Interview with Chief European Economist of the Royal Bank of Scotland Jacques Cailloux

By Zhang Feifei and Paul Pennay
Published: 2010-07-22

The Economic Observer: Can you talk a little bit about how you see the situation for the Spanish banks?

Jacques Cailloux: Yes, we published this report earlier this week. The main point of the report was that we were trying to express our concerns about medium term growth outlook for the Spanish economy. Investors are questioning the medium term outlook.

The Economic Observer: In terms of the funding situation, is it not the case that the interbank market, the money market, especially the banks in Portugal, Greece and Spain are not really working at the moment. That these banks are not able to refinance or are not able to get their hands on any cash through the interbank market.

Jacques Cailloux: Well, there is no variable that people can rely on, but it does look like the funding situation is difficult. I think the only way you can see that through is by the increased funding costs for Spanish banks. It is difficult to gauge the extent of the stress that there is in the interbank market, but it appears that there is some pressure there.

As far as the banking sector is concerned, it is very important that the stress tests are used for what they should be used for, which is basically to restore market confidence in the banking sector. This is true for Spain, but it is also true for other countries. And the way you do this is by being very specific on what conditions are to be met if you want to have a positive response to the stress test.

To me the most important one is that the assumptions which are taken are realistic enough or even not so realistic but are very aggressive in stress testing the system given the amount of skepticism that there is in the market. It is important that the regulators do take that on board and do not come up with a stress test that looks soft. If you do this, you miss the opportunity to restore confidence and then you lose another bullet.

The Economic Observer: On this issue of confidence, in speaking with Spanish bank officials and people at the trade and budget office, they are arguing that the figures are good, yet they have a low growth forecast, but  have already made some decisions in terms of the consolidations of the smaller banks. There has also been a shift in policy in terms of structural adjustment. Why is the market not convinced by these measures?

Jacques Cailloux: The way I look at it is, if you decompose sources of growth of Spain in the 10 years running up to the financial crisis, from 1997-2007, this is an economy in nominal terms which is growing at about 7%. And whose total debt,  if you aggregate self interest and the private sector, is 300% of that to GDP. So think about an economy that is growing at 7%, has very strong private sector debt growth and has very low funding costs. So in a sense, it is a model that you think is sustainable provided that your sources of growth are sustainable. Now it looks as though, if you look at the sources of growth over that period of time, that a very large part of the drivers of growth were actually just transitory. Three transitory sectors are population growth, the real estate market, and consumer price inflation.

The Economic Observer: But obviously there are some sectors such as the two major banks which are very strong, particularly their ties to Latin America. You don't see any potential for growth there?

Jacques Cailloux: Absolutely, there are pockets of strength in the economy and we actually saw it in their export numbers. So there is very impressive recovery in exports. If you look at the growth rate of exports, it is actually stronger than in Germany and in terms of volume, Spain has actually already recovered to pre-crisis levels as far as exports are concerned. That is positive and you also mentioned that Spain's bigger banks are very strong, very well capitalized, some of the best capitalized banks in Europe…

But we are taking more of a medium term view and looking at the drivers of both that economy and the fact that this is an economy which is probably not going to be able to grow anywhere near the pace at which it was growing before, which means that there is an environment where the debt dynamics are more difficult to deal with. So your de-leveraging process that needs to take place in the private sector is not helped by the fact that income growth is weaker. So the way you deal with that is you look for a re-balancing of your domestic economy, and you look for both the household sector and the corporate sector to readjust in terms of the net borrowing position. Now some of that re-balancing internally has already occurred. Look at Spain's current account balance, you can see that.

The current account balance I think at the widest was close to 12% of GDP and on the latest numbers it looks like it is closer to 4%. So there has already been a huge amount of internal adjustment, which is good; it means that the corporate sector is adjusting and the household sector is adjusting to a new sort of critical strain and is going into a de-leveraging process. But the other side of the coin is that domestic money is very weak. You can only return to a net positive position if your expenditures side diminishes. And that is reflected in weaker consumption and weaker investment which itself has implications for the state in terms of raising revenues. So it is not an easy one, it is a long process and the market questions that. The market does not have the patience to wait 2-5 years to see whether that process has been successful or not.

The Economic Observer: On Germany in general, if you compare the German situation to the situation of the Spanish banks, could you comment on the health of the banking sector in each country in terms of how the markets differentiate between the two.

Jacques Cailloux: Well, I guess the big difference between the two from the markets standpoint is that the market does believe that German balance sheet at the sovereign level is solid which I guess is probably the biggest difference.

The Economic Observer: Does this have to do with exposure to real estate?

Jacques Cailloux: No, I think it has to do with the fact that Germany is still considered a very, very credible sovereign and the most credible sovereign in Europe, and so this is a sovereign that can shoulder additional stress in its banking sector; while in the case of the periphery in general, I think there is a view from the market that the balance sheet from the sovereign sector in the periphery is weaker than Germany, so I think while there are doubts in terms of the banking sector. I think there is much less doubt in the ability of Germany to take all that from a sovereign standpoint which is also why Germany is the biggest contributor to the European stability fund.

