WHAT ARE WE TO DO By TAN SRI LIN SEE-YANThe European debt crisis has evolved rather quickly since my last column, “Greece is Bankrupt” (July 2). The European leadership was clearly in denial. The crisis has lurched from one “scare” to another. First, it was Greece, then Ireland, then Portugal; and then back to Greece. On each occasion, European politicians muddled through, dithering to buy time with half-baked solutions: more “kicking the can down the road.” By last week, predictably, the crisis came home to roost. Financial markets in desperation turned on Italy, the euro-zone's third largest economy, with the biggest sovereign debt market in Europe. It has 1.9 trillion euros of sovereign debt outstanding (120% of its GDP), three times as much as Greece, Ireland and Portugal combined.
The situation has become just too serious, if contagion was allowed to fully play out. It was a reality check; a time to act as it threatened both European integration and the global recovery. So, on July 21, an emergency summit of European leaders of the 17-nation euro-currency area agreed to a second Greek bailout (Mark II), comprising two key elements: (i) the debt exchange (holders of 135 billion euros in Greek debt maturing up to 2020 will voluntarily accept new bonds of up to 15 to 30 years); and (ii) new loans of 109 billion euros (through its bailout fund and the IMF). Overall, Greek debt would fall by 26 billion euros from its total outstanding of 350 billion euros. No big deal really.
Contagion: Italy and Spain
By mid-July, the Greek debt drama had become a full-blown euro-zone crisis. Policy makers' efforts to insulate other countries from a Greek default, notably Italy and Spain, have failed. Markets panicked because of disenchantment over sloppy European policy making. For the first time, I think, investors became aware of the chains of contagion and are only now beginning to really think about them.
The situation in Italy is serious. At US$262bil, total sovereign claims by international banks on Italy exceeded their combined sovereign exposures to Greece, Ireland, Portugal and Spain, which totalled US$226bil. European banks account for 90% of international banks' exposure to Italy and 84% of sovereign exposure, with French & German banks being the most exposed. Italy & Spain have together 6.3 trillion euros of public and private debt between them. Reflecting growing market unease, the yield on Italy's 10-year government bonds had risen to 5.6% on July 20, and Spain's, to 6%, against 2.76% on German comparable bunds, the widest spread ever in the euro era.
Italy and Spain face different challenges. Spain has a high budget deficit (9.2% of GDP in 2010, down from 11.1% in 2009) the target being to take it down to 6% in 2011 which assumes high implementation risks. Its debt to GDP ratio (at 64% in 2011) is lower than the average for the eurozone. The economy is only gradually recovering, led by exports. But Spain suffers from chronic unemployment (21%, with youth unemployment at 45%), weak productivity growth and a dysfunctional labour market.
It must also restructure its savings banks. Spain needs to continue with reforms; efforts to repair its economy are far from complete and risks remain considerable. Italy has a low budget deficit (4.6% of GDP) and hasn't had to prop-up its banks. But its economy has barely expanded in a decade, and its debt to GDP ratio of 119% in 2010 was second only to Greece. Italy suffers from sluggish growth, weak productivity and falling competitiveness. Its weaknesses reflect labour market rigidities and low efficiency. The main downside risk comes from turmoil in the eurozone periphery.
Another decade of stagnation also poses a major risk. But both Spain and Italy are not insolvent unlike Greece. The economies are not growing and need to be more competitive. The average maturity of their debt is a reasonable six to seven years. But the psychological damage already done to Europe's bond market cannot be readily undone.
The deal: Europeanisation of Greek debt
The new bailout deal soughts to ring-fence Greece by declaring “Greece is in a uniquely grave situation in the eurozone. This is the reason why it requires an exceptional solution,” implying it's not to be repeated. Most don't believe it. But to its credit, the new deal cuts new ground in addition to bringing-in much needed extra cash - 109 billion euros, plus a contribution by private bondholders of up to 50 billion euros by mid-2014. For the first time, the new framework included solvent counterparties and adequate collateral. For investors, there is nothing like having Europe as the new counterparty instead of Greece. This europeanisation of the Greek debt lends some credibility to the programme. Other new features include: (i) reduction in interest rates to about 3.5% (4.5% to 5.8% now) and extension of maturities to 15 years (from 7 years), to be also offered to Ireland and Portugal; (ii) the European Financial Stability Facility (EFSF), its rescue vehicle, will be allowed to buy bonds in the secondary market, extend precautionary credit lines before States are shut-out of credit markets, and lend to help recapitalise banks; and (iii) buy collateral for use in the bond exchange, where investors are given four options to accept new bonds carrying differing risk profiles, worth less than their original holdings.
