Draghi’s “growth pact” = Internal devaluation


Author Cam Hui

Posted: 07 May 2012

As we await the results of the French and Greek elections, there has been a considerable change of focus in the eurozone from the paradigm of all-austerity-all-the-time to growth strategies. The villians, according to those who push back at the “fiscal compact”, is Angela Merkel and, to a lesser extent, Mario Draghi.

What I don’t get is that many analysts have failed to understand (see the post by Yves Smith as one example out of many) is that Draghi has said repeatedly said that the long-term plan has two components:

  1. “Good austerity” in the form of lower taxes and lower government spending. But the Grand Plan isn’t all austerity, all the time. The second component addresses the problem of the competitiveness gap between northern and southern Europe, which means:
  2. Structural reform, which is the European version of the step China took to “smash the iron rice bowl” in order to create labor flexibility for all, not just the young but all of the current employees in their cushy jobs and gold-plated pension plans. Draghi went on to characterize structural reform as the old days of the European social model being all gone.

He talked about this in late February when he revealed the Grand Plan for the eurozone. He positioned structural reform as a “growth compact” when he spoke to the European parliament in late April. Last week, he went further when the Telegraph reported that ECB president Mario Draghi calls for binding ‘growth pact’:

The president of the European Central Bank (ECB) said it was of “utmost importance” for leaders to impose fiscal discipline but also to generate growth by “facilitating entrepreneurial activities, the start-up of new firms and job creation”.

He echoed demands for a “growth pact” from leaders including the French presidential hopeful, Francois Hollande. But rather than protectionist policies advocated by some, Mr Draghi said his ideal growth pact would be based on free labour markets and structural reforms that would be “agreed collectively, not unlike the fiscal [pact]”.

He said political commitment would be “the most important” part: “Collectively we have to specify the future of the euro; where do we want to be in 10 years’ time?”

The “growth compact” in micro and macroeconomic terms
I feel that the market still doesn’t really get Draghi’s “growth compact”. Let me try to explain it in micro and macroeconomic terms. In microeconomic terms, it addresses the barriers to business formation in many Club Med countries. Simply put, it’s hard to fire people. The “growth compact” is an Anglo-Saxon, or Thatherite, solution to make it easier to terminate employees. This is what Draghi meant when he stated in the WSJ interview that “the European social model has already gone”. His reasoning is illustrated by his response that the current arrangement is inherently unfair to the youth of Europe [emphasis added]:

WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.

The Anglo-Saxon reasoning goes, if it is easier to fire people and make them work harder or take away their gold plated pensions, it creates more opportunity for growth and business formation.

In microeconomic terms, the “growth compact” is structural reform, pure and simple. In macroeconomic terms, the “growth compact” means an internal devaluation by the peripheral countries in the eurozone, which is a fixed exchange rate regime. The Greeks, Italians, Spaniards, etc., just have to work harder and get paid less.

Projecting the gains under a “growth pact”
What are the possible gains under such an internal devalution? FT Alphaville reports that Morgan Stanley’s Joachim Fels and Elga Bartsch took a stab at the problem:

Morgan Stanley projects that the Club Med countries (which include France) could gain about 15% of GDP growth over 10 years if they adopted these structural reforms. This amounts to an average of 1.5% of GDP a year, which is considerable when you consider that the long-run real growth rate in Europe has been hovering around 2% per annum.

Martin Wolf of the FT showed some analysis in a presentation on May 3, 2012 to the National Economists Club and Petersen Institute for International Economics. My conclusion, in the context of the “growth compact”, is that the Club Med countries should try to become more like Ireland.

Note how unit labor costs in the troubled peripheral countries have been rising relative to Germany – all except for Ireland. These structural reforms that make it easier to hire and fire people, or internal devaluation, could get unit labor costs down below German costs and make Greece, Spain, etc., look more like Ireland.

