Europe drifting to an inevitable, disastrous 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 Eurozone’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 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% (for 10 years) and 30% (for 2 years), Irish and Portuguese rates of over 12-13% (for 2 years) and around 10% (for 10 years) testify to this trajectory. Markets put the chance of a Greek default at 80%. The chance for an Irish and Portuguese default is around 40-50%.

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% in 2010 and forecast to fall by over 3% in 2011, a result worse than the IMF plan forecast.

Unemployment, currently around 15%, 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% of GDP to 15.4% and public debt went from 115% of GDP to 127%. Slow progress means that the 2010 budget deficit came in at 10.5% of GDP, against a target of 8.1%.

Debt is now close to 145% 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 of assets looks optimistic, with a number of even €15 billion 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% 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, if Ireland commits an additional €50 billion (a not unlikely figure) to support the banks, Irish government debt would increase to €195 billion (130% of GDP). Given projected budget deficits, Ireland’s debt would easily reach around Euro 240 billion (160% of GDP) over the next 5 years.

Portugal’s fate, under its still to be settled austerity program required to obtain it 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% of GDP, above the 8.6% previously indicated and 25% above the government’s target of 7.3%.

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 conflicts sharply with Moody’s forecast of €120 billion.

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 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 Jose; Luis Rodriguez Zapatero indicated that 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 April 11 this year: “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% 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% of its tax revenue to meet interest payments. The comparable figures for Ireland, Portugal and Spain are 18%, 14% and 10%, respectively. Italy, another vulnerable nation, currently requires 17% of its tax revenue to meet interest commitments.

Ireland illustrates the problem. Assuming its debt peaks at €240 billion (160% of GDP) then financing it at 4% per annum (well below current market rates) would cost nearly €10 billion a year in interest payments, equal to 80% of the government’s income tax revenue. As most of this interest is paid to external creditors, €10 billion in interest every year requires Ireland to grow its GDP (€150 billion) by at least €10 billion each year (6.7%) 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% of its 2012 borrowing requirement would be raised from 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 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 in the period to 2014.

Skin in the game
The EU bailouts have always primarily focused on protecting European banks from the effects of a default by borrowers such as Greece, Ireland and Portugal. In total, banks in Germany, France and the UK have exposures of over €500 billion to these three countries. If exposure to Spain is included, the total increases to around €1 trillion.

Much of this debt - in the form of sovereign debt, lending to banks and also structured securities based on mortgage and corporate loans - is held by smaller banks in France and Germany. If Greece, Ireland, Portugal and (ultimately) Spain have to restructure the debt, then these banks will suffer significant losses. Default or restructuring of European debt, in all probability, will require state involvement in recapitalising these institutions. In essence, attention will switch from bailouts of sovereign nations to bailing out affected national banks.

Default or restructuring would also affect the ECB, which holds around €50 billion of Greek debt alone. The ECB’s total exposure to Greece, including lending to Greek banks and loans against Greek government bonds, is much higher - €130-140 billion.

If Greece defaults, then the ECB could suffer losses as high as €65-70 billion (say 50% of the amount advanced). The losses would almost certainly require recapitalisation of the ECB itself by Eurozone members. As of January 1, 2011, the ECB had a paid-up capital of €5.2 billion (due to be increased progressively to €10.8 billion). The ECB is owned by the 17 Eurozone central banks with the combined capital of around €80 billion.

The ECB’s position on whether peripheral countries like Greece should be allowed to default increasingly appears to be complicated by its own vulnerable financial position. When Lorenzo Bini Smaghi, an Italian board member, stated that a Greek debt restructuring would be ‘suicide’ he may have been referring to the ECB. Statements about Anglo-Saxon ‘vested interests’ seeking the restructuring of Greek debt are now matched by the ECB’s ‘self interest’ in avoiding the same.

