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Analysis: Too slowly, euro zone laggards start to shape up

By Alan Wheatley, Global Economics Correspondent

LONDON (Reuters) - It may be cold comfort for countries on the euro zone's southern periphery mired in recession, but they are making clear strides by some measures towards putting their economies on a sounder long-term footing.

After years of excessive debt-fueled consumption at home, Spain and Portugal are seeing a big increase in exports, while Italy's budget deficit is now comfortably below Europe's mandated ceiling of 3 percent of national output.

All three countries have embarked on far-reaching reforms to labor and product markets that, while falling short of purists' hopes, should over time considerably improve the supply-side performance of their economies.

In short, the wrenching policy corrections set in train by the euro zone's debt and banking crisis are gradually happening.

From the perspective of financial markets, though, the progress is too little too late. With investors skeptical of governments' commitment to protracted austerity and reform, bond yields in periphery countries, especially Spain, are once again rising as fast as their unemployment rates.

"The adjustment is progressing, but the starting position is very difficult and that still leaves them with a long road ahead. They're going to have a hard time in the coming one to two years," said Greg Fuzesi, an economist at JP Morgan in London.

TRADE TURNAROUND

Take Spain. Despite a big bill for imported energy, its trade balance has turned positive. The country still has a current account deficit, because of debt service payments, but the shortfall narrowed in the fourth quarter of 2011 to a seasonally adjusted 6.0 billion euros, or 2.2 percent of gross domestic product.

That was the smallest quarterly deficit since 1999 and was down from 14.3 billion euros in the first quarter of last year, according to Julian Callow, an economist with Barclays Capital in London.

Net trade has in fact added around 2 percentage points to Spanish GDP each year since 2008, after subtracting 1.3 points annually in the preceding five years.

Encouragingly, most of the improvement in net exports between mid-2010 and end-2011 reflected not a compression of imports but a 21 percent rise in exports in nominal terms, Ebrahim Rahbari and Guillaume Menuet, economists at Citi, said in a report.

Nominal unit labor costs are back to 2007 levels, another sign that adjustment is working, albeit painfully, as rising unemployment helps to put a lid on wages.

The problem, as Rahbari and Menuet noted, is that Spain's overall stock of debt owed to foreigners is around 100 percent of GDP, similar to that of Portugal and Ireland, and continues to threaten the country's external debt sustainability.

The trade story is similar in Portugal. Exports of goods reached a record 26.0 percent of GDP, after seasonal adjustments, in the last quarter of 2011, compared with 21.4 percent in all of 2010.

With exports of services remaining firm - think tourism - Portugal's current account deficit fell to 2.5 percent of GDP in the October-December quarter, the smallest in more than 15 years, Callow said.

REMARKABLE

Portugal's budget is also heading in the right direction, albeit too slowly for the liking of investors: in the secondary market, 10-year bonds yield a prohibitive 12.25 percent.

According to BarCap's calculations, Lisbon's net deficit in the fourth quarter, excluding one-off capital transfers, fell to 6.6 percent of GDP from 10.5 percent a year earlier - even though real GDP contracted 2.8 percent over the same period.

"Overall, the program is on track. The fiscal adjustment in 2011-2012 is remarkable by any standards," the European Commission said in its latest review of the reforms Portugal is making in return for a 78 billion euro bailout from the European Union and the International Monetary Fund.

As for Italy, its budget deficit in the fourth quarter shrank to 2.8 percent of GDP - below the EU ceiling of 3 percent - from 4.2 percent a year earlier, the Italian National Institute of Statistics said on Wednesday.

Indeed, excluding debt servicing costs, Italy recorded a primary budget surplus of 2.6 percent of GDP, up from 0.5 percent a year earlier. In other words, Italy's problem is not the flow of new debt so much as the huge stock of old debt.

Investors want countries on the periphery to whittle down their debts preferably by growth, not from a fierce contraction in domestic demand. As such, boosting exports is welcome but insufficient.

If GDP - the denominator of the all important debt-to-GDP ratio - contracts and drags down tax revenues, countries will fall into a debt trap: governments will come under pressure to cut spending further, deepening the downturn and making the burden of debt ever more unsustainable, financially and politically.

Seen in this light, the maiden budget unveiled this week by Spanish Prime Minister Mariano Rajoy failed the credibility test with markets not because it was insufficiently austere but because it brought Spain's economic and social woes into even sharper relief, said Nicholas Spiro, head of Spiro Sovereign Strategy, a London consultancy.

Unemployment in Spain is 23.6 percent and rising, with every second youth unemployed.

"The more the Rajoy government talks about austerity, the more the markets take fright," Spiro said.

(Editing by Jeremy Gaunt.)

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