Also note from the first chart how low Morgan Stanley has projected Ireland’s  gains from structural reforms are, indicating that Dublin has already made the hard choices. This also means that Ireland will be the poster child for the growth pact and structural reform. The preliminary indications appear to be positive. This CNBC report discussing the upcoming Irish referendum on the fiscal compact shows that business are re-locating to Ireland “attracted by its relatively low corporation tax and increasingly cheap workforce”:

Some of the forward-looking indicators for the Irish economy have been more positive. Tax revenues for March are 370 million euros ($486 million) ahead of target in the year to April 2012, driven by healthier corporation tax revenues as companies move to Ireland, attracted by its relatively low corporation tax and increasingly cheap workforce.

Nevertheless, I would expect that the trajectory of Irish growth will be scrutinized intensely to see if the harsh medicine is working.

A more realistic scenario
If all eurozone countries were to adopt the structural reforms that Draghi advocates and the Morgan Stanley analysis is correct, Germany would also gain 12.5% in GDP growth per annum. The spread between Spain and Germany is only 2.5% over 10 years, or 0.25% a year – hardly worthwhile.

Let us assume a more realistic scenario. Supposing that the peripheral countries were to adopt some form of structural reform, but only get two-thirds of the gains projected by Morgan Stanley, i.e. about 10% instead of 15% over 10 years. Assume, at the same time, that the Germans rest on their laurels. Indeed, former IMF chief economist Simon Johnson wrote in Bloomberg that German Unions Seeking Higher Pay Could Save the Euro [emphasis added]:

The solution involves a move straight out of the gold-standard playbook, with a modern twist. Since monetary union began, Germany has had substantial productivity gains and only moderate wage increases, making it highly competitive. Eurostat reports that German wages rose 2 percent a year from 2000 to 2009, while Spanish wages increased by 4.7 percent a year in the same period — more than twice as fast. Because the currencies are the same, Germany’s competitiveness has made it tough for Spain and the other weaker states to sell their products in the euro area.

But the cavalry may show up in the unlikely form of German trade unions, which are seeking big wage increases this year. Recent demands by German workers range from 3 percent to 6 percent. As Bloomberg News reported, IG Metall, Europe’s biggest labor union with about 3.6 million workers, is demanding 6.5 percent more pay at a time when inflation is about 2 percent.

This isn’t crazy. German unemployment is at its lowest level in two decades. German exports have been doing well around the world. To some monetary purists, talk of higher wages suggests that the European Central Bank’s policy is too loose for current German conditions. But this is really taking an idealized version of the gold standard too far.

The point is to have relative wages and prices adjust — higher for Germany and lower for its European trading partners. If German incomes rose, German consumers would have more disposable income with which to buy imported goods. And lower labor costs in other European countries would make their goods and services less costly, giving them a leg up against Germany’s export machine.

If the people in charge — mostly Germans at this point — insist that the adjustment must come entirely through a fall in the absolute level of wages and prices in countries with current-account deficits and large amounts of debt, then Europe is in for a difficult, and perhaps lost, decade.

But if part of the adjustment can come through higher German wages — recognizing productivity gains and consistent with continued prosperity — the path forward will be easier.

In other words, German wages go up while Club Med wages go down. Both Germany and the peripheral countries take actions to bear the cost of this internal devaluation.

The big question
Here is the big question. Assuming that the peripheral countries enact these structural reforms that make them more Anglo-Saxon. Would that create sufficient incentives for big employers like Alstom, EADS, BMW, Siemens to locate plants in Valencia, Thessaloniki or Lisbon, instead of looking at Poland or Slovakia as they do now?

I don`t know. What I do now is that the ECB has always had an agenda, or wish list as outlined by this analysis:

The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.

To the extent that member states are willing to go along with the ECB, it has shown an inclination offer the carrot of supporting the harsh adjustments necessary with easy monetary policy and unconventional policies, such as LTRO. On the other hand, it has the stick that, if a member state were to falter, the ECB has the option of leaving that government to the mercy of the bond market wolves.