Backsliding
In the near term, the EU and Eurozone members are likely to persist with the failed strategy. Further funding needs will be accommodated as they emerge from the existing facilities as much as possible, until these are exhausted. German insistence on commercial lenders sharing some of the burden has wavered. Instead a fuzzy idea of a ‘voluntary’ commitment of existing lenders to refinance existing, maturing debt is now under discussion.

Over time, the palpable failure of the bailout strategy will progressively be revealed. Pressure will emerge to improve the term of the bailout package.
Already, Greece has received reductions in interest rates on bailout funding and some extension in the terms of the financing. The need to provide additional

funding to Greece of around €120 billion is under discussion. In all probability, some deal will be done to provide the funds, against Greek promises that cannot and will not be met. There will be more and more of the same, in a desperate effort to avoid default or restructuring.

In the end, default or restructuring will become inevitable, as other choices are exhausted. Initially, minor changes such as lowering coupons and extending maturities, perhaps as part of debt swaps, will be sought to manage the problem. Ultimately, a major restructuring, involving a significant write-off of outstanding debt is likely. This is the case for Greece and perhaps the other peripheral countries.

Based on history, a loss of around 30-70% of the face value of obligations is expected. The longer the time taken over the process, the greater the likely losses to holders of the obligations. The reason being that unless the debt burden is reduced early, continuing high servicing costs and deficits will continue to increase the level of write off necessitated to restore solvency.

A political matter
European decision-making increasingly echoes Shakepeare’s Richard II’s lament: “I wasted time, and now doth time waste me.” The EU, ECB and major Eurozone members, notably Germany and France, lack the political courage or will to tackle the problem. The absence of an ‘easy’ and ‘painless’ solution means that career politicians and Eurocrats see no benefit in advocating the complex and messy process of default and restructuring.

European leaders dissemble that the debt crisis was the result of traders and financial markets. Anders Borg, Sweden’s finance minister spoke of ‘wolf-pack markets’. Zapatero blamed ‘cynical hedge funds’, ‘cocky credit-ratings agencies’ and ‘neoconservative capitalism’. Greek prime minister George Papandreou accused traders of visiting ‘psychological terror’ on his country. Michel Barnier, the European commissioner for the single market, accused financial institutions of ‘making money on the back of the unhappiness of the people’. Zapatero also found fault with a duplicitous Anglo-Saxon press. In short, it seems anybody but the Europeans are to blame. Cognitive dissonance looms large.

The denouement to the European debt crisis, probably some way off, will come via by the ‘street’ or the ballot box.

In the afflicted nations, public protests and disturbances are increasing as the populace rejects greater austerity. Populist politicians, willing to reject the need for further ‘sacrifice’ and repudiate the country’s debt, hover in the wings. The argument that the country will be an international ‘financial pariah’ does not carry much weight when you are already one with no one likely to lend you money any time soon. It also has less weight when you don’t have a job and the country is on the brink of social breakdown.

For the countries that must provide the bulk of the bailout money, there is angst that the increased level of financing required by the problem borrowers has turned the EU into a ‘transfer union’. Discontented and angry voters in Germany and other saving nations will at some stage also decide to call time on the fruitless and self-defeating support for the overly indebted Eurozone members.

Having falsely linked the problem of over-indebted states with the canards of the euro and the survival of the Eurozone itself, Europe is increasingly drifting towards an inevitable, disastrous and destabilising debt crisis. Rather than amputating a gangrenous limb, European leaders risk poisoning the entire body fatally - weakening the financial positions of the stronger Euro-zone members and their economies, which are paying for the bailout and will suffer the losses when the inevitable defaults come.

The effect on wider money markets and global economy of any defaults is unpredictable. Depending on the quantum of losses and the recapitalisation requirements, the event could create concerns about affected Eurozone banks, providing a channel for contagion in financial market. This could destabilise markets, transmitting the shock through high cost and reduced availability of financing, in a manner similar to what happened after the bankruptcy filing by Lehman Brothers in 2008.

© 2011 Satyajit Das
All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (due to be published by Penguin India in early 2012)