can never leave. You have to keep this thing together because the cost of breakup is too high.
Is the upcoming fiscal cliff of concern to you?
No. It will be dealt with. Politicians in America, like anywhere else in the world, change their minds. There will be some fiscal tightening. We think most [former US President George] Bush tax cuts will be kept, most or all payroll tax cuts will be cut and most planned spending cuts will be reversed.
Who do you think will be friendlier to the markets, Republican presidential candidate Mitt Romney or US President Barack Obama?
Frankly, neither. I’m sure there will be a brief reaction and certain industries will be affected by certain party policies such as defense, healthcare and banking. The issue for us is that its not just the presidency, it’s the Senate which is very closely balanced and the House of Representatives and within that, the influence of the Tea Party among the Republicans and the moderates among the Democrats, etcetera. I don’t think you will get results where you pound the table and say buy or sell equities on these results.
With all the money-printing going on at central banks, do you think inflation is a risk going forward?
No. In developed countries, inflation is about 70 percent domestic labor costs and 10 to 15 percent commodity costs. I don’t see an increase in labor cost inflation in the current climate in the coming years. I do think commodity prices will trend somewhat higher but it will not be a major inflation issue. Printing money has never created inflation; printing too much money creates inflation. We have seen a huge increase in demand for cash globally and central banks have supplied that cash; that’s not inflation so I don’t see it as a major shock.
Are you worried about the slowdown we are seeing in some of the major emerging economies?
It is a mixed picture. We are seeing a refocus on domestic growth from global growth but I don’t think it will be a major crisis. If the emerging economies can manage more domestic demand coming through, they will sustain their growth.
Following the revolutions that the Arab world has witnessed, what are your thoughts on Middle East and North African economies?
There are a number of challenges for the region. As a result of the financial crisis and the European debt crisis, globalization of capital is reversing. For instance, French banks and life insurers invest in France; Italian pension funds invest in Italy.
For the MENA region, it is a problem because international capital will be less easy to secure and it will be harder to obtain the expertise that comes with it in many cases. Of course the region has a lot of capital so it can become more self-dependent, but capital coming from a sovereign wealth fund does not have the same motive as a private investment. My concern is that investments [may] become less efficient.
Also, political risk in the region is present at a time when many investors globally are adverse to risk. The problem here is that international investors first decide if they should invest in a region and then which country in the region. Countries with good stories might be overlooked for the time being. Hopefully when things will calm down, people will consider the region but at this stage, it is probably too early.