FANG and PIIGS Continue to Diverge

Euro Fair Value

Analysis: Euro overshoot will rekindle bloc-wide tensions | Reuters.

Exports of goods and services (% of GDP).

Morgan Stanley FXPulse 20130117.

Some eurozone countries are losing the currency war, but others are winning. The euro has a different effect on each country that uses it. The Germans are using a vastly undervalued currency which drives their export machine, but the Greeks must use an overvalued currency, which is choking the life out of the country.

The euro crisis narrative places the blame on the peripheral countries for their spendthrift ways, but the real problem is Germany. Since it is the largest country accounting for over a quarter of the Eurozone’s GDP, the euro tends to skew towards the valuation of the old  mark.

There are two Eurozones. One is comprised of the FANG countries whose exports account for at least 41% of GDP lead by the Netherlands (83%) with Austria(57%), Germany (50%) and Finland (41%). The PIIGS plus France have exports accounting for one quarter to one third of their GDPs with the other countries belonging to each group depending on its export percentage.

These numbers are important because they debunk the “Export to Growth” myth that has been repeated ad nauseam over the last few months:

Standard & Poors analyst Frank Gill said Spain, Portugal and Ireland have all made ‘rapid progress’ in rebalancing economies via rising exports and to countries outside the zone. He expects all three to return to current account surplus in 2013 and said that will hasten a return to growth well ahead of forecast.

When exports account for one-third of an economy, that tiny portion must grow at a fantastic rate to counteract the drag from government cuts and reduced consumption.

Let’s say Spain increases its exports by 10%. This sector of its economy is 30% of GDP, so a 10% rise will add 3 full points to GDP growth. However, at the same time, savage budget cuts, reduced consumer spending and investment are reducing the other 70% of the economy more than enough to keep Spain’s economy shrinking. A 5% decrease in this portion subtracts 3.5 points from growth resulting an overall shrinking economy.

The article also mentions the internal devaluation ongoing in the periphery. “Internal devaluation” is a euphemism for wage cuts. When people earn less money, they spend less and they cannot afford their pricey mortgages financed when their property and their income was much higher. What is really needed here is an external devaluation, but that would require countries to revert to their old national currencies.

The PIIGS and France would all benefit from leaving the eurozone, but the Germans will do whatever it takes to keep the currency area together. They have an undervalued currency, which is still strong enough to maintain a low rate of inflation. Why would they ever want to leave the Eurozone? For example, the price of oil has risen 20% in dollar terms since November 7 but only 12% in euro terms:

Oil Price in Euros 02.06.2013

Meanwhile, the German economy alone will probably resume growth in 2013:

January Markit PMI Germany

While the Germans like to talk about a grand political union, what is really driving their actions is maintaining the very good deal they receive from the Eurozone.

The French, God bless them, may actually believe in a political union, because they are sacrificing a great deal by remaining within the common currency. The French economy is performing poorly in line with its overvalued euro:

January Markit PMI France

France will not leave the eurozone, but Italy just might. Silvio Berlusconi has a chance to lead the government again, and he has already mentioned a lira reversion.

As long as these two Eurozones exist side-by-side, the breakup risk will never totally dissipate. ECB money may lower rates and raise stock markets in the short-term, but in the long-term drastic economic reforms are necessary in the both Eurozones. The PIIGS require more efficient labor markets, and the FANG needs to rely less on exports and more on consumption to drive growth. Until these reforms are implemented, the specter of break up risk will hover over the continent.


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