Monday, 20 June 2011

The European Debt Crisis...

In Oscar Wilde's Importance of Being Earnest, Lady Bracknell memorably remarks that: "To lose one parent… may be regarded as a misfortune; to lose both looks like carelessness."

The Euro-zone's need to rescue three of its members (Greece, Ireland and Portugal) with three others (Spain, Belgium and Italy) increasingly eyed with varying degrees of concern smacks of institutionalised incompetence.

Executed with Northern European creativity, charm, flexibility and humility and Mediterranean organisation, leadership diligence and appetite for hard work, the European rescue plan – "the grand compact" - is failing.

European Debt Crisis returns

In little over a year since the announcement of Greece's debt problems, the European debt crisis has ebbed and flowed with markets oscillating between euphoria (resolution) and despair (default or restructuring). The European Union's (EU) "confidence-boosting", short-term "liquidity enhancement" programs, unfortunately, have failed to resolve deep-seated structural problems.

The most recent concern about the peripheral countries was triggered by concern about Greece. Having repeatedly failed to meet economic targets prescribed by the EU, European Central Bank (ECB) and International Monetary Fund (IMF), Greece needs additional financing or a fresh bailout to meet its financial commitment. An immediate concern was the suggestion that a further tranche of 12 billion euro might be withheld making its impossible for Greece to meet its commitments to repay lenders on a maturing bond in mid-July.

While an immediate crisis may be avoided, the stage is now set for a slow, Wagnerian drift towards a future debt restructuring for some of these peripheral countries and a European banking crisis. Greek interest rates of around 18 per cent (for 10 years) and 30 per cent (for two years), Irish and Portuguese rates of over 12-13 per cent (for two years) and around 10 per cent (for 10 years) testify to this trajectory.

Markets put the chance of a Greek default at 80 per cent chance. The chance for an Irish and Portuguese default is around 40-50 per cent.

Greek Death Watch

The peripheral countries may not be able to ever pay back the debt they have incurred. Bailout programs, designed to rehabilitate over indebted economies, have failed, despite protestations from politicians and central bankers that things are "on track".

The basic plan was temporary loans, combined with some fiscal and structural steps by the countries, would restore growth, competitiveness, financial health and access to commercial financing sources at acceptable costs. The plan was always difficult if not impossible – a case of wishful thinking.

In Greece, the austerity program has led to a deep recession with Gross Domestic Product (GDP) falling by 4.5 per cent in 2010 and forecast to fall by over 3.0 per cent in 2011, a result worse than the IMF plan forecast. Unemployment, currently around 15 per cent, is expected to rise further. Greek public finances have deteriorated as tax revenues have fallen faster than government spending.

The 2009 budget deficit was revised from 13.6 per cent of GDP to 15.4 per cent and public debt went from 115 per cent of GDP to 127 per cent.

Slow progress means that the 2010 budget deficit came in at 10.5 per cent of GDP, against a target of 8.1 per cent. Debt is now close to 145 per cent of GDP, a level above that expected to be reached by 2013 under the EU/ IMF "rescue" plan.

Despite some progress, structural reforms are proving difficult and slow to implement. A plan to privatise 50 billion euro of assets looks optimistic, with a number of even 15 billion euro looking difficult to achieve.

Claims by the intelligentsia of the EU and ECB that Greece is "solvent" assume that most of the desirable bits of Greece, the Parthenon, other antiquities and the nicer Aegean Islands, can be sold to some Russian and Chinese oligarchs.

Pain Sharing

Ireland's initial self-imposed and subsequently EU-mandated austerity has had similar effects to that in Greece. GDP has fallen by around 20 per cent from its highest point and unemployment is in the mid-teens. According to optimistic commentators, living standards have deteriorated only to the levels of the early 2000s. Emigration out of Ireland has risen, reversing the trend of recent years.

Ireland's problems are exacerbated by its ailing banks, whose property loans made at the height of the country's boom have unravelled. The decision to originally guarantee the banks' borrowing and also de facto nationalise many of the banks is looking increasingly ill-advised. Having already committed around 50 billion euro, if Ireland commits an additional 50 billion euro (a not unlikely figure) to support the banks, Irish government debt would increase to 195 billion euro (130 per cent of GDP). Given projected budget deficits, Ireland's debt would easily reach around 240 billion euro (160 per cent of GDP) over the next five years.