Draghi realizes that these prescriptions are harsh and that`s why he used the analogy of crossing the river in this report:

Structural reforms are essential to restoring competitiveness but will also cause pain in the short term, the ECB president said.

“Structural reforms hit vested interests,” he said, adding that they “change profoundly the society.” These changes are themselves “a source of pain,” he added.

We are just in the middle of the river that we are crossing. The only answer to this is to persevere and for the ECB to create an environment that is as favourable for this as possible,” Draghi said.

Notwithstanding the news flow over the pending elections, the fight over austerity and structural adjustments is by no means over, regardless of the electoral outcome.

My bet, in the long run, is still on Draghi and Merkel. In the short run, however, anything can happen.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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How much more pain in Spain?


Author Cam Hui

Posted: 19 Apr 2012

The headline read: Ray Dalio’s Bridgewater Says Spain Is Worse Off Than It Was Before The LTRO. Simone Foxman reports Ray Dalio of Bridgewater Associates believes that:

The fund argues in a recent note to investors that Spain is even worse off than it was before the ECB announced its two LTROs in December.

Dalio argues that the tenuous circle of fragile Spanish banks providing funding for the Spanish government which in turn supports the troubled banks is swiftly eroding, if not vanished already:

I have argued in the past that the European Elites have a Grand Plan, consisting of austerity and structural reform, combined with a compliant ECB as long as the first two initiatives are followed. Foxman reports that Bridgewater believes that any policy response will be complicated:

  • Dalio and his team believe that since the burden is being shifted to the public sector and domestic banks, we will be less likely to see the kind of private sector debt restructuring used in Greece.
  • They also predict that EU leaders could soon tire of the slow progress of Spanish bank mergers meant to clean up Cajas’ balance sheets.
  • Dalio believes that EU policymakers remain committed to ill-fated attempt to “save almost everyone” by using under-capitalized bailout funds like the European Financial Stability Facility.
  • But they will also have to act in a much more of a hurry than they previously believed, given Spain’s predicament. This will show the inadequacy of currently budgeted resources to deal with the problem, and could pain EU leaders’ abilities to deal with crisis problems in a negative light.
  • Ultimately, Dalio thinks, trying to save Europe without restructurings will prove to costly, and EU leaders will have to accept that more restructurings will be necessary.

In other words, a policy response will have to be quick. It will be complicated, but not impossible. Megan Greene of RGE says that a Spanish bailout is pretty much inevitable:

If Spain is unable to regain market confidence, will it be pushed into a bailout programme? Not immediately, but this does seem inevitable. The good news as far as Spain is concerned is that the country has already pre-funded half of its debt rollovers for 2012. Even if Spain faces unsustainable borrowing costs, it will not actually run out of cash this year.

Furthermore, the ECB will not stand idly by while Spain is forced into a bailout programme. At the very least, the ECB will step up its Spanish bond purchases through the securities markets programme (SMP). While additional long-term refinancing operations (LTROs) are unlikely so soon after the three-year LTROs were offered, the ECB may take further steps to prop up the ailing Spanish banking system.

While ECB intervention could buy some more time for Spain in the short-term, it is extremely unlikely to fundamentally change Spain’s fiscal or economic trajectories. In the absence of economic growth, Spain will eventually be forced to request official financing, potentially as early as next year.

Italy, 2011
Consider the recent history of the eurozone. Despite the dire headlines, the eurocrats were able to avert a catastrophe in 2011. Take the case of Italy, which was considered to be too big to fail but too big to save. A look at the MIB Index, which represents a broad index of Italian stocks, show that the MIB plunged and tested the technical support level offered by the lows in 2008  2009 – and support held.

Spain, 2012?
If you were to believe that the eurocrats have a Grand Plan for Europe (and there seems to be convincing evidence that there is one), then the most likely scenario is the northern Europeans hold peripheral country governments’ feet to the fire in order to enact Grand Plan reforms, e.g. Spain plans to strip regions of powers in bid to calm markets. Were a real financial crisis were to hit, however, the authorities (e.g. the Troika) would come to the rescue and take steps to kick the can down the road a little bit more.

