Before we get into today's Outside the Box I want to clear up a few ideas from this weekend's letter. There have been posts on various websites equating my piece on deflation with Paul Krugman. They say I am advocating kicking the can down the road and not reducing the deficit.
Wrong. What I have been trying to point out for several years is that we have no good choices. We are down to bad and very bad choices. The very bad choice (leading to disastrous - think Greece) is to continue to run massive deficits. The merely bad choice is to reduce the deficits gradually over time. As I try to point out, reducing the deficits has consequences in the short term. It WILL affect GDP in the short term. Krugman and the neo-Keynesians are right about that. To deny that is to ignore basic arithmetic.
I am not for kicking the can down the road. Not to begin to deal with the deficits, and soon, risks an even worse problem. But - and this is a big but - I don't want to stomp on the can, either.
Now, let's get into this week's Outside the Box. I offer you a very intriguing essay by those friendly guys from Bedlam Asset Management in London. They argue that Belgium's sovereign debt should be suspect, and is the country that could be a "sleeper" problem. This is a very interesting read, with a lot of history. It is not too long and very interesting. Enjoy. (www.bedlamplc.com)
Your thinking sovereign debt is the biggest bubble of all analyst,
John Mauldin, Editor
Outside the Box
Running Through a Minefield, Backwards
Part II - farewell Flanonia?
The last issue concentrated on sure sovereign default by Greece, Spain and Portugal - partly due to hopeless economic numbers but more because of various 'soft' issues. For, just as the numbers in a company's balance sheet theoretically provide all that is required to understand and value it, the reality is that squishy issues, such as the quality of management, staff morale or even simple luck can make a mockery of these numbers. Part I also emphasised the futility of gnawing at the bone of the de facto bankruptcy of these three countries. Backward looking investment never makes money; better surely to recognise the sovereign default cycle has further to go, and so spend time identifying the next unexpected candidate.
On the numbers alone, the most likely casualties are the UK and US in that order, but both have good odds of escaping. Many hard issues help. In America, one such is the dollar's currently irreplaceable role as the world's reserve currency. In the UK, the relatively excellent debt duration (i.e. it is spread over many years rather than near-term) is a plus. Each also has good soft issues: the market likes the new British government's tax and slash policies so is a willing buyer of UK debt, whilst the Asian central banks have so many US bonds they simply self destruct if they refuse to keep buying.
The standout surprise candidate for sovereign default by end-2012 is Belgium. A decent country; civilised, at peace, wealthy and globally competitive in several areas. Moreover, first glance at the numbers gives no particular reason to expect Belgium to default. Its potential financial problems have been on the radar screen for so long that we have grown used to them, rather like those many parents who fail to recognise the repulsiveness of their offspring. With net government debt of €400bn, it is hardly a huge world borrower in absolute terms. Yet default could occur almost entirely by accident and the ripples be far greater than its size warrants, because of its position as the de facto federal capital of the EU. Belgium's hastening car crash is not in current bond prices or exchange rates.
The glue has dissolved
There are five reasons why Belgium has hung together for the last 180 years: Britain, God, the King, fear and most importantly, money. Before addressing these, it is necessary to understand why Belgium exists at all. When in 1815 Britain was the Big Beluga after the battle of Waterloo, it wanted a buffer state to contain France. The easy solution was to give the area now known as Belgium to one of its staunchest allies, Holland. Unfortunately, King William I of the now-renamed United Netherlands was not, even according to Dutch history books, the smartest primate in the zoo, and he suffered from the diplomatic skills of a water buffalo. Holland (or the Kingdom of the Netherlands to give it its official name) had a long history of Calvinism. This was unpopular with the newly acquired Dutch and French Catholic subjects alike. Moreover, by deliberately ensuring the French were under-represented in all parts of government, yet overtaxed, the embers of resentment smouldered. These grew hotter in 1823 after an attempt to make Dutch the official language for the whole population. Surprisingly, full rebellion was ignited by the staging of a sentimental patriotic opera in Brussels in 1830. The crowds poured out of the theatre and went on the rampage. As Britain still wanted a buffer state, and was still the world superpower, it quickly moved to ensure the creation of a new country called Belgium, uniting Flanders and Wallonia (hence Flanonia might have been more appropriate).
The people, having suddenly been rebranded, opted for a French king. Britain growled, ever mindful of France's latent imperial ambitions, thus a minor German duke's second son was chosen instead. After nine years' skirmishing, as Holland held onto a few strong points, and a minor invasion by France, Holland withdrew to sulk.
The Dutch king's alienation of his many Dutch speaking but Catholic subjects in Belgium united them with their French counterparts, providing a powerful glue to hold society together well into the late twentieth century. Now, like most of Western Europe, society has rapidly turned secular. In 1967, 43% of the population attended Catholic mass every Sunday. By 1998 (the last year in which the Roman Catholic Church produced data) this was down to 11%. It is estimated to have fallen by 0.5% p.a. ever since, possibly accelerating given the latest sex-scandal investigations. (The Bishop of Bruges confessed to an unpleasant 20-year history and resigned; the police then raided and sealed off the Archbishop's palace, also the national catholic HQ on similar charges. The investigation continues.)
