Satyajit Das: The real debt crisis is in Europe, not the US

Despite the media and pundit hyperventilation with accompanying hyperbole about the downgrade of US’s credit rating, the real issue remains Europe.

The US is not likely to default on its debt as long as it can continue to print greenback and legislators can stop bickering long enough to keep raising the debt ceiling.

There is no also imminent danger that the US cannot finance its requirements. The US’s cost of debt will not increase significantly as a result of the marginal downgrade, by one of the three major rating agencies.

Despite the shrill rhetoric, the Chinese and other foreign investors will continue to buy US dollars and government bonds, if only to protect their existing investments and because of the lack of markets with the size, depth and liquidity of US Treasury securities.

The role of the dollar as a reserve currency and in international trade are not likely to be affected, at least in the near term.

In contrast, for many European countries, the inability to access markets is a clear and present danger, with several countries having serious solvency problems. There is a real risk that some countries will not be able to pay back their borrowing and will default. The problem also threatens to spread wider, engulfing all of Europe quickly.

The grand illusion
Echoing Neville Chamberlain’s infamous ‘peace in our time’ announcement, the European Union (EU) on Thursday July, 21, 2011 announced their plan to end the European debt crisis. The deal includes a €109 billion second bailout for Greece, provided by the European Financial Stability Fund (EFSF) and the International Monetary Fund (IMF) with a ‘voluntary’ contribution by private sector bondholders, in deference to German insistence.

The new package reduced interest rates charged to Greece to 3.5% per annum, as well as lengthening the maturity of loans to from the current 7.5 years to a minimum of 15 years and up to 30 years, with a grace period of 10 years. Portugal and Ireland were also offered the more favourable loan terms.

In order to reduce the risk of contagion, the powers of EFSF were increased, enabling it to buy bonds in the secondary market (previously only allowed in the primary markets) and buy equity stakes in banks. The EFSF was also authorised to take pre-emptive action where required.

The change is less significant than suggested as the EFSF just takes over the role played by the European Central Bank, which has been active in buying sovereign bonds.

The program called for European public investment to help revive the Greek economy, dubbed by French President Nicolas Sarkozy — the European ‘Marshall Plan’, the $13 billion US plan to help rebuild Europe from the effects of World War II.

Details of the public investment plan and other elements of the grand compact are sketchy.

Several elements of the plan must be ratified by national parliaments in the euro zone members, expected by September 2011 although events may force this to be accelerated. Christine Lagarde, the new president, has been guarded about further IMF participation, reflecting increasing opposition from emerging market countries.

Debt fudges
An effective plan must reduce the debt burden of the over indebted countries. In addition, any effective plan must limit contagion — the spread of problems to the banking system, other vulnerable countries such as Spain and Italy, which are both ‘too big to save’ and ‘too big to fail’, and stronger European countries, especially Germany and France.

An effective plan must address deep seated structural problems, increasing the level of European growth rates and correcting intra-European financial imbalances.

The new plan even if it can be implemented does not adequately meet any of these challenges.

Economists accept that the debt levels in Greece must be reduced by around 30-60% for the country to have any prospect of returning to growth and solvency. But the central premise of the EU plan is not to reduce debt.

It replaces private lenders with official lenders, who are increasingly being subordinated, that is ranking behind, to private lenders as they get paid out after banks and other investors. 

If the two bailout packages are fully implemented, official lenders will total around €219 billion, over 60% of Greece’s current total debt of €340 billion.

Under the plan, Greece’s debt is reduced, at best, by around 10-12% of gross domestic product (GDP). Given that the level of debt is around 150% and expected to increase further to 175% if EU/IMF plan targets are met, the reduction is far short of the required level of debt reduction.

The need for debt relief for Ireland and Portugal has not even been considered.  The EU has repeatedly stated that this plan is only a ‘one-off’ for Greece.

Dud prophylactics
The EFSF is now tasked with preventing contagion by re-capitalising financial institutions, providing funding to nations and banks as required and intervening in the bond markets to ward of speculative attacks on vulnerable countries, read Spain and Italy.

When announcing the new measures, the EU elected not to increase the size of the EFSF. Taking into account existing commitments to Greece, Ireland and Portugal, the EFSF has around €300 billion left out of its total resources of €750 billion (including the full IMF contribution) available to meet any new commitments. It is doubtful whether the EFSF has the resources to play its super-hero role.