This would suggest a highly speculative trading strategy. Wait for the the IBEX Index, which represents Spanish stocks, to test its 2008 2009 lows – and then buy and wait for the cavalry to come over the hill.

Currently, IBEX has taken out its 2011 lows, but has not yet tested its 2008 2009 lows. Should such a test occur, the risk/reward ratio would likely be favorable enough to put on this highly speculative trade. For North American based investors, there is a Spanish market ETF available (EWP). Banco Santander (STD) is also US-listed.

If I am right, then there isn’t very much downside to European equities. If Dalio is right and the European authorities “have to act in a much more of a hurry than they previously believed”, then the crisis will be upon us sooner than anyone expects. In that case, maybe we should getting ready to buy in May?

Warning: Such a trade is highly risky and anyone who enters into it should size their positions carefully in accordance with their own risk tolerances (which may mean a zero position). If you were to put on such a trade, I would suggest that you enter a stop loss at 5-15% below your entry point in order to limit your downside. The risk/reward ratio should be favorable, but in this case, we would be playing the odds and the upside potential, though considerable, is highly uncertain.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Sarkozy follows the Grand Plan script


Author Cam Hui

Posted: 09 Apr 2012

As we enter the French presidential campaign season, the Economist complained that the candidates were ignoring the economy, the FT had an article with the headline of Sarkozy to campaign on public finances:

President Nicolas Sarkozy put controlling the country’s public finances at the centre of his re-election campaign, saying France faced a “historic choice” if it wanted to avoid sliding into economic crisis like Spain or Greece.

Unveiling a 32-point programme on Thursday that detailed tax and spending plans for the next five years, he promised to eliminate France’s chronic budget deficit in 2016 and return the country to a budget surplus in 2017 for the first time in more than 40 years.

“Some countries are on the edge of a precipice today,” Mr Sarkozy told a press conference in Paris. “We cannot refuse to make the historic choice of competitiveness, innovation and reducing public spending.”

“The situation which our Spanish friends are experiencing, after what our Greek friends experienced, remind us of the realities,” he added.

In concert with his economic focus, Sarkozy released a 34 page manifesto that told French citizens the way it is, with little sugar coating.

Starting on page 16, he recounts the economic difficulties that France has experienced in the last few years. For those who don’t read French, here are the original, along with the English version from Google Translate:

En 2011 enfin, la crise de la dette des Etats a failli faire disparaître l’euro. L’euro n’a pas tenu toutes ses promesses, c’est un fait, mais rien n’aurait été pire que son implosion. C’eût été le saut dans l’inconnu, l’Europe divisée, de nombreuses banques en faillite, des millions d’épargnants cherchant à retirer leurs liquidités, les Etats, dont la France, obligés d’emprunter à des taux rédhibitoires, et de réduire en conséquence leurs dépenses de façon brutale tout en augmentant lourdement les impôts.

Finally in 2011, the debt crisis of the States has threatened the existence of the euro. The euro has not kept its promises, it is a fact, but nothing was worse than his implosion. It would have been jumping into the unknown, Europe divided, many failed banks, millions of investors seeking to withdraw their cash, states, including France, forced to borrow at prohibitive rates, and consequently reduce their costs while increasing brutally heavy taxes.

The recession would have been even greater violence. That’s why I did everything to save the euro and to save Greece. Greece only let out of the euro, it was admitting the reversibility of the single currency. Why not then Italy, Spain, Portugal? It would have been to risk a dangerous contagion.

How many politicians actually tell the voters the harsh reality? What’s even more interesting is Sarkozy’s assertion that Germany has the least to lose from a eurozone breakup, indicating that it is up to the rest of the eurozone, including France, to make difficult adjustments:

L’Allemagne est le pays auquel l’implosion de l’euro aurait causé le moins de problèmes. Elle s’est conduite en alliée pour sauver notre monnaie commune. En même temps, la France a obtenu une réforme de la zone euro pour que les errements du passé ne se reproduisent pas : le gouvernement économique de la zone euro que je réclamais depuis des années est désormais en place et la convergence des politiques économiques est engagée.