In line with this trend, reverence for the monarchy has also waned, although most of the country's kings have done a good job given they have forever walked the high wire over ferocious political and linguistic divisions. Little needs to be said of the fear quotient. Belgium has suffered from three highly aggressive neighbours: Germany, France and the Netherlands. It was a popular sport for each to routinely stomp all over the area. They have all changed their ways. Leaving aside a lack of clout, the British are now wholly ignorant of how or why they created Belgium at all.
The language chasm
Belgium is a federation of three states: Flanders in the North, where Dutch (Flemish) is spoken by the native Flemings; Wallonia in the South where the official language is French; and thirdly the all-important region of Brussels. This is surrounded by Flanders although the majority of the region speaks French. The linguistic divide is well-known, but this is not of the Mandarin vs. Cantonese or Castilian vs. Catalan spat variety. It is aggressive. Ten metres either side of the official linguistic border, the other language does not exist. Municipalities can and often do insist official documents and meetings only take place in their local language. This draconian legal divide was foolishly legislated into place in 1980 and has become more intolerant every since. Belgian politics are so culturally divided that all 12 of the major parties break down on linguistic lines and cannot stand in the other language area.
A shifting balance of power
Post-independence the balance of power shifted to the French speakers. The richer Flemish Belgians were highly dependent on Holland's colonial trade and capital. Post independence, this stagnated and so they concentrated on successfully out-breeding the French over the next 150 years. Meanwhile the French speaking south boomed. The development of iron, steel, coal and heavy industry - funded by French, and to a lesser extent German, capital and supplied by the major mineral deposits nearby - put all the financial and industrial power into Walloon hands. Like their previous masters in Holland, this was gradually abused. Almost all higher education was in French; plump political posts always went to French-speakers.
Meanwhile, the Flemish-speakers developed into a distinct but majority underclass. By the early 1970s, the wheel had again turned. Today, 75% of GDP is accounted for by the service sector as industry withers. The majority Flemings now sit in the financial chairs and have not hesitated to embark on a little light payback, such as splitting up key universities into Flemish and French speaking sections from 1968 onwards. The relative wealth of the Flemings is simply overwhelming. Their income per head is 118% of the EU average - the French-speakers 85%. Per capita productivity is 20% higher. They make up over 70% of the skilled labour force. French unemployment is twice that of the Flemish speakers.
Per capita, subsidies for French speakers are 50% more than for the Flemish. In short, Flanders funds and props up Wallonia.
This has not been lost on the ever chaotic voting system. Recent headlines have screamed that the independence parties have taken over. A slight exaggeration. True, the Flemish speaking, free market and pro-independence Vlaams Belang (VB) party won the most seats in the 150- member lower house, with an increase from 17 to 27 (in line with the wealth divide, the second largest party with 26 seats is the French-speaking Socialist "welfare" party). But this does not ensure separation, even though in those areas where it was allowed to stand, VB and its sympathisers won over 40% of the votes. Belgian law requires that at least four of the 12 "major" parties (seven Flemish and five French) form a government with at least one from each state. Hence, once again various caretakers are manning the desk. There is no elected government.
The most heated and longest debates in parliament concern two issues: language superiority and the French speakers demanding, and to date getting, an ever greater and disproportionate share of the welfare pie. Up north, not surprisingly this is unpopular. The result is net government borrowing equal to 100% of GDP. Not quite as bad as Greece and a few other miscreants, but add a budget deficit of 6% of GDP and a too-high a structural deficit, and Belgium is in the top fifth of over-borrowed nations globally, a position it has steadfastly maintained for the last 30 years. It has even been worse. Throughout most of the late 1980s and 1990s net government debt averaged 114% of GDP.
As with several Mediterranean countries, Belgium was a huge beneficiary of joining the euro (it was the first to do so) because the implicit German guarantee allowed heavy borrowing at much lower interest rates. Before joining the euro zone, general government net interest payments in 1992 absorbed a whopping 10.3% of GDP. In 2009, even after the collapse and necessary bailing out of its banks, especially the big two of Fortis and Dexia, interest payments were only 3.6%.
Follow the money
High debt and gradual linguistic separation have been a constant for 30 years. The recent elections confirm the trend of accelerating separatism. Yet these are likely to morph faster than expected into a financial problem because of Brussels.
Much to the dislike of most politicians across Europe, Brussels is the de facto Federal Capital. A small city; and only 1.1m people live within the "Brussels region". It is wealthy, with income per head 233% above the EU average. Moreover, despite being only a tenth of the Belgian population, it accounts for over a fifth of GDP. The reasons are well-known. Since the early 1950s treaties presaging the European Union, money has poured into Brussels. The EU Commission alone employs 25,000 people, the EU parliament another 7,000. There are over 10,000 registered lobbyists and more diplomats and countries represented in Brussels than in Washington. Then there are 1,200 accredited journalists (which may explain why expenditure on expenses accounts alone was €800m in Brussels in 2009). Just for direct running costs (i.e. rentals and electricity), the EU pumps $1bn into Brussels every year. Yet this money fountain is not only the EU. 40% of the population comes from outside Belgium, as it is headquarters to a range of other organisations which have developed into an administrative cluster. The better known includes groups like NATO, where Brussels is the European HQ with 5,000 employees. The range includes the weird, such as the heavily funded, big employing World Customs Organisation or EURATOM.