Ireland and Portugal may require additional funding. Italy and Spain must raise around €700-750 billion in the period to the end of 2012 to refinance maturing debt and fund projected budget deficits. In addition, European banks may need additional capital, estimated at as much as €250 billion.

In a recent research piece, analysts at UK bank RBS estimated that containing the crisis could require a bailout facility of over €3 trillion, providing an effective lending capacity of around €2 trillion. The size of the facility is dictated by the fact that maximum lending capacity is limited by the guarantee commitments of the AAA countries. In effect, Germany, France, Netherlands and the Scandinavian countries would have to bear the bulk of the burden of the bailout facility.

As Stephen Jen, a currency strategist and former economist for the IMF, observed: “The creditors are becoming the debtors ….The burden of support in the euro zone will become even more concentrated on Germany and France.”

This will ultimately affect the credit ratings of these countries, causing financial problems if the contingent liabilities were triggered. Already, there is increased scrutiny of France’s financial position and its cost of finances, relative to Germany, has rise sharply.

Germany has indicated that it does not support an increase in the EFSF. Parliamentary approval for any increase may also be difficult to achieve in Germany, Netherlands and Finland.

If the new plan fails to arrest the problems, Europe’s peripheral economies will be affected first, with problems spreading to Spain and Italy and perhaps Belgium. Increasingly, it would affect the stronger countries like Germany, France and the Netherlands. Rather then containing contagion, the EU plan risks spreading the crisis to the stronger members of the euro zone.

The panic room
The EU’s reaffirmation of their commitment to do whatever is needed to ensure the financial stability of the euro zone, was initially greeted with relief. Similar ‘shock and awe’ declarations a year earlier bought a few months of respite. This time celebrations lasted for less than a week as investors realised that the deal had not reduced the risk of financial contagion in the euro zone.

By Tuesday July 26, 2011, the markets had become more circumspect and interest rates on Spanish and Italian bonds rose to levels seen before the bailout was announced. By early August, the pressure on European sovereign increased even further, compounded by the downgrade of the US sovereign debt ceiling.
Given the EU package still needed ratification by national governments, market panic forced the ECB reluctantly to re-commence it program to purchase European sovereign bonds to support the market.

The impact of intervention is also highly uncertain. Similar intervention under the Securities Markets Program was not effective in containing the rise of borrowing costs for Greece, Ireland and Portugal.

In the background, arguments between the European Central Bank and EU about who would guarantee these purchases continued.

The bank, with a capital of €5 billion (being increased to €10 billion) and individual euro zone central banks with a capital of €80 billion do not have the resources to stop the contagion.
There is also the question of how the central bank will finance the purchases. Should it choose to ‘monetise’ its purchase (that is print money), the ramifications, both economic and political, would be profound.

In essence, the European Central Bank cannot resolve the crisis by its actions.

The long goodbye
The EU’s July attempts to resolve the debt crisis was the latest in a series of missed opportunities.

At best, the proposals buy time - a few months for banks to build a capital and loss reserves and beleaguered countries to undertake necessary reforms. On the most optimistic view, this will reduce the losses in any subsequent major debt restructuring. At worst, its sets up an even more dangerous crisis.

The continued acquiescence of the domestic voters and taxpayers cannot be taken for granted. In the indebted nations, protest against the harsh austerity and the financial egotists is likely to intensify. Resentment towards external interference and control of their economy will increase. Suggestions that the Finns sought the Parthenon and Aegean islands as collateral for a new bailout would not have engendered Greek gratitude for their saviours.

In the nations providing the bailout funds, taxpayers will become increasingly reluctant to finance their neighbours and more resentful towards the financial institutions successfully socialising their losses. Elections and changes in leadership will feed this uncertainty.

The game is all but over for the weaker countries - Greece, Ireland and Portugal. Vulnerable countries - Spain and Italy - are now being relentlessly hunted down. The stronger countries - France and Germany - no longer look secure, immune from the problems.

For India, there are several risks. Europe and North America are major trading partners. A slowdown in those regions will affect Indian exports and growth. A major disruption in money markets would affect the volume and price of funds for Indian companies, who are reliant on overseas markets for part of their financing.
Whatever happens, the European debt crisis remains a key risk to the global and Indian economy.

© 2011 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011)