Germany is the country to which the implosion of the euro would cause the least problems. She was driving an ally to save our common currency. At the same time, France was awarded a reform of the euro area so that past mistakes are not repeated: the economic government of the euro area that I claimed for years is now in place and convergence of economic policies is engaged.

He went on to say that there is no going back and, implicitly, Hollande’s assertion that he would try to get France a better deal within the EU is doomed to failure:

Tout cela a été très difficile. Nous étions au bord du gouffre. Croire dans une réouverture des négociations est une utopie tout simplement parce que celles-ci viennent de s’achever et que pas un gouvernement en place en Europe ne le souhaite. Avec le sauvetage de la Grèce, la réforme de la zone euro vient en outre d’enregistrer son premier succès majeur. Cela n’a donc rien à voir avec la réforme de la zone Schengen que je propose, dont le traité fondateur date de 1985 et dont les insuffisances sont criantes. Cette réforme est au surplus souhaitée par un nombre croissant d’Etats.

All this was very difficult. We were on the brink. Believe in a reopening of negotiations is a utopia simply because they have just been completed and that no government in place in Europe wants. With the rescue of Greece, the reform of the euro area has also recorded his first major success. This has nothing to do with the reform of the Schengen area that I propose, whose founding treaty in 1985 and whose weaknesses are glaring. This reform is moreover desired by a growing number of states.

Sarkozy is, in effect, following the Grand Plan laid out by the eurocrats as outlined in the interview by Mario Draghi by dragging the French screaming and kicking into a market based reality. The Grand Plan calls for “good austerity” in the form of tax cuts and government cutbacks, along with structural reform that does away with the European social model.

Will Sarkozy’s approach of giving the unvarnished truth to the French electorate work? Bloomberg reports that a recent poll shows that he is narrowing the lead on Hollande. Even though his socialist challenger is in the lead, Sarkozy has shown himself to be a formidable campaigner. Hollande is being pulled to the left with his proposals to raise the top marginal tax rate and to lower the retirement age back to 60 from 62, which may hurt him.

While the markets may not react well to a Hollande win, all is not lost. The new president will have to deal with the bond market vigilantes, who will be out in force shortly after the election. No doubt Merkel and the Germans would prefer to deal with Sarkozy because he is the devil they know, Hollande has also shown himself to be European in outlook and he is committed to the European Union and understands the consequences of a eurozone breakup. If he were to get elected, we will no doubt seem some back-and-forth which leads to a watered version Grand Plan 2.0, but Europe is likely to continue to proceed down the reform path.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Europe takes one step back?


Author Cam Hui

Posted: 29 Mar 2012

The story of Europe has been the story of two steps forward and one step back. Here are the two steps forward/

Since the eurozone crisis, the ECB has taken steps with its LTRO programs to stabilize the banking and financial system. Moreover, I wrote that Mario Draghi, on behalf of the eurocrats, outlined the Grand Plan as a way to fix the long-term problems within the eurozone. The Grand Plan consisted of two steps, which sound like pages taken from the Maggie Thatcher playbook:

  • Austerity in the form of “good austerity”, defined as lower taxes and less government spending; and
  • Structural reform, which is the European version of the China taking steps to smash the iron rice bowl, which translates to union busting and going after all of the entrenched interests of the old with their lifetime jobs and gold-plated pensions at the expense of the young jobless.

The one step back happens when Europe dilutes these grandiose object. In the wake of the German and Dutch failure to hit austerity targets, a step backward is inevitable.