The Economic Observer: The topic of communication is very interesting because when you talk to officials, they are saying that the market is not getting it and that they are talking very clearly and giving clear signals but the market is not reacting while the market says policy makers need to talk clearly.

Jacques Cailloux: Yeah, I have had these discussions as well with policy makers who miss the point when they say, "Look, you can not question our solidarity because in the end we put the money on the table much earlier than people expected. How can you question our solidarity and cooperation?"

To this, I would say we did go through a period of time between March and May during which we did question this solidarity and the ability of policy makers to communicate well. In comparison, two countries like the US or the UK where you only have one treasury, you only have one prime minister or one head of state or whatever, so the communication around those issues can be streamlined and can be quite powerful which for a region like the European Union is extremely difficult too. So I think that was quite damaging for the vision or view that the market had for the region's ability to resolve the crisis.

The Economic Observer: And this delay between March and May got people thinking?

Jacques Cailloux: Yes,that had a massive impact in terms of the international investors view about the region. To regain their confidence is very difficult. Especially when you hear different comments made by different policy makers that seem to be in contradiction with one another.

There is no institution in Europe which can take over and speak with one voice. So that is where the fundamental issue is as far as communicating with the market is concerned, so the European Commission is not your typical institution that is used to speaking with the market.

The Economic Observer: Quickly on this idea that there is no institution to deal with sovereign debt, do you see any potential for a new institution to take on this role?

Jacques Cailloux: You know, what I think is going to come out of this commission is going to be probably limited by the constraints of the treaty. So they can hope for major reform but they will find themselves quite constrained by the treaty so I do not expect a major transformation as a result of that.

The Economic Observer: You gave me a picture of short term grade prospects and you said there will be an inflection point in June. Looking further out in maybe a 3-5 year period, given that suddenly these peripheral economies have been making structural adjustments, do you see greater growth prospects looking out over the medium term?

Jacques Cailloux: I guess the answer is no, but you are right if you think about economies like Greece where the kind of structural reforms which have been injected in that economy, you think that this is going to unleash potential growth over the next ten years. That is why the labor market reforms in Spain are going to generate an awful lot of growth potential.

The Economic Observer: Is that not what economists have been saying for the past many years? That if these economies implement these adjustments,there will be growth.

Jacques Cailloux: So with that, the reforms might result in a medium boost and we might be underestimating the impact that this is going to give.

The Economic Observer: What is countering that?

Jacques Cailloux: The countering factors are that we have had 15 years of a buildup of debt either in the private or in the public sector depending on which country you looked at. And that needs to be worked out over time. Structural reforms sometimes have a negative effect on domestic demand in the short term and can result in weaker nominal growth.

The Economic Observer:  I was just talk to a professor from the Frankfurt school and he suggested that if some of these countries like Greece,Spain,or Portugal are unable to remain competitive, they may turn away from free trade if put under enough political pressure. Do you see any prospects of that ever happening?

Jacques Cailloux: I think to some extent we have seen it in this crisis. We have seen that if your domestic economy does not do well and unemployment rises, the population tells itself to look back on domestic issues and so does the government as a result of that, which to some extent is probably one of the reasons why solving the crisis in Greece has been so difficult because it is easy to help your neighbor when you are growing fast and your economy is expanding than it is when you are just coming out from one of the deepest recessions in generations.

Typically these protectionist movements or phases tend to be associated with the business cycle, so the weaker the business cycle, the higher the chance of some form of protectionism. So in that context, yes, you could see that in those economies that are struggling the most that they may actually try to focus on their own economy with some sort of protectionism.

The Economic Observer:  I spoke to an economist who said that if this crisis was not happening then what we would all be talking about is this huge spike in commodity and energy prices as demand from emerging economies increases. How do you see the prospect for that? When a recovery takes place and things stabilize, will that be the next big challenge that Europe faces?

Jacques Cailloux: Yeah, it is clear if you look at the inflation for the region, you struggle to find any domestically generated factors that might create inflation. In fact, if you are looking domestically, it looks more like a deflationary situation than an inflationary situation so you need to look at external factors. If the global economy continues to grow at the similar pace that we had in the first half of this year, which was exceptionally strong, but clearly skewed toward those economies in the world that are heavy consumers of commodities, then you could see pressures on importing inflation from Europe. This becomes an issue because this is an economy that is not growing very fast, you do no want to have inflation in a region that is not growing very fast because it creates this huge problem for the central bank. How do they respond to it? We are just going to have a lot of challenges. When one goes away, another one comes. If it is not aging, then it is the price of commodities and if it is not that then it is the debt crisis and so on. It does look like the headwinds are there to stay I'm afraid.