Edward Altman: Look to Private Sector Health, Else Eurozone Austerity Programs Could Mean Japanese-Style Recession

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Edward Altman is a professor of finance at NYU Stern. Dr. Altman developed the widely-used Altman Z-score, which was initially designed to estimate the probability of a firm defaulting. Recently, he has reworked his metrics to apply them toward analyzing sovereign risk. We spoke with him on Benzinga Radio to get his insights on the various economies that comprise the eurozone. How are you applying the Altman Z-score, a measure used historically to measure a firm's susceptibility to bankruptcy, to analyze sovereign risk, for example, in the eurozone?
I've always felt that one of the things that most analysts lack in evaluating a country's creditworthiness is the health of the private sector. We all know about the macro indicators (debt-to-GDP, deficits-to-GDP, productivity, unemployment, and the like). They are decent, but they rarely give you an early warning about an impending problem. Indeed, in the case of some very prominent countries that have gotten into trouble in the past, if you had simply looked at the health of the private sector, you would have had a much better early warning. For example: South Korea, back in 1997, was the most risky private sector of any Asian country, and yet had been growing at 10 percent rates for at least a decade. It was considered one of the Asian tigers with the largest teeth. Yet, they almost defaulted within six months of the end of 1996 because of the health of the private sector all of the sudden imploding as the government could not bail out the banks that had been lending to those companies. The idea is to look at some sort of aggregate measure of the health of the private sector by aggregating the individual firm Z-scores. From the score, you can then estimate a probability of default. We arbitrarily chose the 50th percentile--the median company--in 11 European countries and the United States as a reference point. We calculated what the median companies probabilities of default were, and we did it before sovereign risk of Europe was in the news and before investors were concerned with it. Lo and behold, we found that down at the bottom were two countries that we now know are the sickest in Europe--Greece and Portugal. Very close to them, but not quite as bad, were countries like Italy, Spain, and Ireland. This was at the end of 2008 when nobody was really that concerned, and a country like Italy was selling at a very high credit rating and a very low interest rate. It looked vulnerable to us because of the health of the private sector. After all, it's the private sector that pays taxes if they are profitable and hires the workers if they want to expand and grow--and just the reverse when they get into trouble. So, that's the basic idea, and it seems to have been fairly prophetic with respect to the countries that eventually got into trouble.
How have declining equity indices in Europe over the past several months affected the measures produced by this method?
If it's a publicly-traded company, the market value of equity relative to its liabilities and the volatility of that equity are very important indicators of the financial distress of companies. Obviously, a company that has a high market equity to its liabilities is a much lower credit risk--and just the reverse for companies that are not in that lofty position. For example, the average company in Italy this year's stock price has fallen close to 30 percent. We've estimated that the impact of a stock price falling 30 percent has a very dramatic on its Z-score, and therefore, it's probability of default is much higher. Just since the end of 2010, year-to-date, I would guess that the average company in Italy has maybe a 30-40 percent increase in its probability of default just because of its stock price. A lot of firms in these countries are [already] hurting profit-wise because of the lack of confidence and the austerity programs that are filtering through now, which are going to get a lot worse before they get better. I'm very concerned with any policies on the part of governments that cut out the heart of the private sector.
What are the numbers telling you now in terms of Italy--comparing these updated metrics to the sovereign credit risk markets?
Italy is a very special case. Certainly, the average scores are deteriorating based on poor performance in 2011. They actually had improved from 2008-2010 because of the improvement in the stock market in those periods. The current levels are telling me that they are better than countries like Portugal and Greece. They are slightly better or about the same as Spain, but markedly worse than most of the other countries in Europe. So, that is one issue. However, the Italian situation is far more complicated than simply a Z-score. Italy has enormous wealth in the private sector and in the corporate sector that could be tapped by the government if they do it forcefully. There is some risk of social protest there, as you know, so it has to be fair in the sense that everyone has to contribute--and made to understand that if they don't, their quality of life will fall dramatically. It's important to tap that. Unfortunately, the average Italian--especially those in the upper class--are used to being able to utilize their wealth and have a very high standard of living. It's hard to make anyone give that up. Mario Monti, the new prime minister, knows that very well. He is from that class. I know him personally--fairly well--and I have a lot of respect for his economic and financial acumen as well as his influential way of presenting things. They call him "Super Mario" for a number of reasons; one of them is that he's been very successful in just about everything he's done up to this point in his life. However, this challenge is far greater than anything he's come across yet--even when he was the EU commissioner for competition, taking on firms like Microsoft and other large U.S. companies in antitrust aspects of European operations.