Portugal's fate, under its still-to-be-settled austerity program required to obtain its own bailout, is unknown but unlikely to be fundamentally different. The early signs are not good. In the course of bailout talks in April 2011, Portugal indicated that its deficit for 2010 was actually 9.1 per cent of GDP, above the 8.6 per cent previously indicated and 25 per cent above the government's target of 7.3 per cent. A continued concern is the risk of the contagion affecting Spain – which may be "too big to fail" but may be also "too big to save". While economic fundamentals are better than some countries that have required bailouts, Spain remains vulnerable.

The Iberians have adopted the "best" of Greece, Portugal and Ireland - low rate of growth, poor competitiveness, significant structural issues within its economy and also potential problems of its banking system. Spain experienced a significant real estate boom in the lead-up to the crisis. Banks, especially the smaller cajas, community savings banks, remain vulnerable as the bulk of the expected property price correction and resulting loan losses are yet to occur. The Bank of Spain's estimate of bank recapitalisation requirements of 15-20 billion euro conflicts sharply with Moody's forecast of 120 billion euro.

There are other worrying signs of Spain's potential problems. Reminiscent of announcements by Greece early in 2010, the Spanish prime minister claimed that China had committed around 9 billion euro in Spanish bonds. When the Chinese denied any such commitments, the Spanish sought to explain it away as being a problem of translation. Suggesting significant internal political tensions about policy, Spain's prime minister Zapatero indicated he would not contest the next election creating a decision-making vacuum, strikingly similar to that in Portugal. Most worryingly, Spanish finance minister Elena Salgado bravely told Bloomberg on 11 April 2011: "I do not see any risk of contagion. We are totally out of this."

A Sea of Troubles

The problems faced by the troubled peripheral economies include low rates of growth and high levels of indebtedness with rising debt servicing costs. The combination of reduction of government spending and higher taxes is literally strangling these economies. The austerity programs prescribed by the economic automatons of the EU, ECB and IMF, as a condition of the bailouts, reinforce this pernicious slide into economic oblivion.

The peripheral countries are trapped in a vicious cycle. A weak economy increases budget deficits which, in turn, drives higher government debt. This requires even greater cuts in government spending and higher taxes to reverse the deterioration in public finances, leading to further contraction in the economy. This drives a deteriorating credit rating outlook, reduced access to commercial financing and higher funding costs which contributes to a further declines. As some of these countries are also heavily dependent on external financing from banks and investors, around 60-70 per cent for Greece, Ireland and Portugal, a financing crisis becomes almost inevitable.

The difficulty of escaping this maelstrom is evident by the rising proportion of tax revenue committed to making interest payments on government debt. Greece currently needs over 30 per cent of its tax revenue to meet interest payments. The comparable figures for Ireland, Portugal and Spain are 18, 14 and 10 per cent respectively. Italy, another vulnerable nation, currently requires 17 per cent of its tax revenue to meet interest commitments.

Ireland illustrates the problem. Assuming its debt peaks at 240 billion euro (160 per cent of GDP) then financing it at 4 per cent per annum (well below current market rates) would cost nearly 10 billion euro a year in interest payments, equal to 80 per cent of the government's income tax revenue. As most of this interest is paid to external creditors, 10 billion euro in interest every year requires Ireland to grow its GDP (150 billion euro) by at least 10 billion euro each year (6.7 per cent) just to stand still.

Unless growth reaches this level, the economy would start to shrink.

Economic growth is unlikely to reach the levels needed to make the current debt burdens on these over-indebted nations sustainable in the near term. This creates new financing problems for these countries, which prevent them from reducing their reliance on bailouts.

For example, Greece's rehabilitation plan agreed in May 2010 assumed that around 50 per cent of its 2012 borrowing requirement would be raised form commercial sources. Always unlikely, this is now impossible because of the absence of purchasers of Greek debt and the high cost of such financing.

Greece and possibly the other bailout recipients will need open-ended financing commitment from the EU, ECB and the IMF to avoid default. It is possible that over time Greece, Ireland and Portugal alone will need anywhere up to 500 billion euro in financing to meet maturing debt and also additional financing for its budget shortfalls.

The scale of the problem can be seen from the fact that the most heavily indebted Euro-zone nations (Greece, Ireland, Portugal, Spain and Italy) have to refinance maturing debt of around 1.6 trillion euro in the period to 2014.

Article by Satyajit Das -

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