The IIF (Institute of International Finance), the industry trade group that negotiated for the banks, insurance funds and other investors, had estimated that one-half of the 135 billion euros to be exchanged will be for new bonds at 20% discount, giving a savings of 13.5 billion euros off the Greek debt load. Of the 109 billion euros from the new bailout (together with the IMF), 35 billion euros will be used to buy collateral to serve as insurance against the new bonds in exchange, while 20 billion euros will go to buy Greek debt at a discount in the secondary market and then retiring it, giving another savings of 12.6 billion euros on the Greek debt stock.
Impact of default
Once again, the evolving crisis was a step ahead of the politicians. There are fears that Italy and Spain could trip into double-dip recession as global growth falters, threatening the debt dynamics of both countries. This time the IMF weighed in with serious talk of contagion with widespread knock-on effects worldwide. Fear finally struck, forcing Germany and France to act, this time more seriously. The first reaction came from the credit rating agencies. Moody's downgraded Greece's rating three notches deeper into junk territory: to Ca, its second-lowest (from Caa1), short of a straight default. Similarly, Fitch Ratings and Standard & Poor's have cut Greece's rating to CCC.
They have since downgraded it further. They are all expected to state Greece is in default when it begins to exchange its bonds in August for new, long-dated debt (up to 30 years) at a loss to investors (estimated at 21% of their bond holdings). The rating agencies would likely consider this debt exchange a “credit event”, but only for a limited period, I think. Greece's financial outlook thereafter will depend on whether the country would likely recover or default again. History is unkind: sovereigns that default often falters again.
What is also clear now is the new bailout would not do much to reduce Greece's huge stock of sovereign debt. At best, the fall in its debt stock will represent 12% of Greece's GDP. Over the medium term, Greece continues to face solvency challenges. Its stock of debt will still be well in excess of 130% of GDP and will face significant implementation risks to financial and economic reform. No doubt the latest bailout benefitted the entire eurozone by containing near-term contagion risks, which otherwise would engulf Europe. It did manage to provide for the time being, some confidence to investors in Ireland, Portugal, Spain and Italy that it's not going to be a downward spiral. But the latest wave of post-bailout warnings have reignited concerns of contagion risks and revived investor caution.
Still, the bailout doesn't address the very core fiscal problems across the eurozone. This is not a comprehensive solution. It shifted additional risks towards contributing members with stronger finances and their taxpayers as well as private investors, and reduces incentives for governments to keep their fiscal affairs under strict check. This worries the Germans as it weakens the foundation of currency union based on fiscal self-discipline. Moreover, the EFSF now given more authority to intervene pre-emptively before a state gets bankrupt, didn't get more funds.
German backlash appears to be also growing. While the market appears to be moving beyond solvency to looking at potential threat to the eurozone as a whole, the elements needed to fight systemic failure are not present. At best, the deal reflected a courageous effort but fell short of addressing underlying issues, leading to fears that Greece-like crisis situations could still flare-up, spreading this time deep into the eurozone's core.
The excitement of the bailout blanked out an even bigger challenge that could further destabilise the eurozone sluggish growth. The July Markit Purchasing Managers Index came in at 50.8, the lowest since August 2009 and close enough to the 50 mark that divides expansion from contraction. And, way below the consensus forecast. Both manufacturing and services slackened. Germany and France expanded at the slowest pace in two years in the face of a eurozone that's displaying signs it is already contracting. Looking ahead, earlier expectations of a 2H'11 pick-up now remains doubtful.Lower GDP growth will require fiscal stimulus to fix, at a time of growing fiscal consolidation which threatens a downward spiral. At this time, the eurozone needs policies to restart growth, especially around the periphery. Without growth, economic reform and budget restraints only exacerbate political backlash and social tensions. This makes it near impossible to restore debt sustainability. Germany may have to delay its austerity programme without becoming a fiscal drag. This trade-off between growth and austerity is real.
IMF studies show that cutting a country's budget deficit by 3% points of GDP would reduce real output growth by two percentage points and raise the unemployment rate by one percentage point. History suggests growth and austerity just do not mix. In practical terms, it is harder for politicians to stimulate growth than cut debt.
Reform takes time to yield results. And, markets are fickle. In the event the market switches focus from high-debt to low-growth economies, a crisis can easily evolve to enter a new phase one that could help businesses invest and employ rather than a pre-mature swing of the fiscal axe. Timing is critical. It now appears timely for the United States and Europe to shift priorities. They can't just wait forever to rein in their debts. Sure, they need credible plans over the medium term for deficit reduction. More austerity now won't get growth going. The surest way to build confidence is to get recovery onto a sustainable path only growth can do that. Without it, the risk of a double-dip recession increases. Latest warnings from the financial markets in Europe and Wall Street send the same message: get your acts together and grow. This needs statesmanship. The status quo is just not good enough anymore.
Former banker Dr Lin is a Harvard educated economist and a British chartered scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email: firstname.lastname@example.org.