What about those "core" economies in the eurozone? How well are they really positioned?
France is a special case mainly because of the vulnerability of some of its big banks, and history has shown to be pretty clear that the government takes a pretty active role in shoring up the banking system, moreso in France than in any other country in Europe. So, I think France is only a special case because of the size and importance of its banking sector, but that is true also of Germany. The resources that France has are considerable--it's a very modern, efficient country--but it has many of the same problems as the other socialist-oriented countries with a tremendous safety net for unemployment, pensions, and the like. This is adding up to a potential disaster if, in fact, the growth of these countries staggers, which appears to be the case.
Is there a way out of the dark for these eurozone economies?
We need to not kill the golden goose [of the private sector] when we are building into economies these austerity programs to cut costs and to increase efficiencies. It is one thing to cut pension payouts and other social safety net mechanisms, to try to collect more taxes from those who aren't paying, and to cut down on bloated bureaucracy and the like. That has to be done. We need to monitor the private sector. These central banks have their own mechanisms for monitoring health, but they don't do it to stimulate the economy. They do it mainly to look at the exposures of banks and to keep the safety-and-soundness of the banking system by looking at their portfolios of loans. I'm talking about using the metric that I'm proposing as a measure of saying, "Look what is happening to our private sector. We can't tax them more; we need to nurture them. We have to provide stimuli for growth and incentives--maybe through tax policy or direct infrastructure investment and the like. The other thing is the European Central Bank. There is a long history in Europe that the central bank's major objective is to fight inflation. Therefore, you rarely see the central bank in Europe doing anything in the way of stimuli for the economies. I'm mainly talking about printing money and putting a lot of the toxic assets, if you will, on their own balance sheet. Now, they are doing that somewhat by buying the bonds of Italy and Spain to keep the interest rate below 7 percent. However, that has proven to be very expensive and not all that effective in the long run. In the short run, you do get some benefits. So, I think there is a basic philosophical issue in Europe, and particularly in Germany, which is the bulwark and strongest country in Europe by far, saying categorically that they are against the central bank printing money and stimulating the economies through monetary policy. I think that goes back to the history of Germany. They remember the Weimar Republic, which had enormous inflation and caused the country to have incredible problems. They say, "We will not permit the central bank to stimulate the economy through monetary policy because it leads to too much inflation." I think it's getting to the point where [the ECB is] the lender of last resort for many of these countries. When you have a negative economic growth situation as seems to be likely in the next few quarters, then you are going to have a very negative series of pieces of information hitting the market just as they are trying to turn around their economies by cutting costs and implementing some of these austerity programs. I am fearful that the negative economic news coming out of these countries--and it's not just going to be the vulnerable countries, like the PIIGS--it's going to be throughout the European Union, and even a country like Germany is going to suffer if their trading partners in Europe cannot buy as many goods from them as they used to, which I think will be the case. The only thing that can help Germany and the other exporting countries is the value of the euro falling. Up to now, it's been stubbornly high, but it will fall probably if they institute this more expansionary monetary policy. It's a mixed blessing--it will certainly help exports, but at the same time, could lead to higher inflation. This is the basic philosophical problem. Countries like France and probably Italy would like to see the ECB become more directly involved, and countries like Austria, Germany, Finland, and maybe the Netherlands are fearful of that happening. I'm feeling that this is unfortunately going to be necessary to fly in the face of a deteriorating economic situation, which is almost certain to happen based on these austerity programs. The third thing in these countries is--and I think they will do this, but I'm not sure how effectively--to implement [fiscal] policies to stimulate growth. That is going to be a very controversial thing as well because here they are, being told by the IMF and certainly the ECB that they need to do these austerity programs. Well, how can you do austerity and stimulate growth at the same time? That is a very tricky thing, but I think it's really necessary to turn these economies around fairly quickly. Otherwise, they could go into a very deep recession for a number of years, and you could have a Japanese-type recession for a decade in many of these countries if the austerity programs are combined with a lack of confidence and a drop in the stock markets.
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