Time for Grand Plan 2.0
Most recently, the OECD warned that the eurozone debt crisis is far from over. The organization indicated more work needed to be done, i.e. Grand Plan, and market confidence is fragile. At about the same time, Willem Buiter at Citigroup issued a warning on Spain:

Spain is likely, in our view, to be pushed into a troika (EC, ECB, IMF) programme of some kind during 2012, possibly by losing access to market funding on affordable terms, but more likely by the ECB making a programme for the Spanish sovereign a condition for continued willingness to fund the Spanish banks, which are currently the main buyers of newly issued Spanish sovereign debt. The existing and likely near future EFSF/ESM and IMF financial facilities are unlikely to be sufficient to both fund the Spanish sovereign fully and leave enough financial ammunition in reserve to deal with possible sovereign financial emergencies in Italy or in the ‘soft-core’ of the euro area. The Spanish sovereign would therefore likely continue to fund itself at least partly in the markets even if it comes under a programme. To ensure market access by the Spanish sovereign, the same combination of cheap ECB funding for periphery banks and financial repression of periphery banks by their national authorities that has been effective in lowering sovereign yields since the first LTRO is likely to be required.

Buiter did concede that the government is taking steps to implement structural reforms:

It did use this period to pass several important pieces of structural reform legislation. Among these were labour market reforms aimed at reducing severance pay in the long-term contract sector (while introducing or raising it in the flexible contract sector); reforms aimed at reducing the scope and incidence of industry-wide collective bargaining and replacing it with something closer to firm-level or establishment-level contracting; the imposition of an additional €50bn provisioning requirement on the banks; and laws aimed at strengthening central government control over the finances of the lower-tier authorities (autonomous regions and municipalities).

…though he was uncertain as to their implementation:

Passing legislation and implementing it are not the same thing, however, as we know from the Greek experience. In addition, both structural reform and a medium-term programme of fiscal austerity based on a politically acceptable formula for fiscal burden sharing look necessary to restore Spain to fiscal sustainability. The new government’s decision to wait 100 days to introduce its first budget, in the pursuit of electoral gain, did little to boost Spain’s standing in global markets.

Spain is a too-big-to-fail country within the eurozone. Market angst is starting to rise over the willingness of the Spanish government and the Spanish people to bear the pain of austerity.

Will Spain fall and bring down the eurozone in another crisis? I doubt it. This is the back-and-forth of the Theatre of Europe, but some form of Grand Plan 2.0 compromise will likely emerge. I agree with Gayle Allard at the IE Business School in Madrid who says to not count Spain out in a crisis:

[Allard] said Spain’s biggest problem is investors’ lack of faith in the population’s willingness to withstand austerity. “They don’t see the Spanish people in that way, they don’t understand how a country can put up with it,” she said.

“Having watched Spain through previous crisis, they are a pretty surprising country. They get behind things, hard things,” Allard said. “I don’t think this is ever going to look like Greece and that’s something the markets don’t understand.”

Italy does structural reform
Over in Italy, FT recently reported that Mario Monti clashed with the unions over structural reforms “that would give companies more flexibility to fire workers for economic reasons” and he is winning because of weakened opposition:

[W]ith the [labor union] CGIL considerably weaker than a decade ago and with the main political parties in no position to offer a coherent alternative to the present government, political commentators doubt Mr Monti’s technocrats risk being driven from office.

Opinion polls indicate strong public support for Mr Monti in general, although a majority of Italians opposes changing Article 18 which protects workers in the courts from wrongful dismissals for economic reasons. Under the proposed changes, employees would receive compensation but not reintegration back into their workplace.

Monti is also following the Grand Plan script of structural reforms which pit the young unemployed against their elders, who have secure jobs:

With nearly a third of young people unemployed, Mr Monti also wants to end Italy’s two-tier labour market that protects older workers on indefinite contracts but provides little or no security for mostly new hires on short-term contracts.

The politicians are indeed following through with painful structural reforms. In the meantime, there is doubt from the markets that they can implement them even if the legislation is passed. In a typical EU-style compromise, some of the legislation will get watered down, but I believe that the pendulum is swinging back and the momentum toward structural reform is inevitable.

For now, the message for investors is be prepared for some downside volatility out of Europe. But also know that it is likely a temporary hiccup out of which Grand Plan 2.0 will emerge.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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