Coming out of the G-20 meeting over the weekend we have two diverging views coming from Europe and the US. In Europe, the strong consensus is that high budget deficits need to come under control in order to strengthen the fiscal position of government's balance sheets. In the US, the focus was on trying to increase demand from trade surplus nations to buttress the global recovery.
From the G-20 Communique:
The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions.
The language here was influenced by new UK Chancellor of the Exchequer George Osborne. We have already seen troubled nations like Greece, Portugal and Spain pass plans that impose austerity measures on spending. That is being followed by announcements from Germany and the UK of large spending cuts.
Germany Preparing Cuts of €10 billion per Year
Today, German Chancellor Angela Merkel's Cabinet will meet to hammer out a plan to cut government spending. The budget cuts will shape government policy for years and will try to cut €10 billion ($12 billion) of government spending per year. That could impact growth as the economic recovery in Germany is being led by the export sector while domestic demand has yet to return to strong levels. Tax increases, cuts in welfare and jobless benefits and the loss of about 10,000 civil service posts are among the German measures being considered.
Germany's budget deficit is forecast to rise to 5.5% of GDP this year, much smaller than the 13.6% seen in Greece last year, or the 11.1% seen in UK for the fiscal year to March 2010. However, it is still above the 3% set out by the EU. Merkel's move is a signal to the rest of the Euro-zone nations that spending cuts and bringing deficits in line is the order of the day, in order to restore confidence in markets and keep the credit ratings of the sovereign debt in the large countries of the Euro-zone, like Germany and France, at the top rating of AAA. Spain for instance, got its credit rating downgraded to AA+ two weeks ago.
UK Prime Ministers Tries to Gain Backing for Sharp Cuts
David Cameron, the new UK Prime Minister, began preparing voters for deep spending cuts. In a speech today Cameron said, The overall scale of the problem is even worse than we thought. The decisions we make will affect every single person in our country. And the effects of those decisions will stay with us for years, perhaps decades to come.
One troubling figure is the estimate that government debt-interest costs could reach €70 billion ($101 billion) in 5 years time, up from €31 billion in the last fiscal year.
Effects on Euro and Pound in Medium Term
These changes will affect the Euro and Pound in the medium term as it will take time to implement spending cuts. Both have slid sharply against the Dollar and others as the Euro-zone sovereign debt crisis put the focus on government's fiscal and debt positions. While the moves show to investors for government bonds that the message has been heard loud and clear that government's need to bring their fiscal house in order, it could mean some retrenchment in terms of domestic demand.
In the short to medium term the Euro will continue to be pressured due to the debt crisis as we saw a fresh round of selling to end last week. The EUR/USD is therefore likely to continue dropping, falling to the $1.15 level in the next three months.
The Pound meanwhile while also facing pressure from the debt issues in the Euro-zone and growth is slow (0.3% in the 1Q), inflation has been running rather high which could cause the BOE to sound more hawkish at its interest rate meeting this week.