All these foreigners, usually funded by their overseas governments, are amongst the very highest earners in Europe, creating a major multiplier effect on schools, restaurants, cleaners, auto sales or house building. Originally majority Flemish-speaking, now most locally born Brussels residents speak French, the result of policies introduced when they were at the top of the economic tree. Yet Flemings - residents and commuters - still dominate the better paid and skilled jobs, hence Brussels is the only part of Belgium where both languages must co-exist by law. Some local French speaking politicians have been muttering darkly about doing to Flanders what Flanders wants to do to Wallonia, i.e. spin out of Flanders or even Belgium itself. This is because the money spigot is about to jam.
Turning off the taps
As the third richest region in Europe (after Luxembourg and London) it could in theory exist as a wealthy city-state cum federal capital, but such a dream is a chimera. Derided eurocrats live a life apart. Even Brussels-born residents who benefit from their largesse often complain that the many organisations have created rich ghettos from which they are excluded. That these eurocrats are out of touch has been demonstrated both by pay and expenses enough to make a third world dictator blink, and recent demands for pay rises.
There is a commonsense test to apply to the financial future of Brussels. Most European countries are net recipients of aid from the EU. Of the minority putting money in, Germany dominates. Other small contributors such as Scandinavia or the UK are co-joined triplets with Germany. Forced to slash their own capital, social, and welfare budgets following the financial crash, they will not put more into Brussels. It is a matter of time before each country decides to reduce its net or gross cheques written out to various Brussels organisations; hence the second most important engine of Belgium's economy (after the wider economy of Flanders) suffers its first ever post-war squeeze. This means it has less largesse to spread around - particularly in Wallonia.
Moreover, Brussels is no longer so logical a geographic centre for a federal capital since the EU expanded eastwards. This has not been lost on the Germans (Brussels' most significant honey provider). Its press and politicians have suggested for example that NATO be moved from a largely neutral country with minimal military capability to one with a little more vim, such as Germany. France would murder to get its hands on more EU institutions. Even the UK, ever-equivocal about what it really wants form the EU, and outside the euro zone, would like a few pointless but foreign funded pork barrels like EURATOM. Such major political changes will take time. Turning off the money spigot is easier and will happen sooner.
How it plays out?
What is evolving in Belgium is old news. The problem now, as for divorcing couples, is how to divide up the assets, or more precisely in Belgium's case, its sovereign debt. It is noteworthy that the government is chary in producing full data on how much Brussels and Flanders subsidise the minority Walloons, but roughly speaking the national debt should probably be split about 35:65 Dutch:French. Yet relatively poor Wallonia simply could not service nearly €260bn of national debt (€175,000 per person in employment). Meanwhile, wealthy Flanders would emerge with a budget surplus, a minute structural deficit and debt to GDP the lower than any EU nation outside of Scandinavia. The imperative for Flanders, along with the scope for argument, is clear.
There is a growing risk of a faster than expected dissolution of Belgium which will result in sovereign default; this is based on a belief in the inability of the individual nations within the euro zone, let alone the EU institutions themselves, to realise that as nations unravel, speed is of the essence. To repeat, the net €400bn national debt is chicken feed - less than half the loss racked up by America's AIG in 2007-8. And in wealthier times, the dream then shared by most of its members, of a politically united Europe would have ensured a quick bailout led by Germany. Mrs Merkel has already discovered that small cash subsidies to the profligate, such as Greece, are very expensive electorally. So foot dragging and evasion are sure to be the political order of the day. As the divorce commences, little is gained in double guessing the next phase. Whether Flanders goes alone as a fabulously rich small state or joins up with Holland (now the religious issue is moribund) is a moot point. Equally, whether France chooses to absorb Wallonia into greater France (Sarkozy's wild card to escape likely electoral defenestration?) or to subsidise Wallonia as a client state again, is also an unknown. On every topic, there is no agreement on how these regions should evolve, nor who is responsible for the debts, further ensuring delay.
Investment conclusions
If markets have re-learned one lesson recently, it is that small events have disproportionate results. Belgium ranks as the world's 20th economy by size, accounting for 0.8% of world GDP. Greece before the fall was No. 28, with 0.6%; its problems continue to shake markets, both because they were unexpected and because of the risk of a domino effect. So too would be the problem with Belgium. It is yet another reason why government bonds are toxic and why at some stage their yields will blow out, thus capital values fall.
Obviously, not holding Belgian shares on a medium term basis is sensible unless valuation work has fully taken account of these unexpected risks (clients have zero exposure). Once again the euro would fall and the German export machine boom. Equity markets would rattle around for a while but then absorb the key lesson. For Belgium is yet another example, as if one was needed, that the supply of government bonds over coming years will continue to soar to unprecedented levels even. All commodity prices tumble when the supply is perceived as infinite. Meanwhile, equities would benefit.
Regards,
Bedlam Asset Management plc
