In June the world watched as the Greeks went to the polls to elect a new government. The choice was clear, a win by the left wing Syriza party would effectively lead to Greece exiting the Eurozone (EZ) and going back to the Drachma, while a win for the conservative New Democracy party would be a vote to maintain the status quo. A narrow victory by the coalition government led by New Democracy mattered little. While victory for now may delay an exit, the reality is that Greece remains under enormous pressure to continue to meet its quarterly fiscal and reform targets to ensure continued access to funding. The new government changes nothing. Ongoing austerity will not help make any new jobs (the official unemployment rate is now edging towards 25% and the youth rate towards 50%), nor will it make business more competitive as they remain tied to the Euro, nor will it help businesses secure funding. Many businesses have already lost access to capital markets as external suppliers won't accept bank guarantees issued by Greek banks. So the prospects for Greece remain incredibly grim.
Source: Markit....A reading above 50 indicates expansion. India and the US shine while Greece manufacturing is in a severe depression...
Meanwhile, as in Greece, the flight to safety has begun to spread to other troubled countries. In the first 3 months of 2012, almost $100 billion Euro was withdrawn by depositors from Spain's banking system on fears that it too could collapse. Little wonder that in June, the Spanish Government requested an equivalent sum to recapitalise its banks. The latest EU summit held last week proved a win of sorts for Spain as the bank bailout will now come directly from the EU bailout funds rather than via a loan to the Spanish Government itself, an important distinction because a loan to the Government would only increase public debt further. With solvency concerns remaining in Italy and Portugal (among others), the likelihood of more bailouts increases by the day.
Unfortunately an obvious solution to the crisis remains as unclear as ever. The dominant view at the moment is for EZ's currency union to be strengthened by a fiscal and banking union. The alternate view is to simply let the weak nations (at least Greece) exit the union altogether (in an orderly fashion). A cursory look at these two options follows;
- Greater fiscal and monetary integration
A fiscal union can mean many things but what is currently proposed is for a central body to set and oversee deficit limits for member countries. To further strengthen the union, calls for debt to be issued via EuroBonds, guaranteed jointly and severally by member states, is also gathering momentum. The banking system would also be more integrated and include deposits guaranteed via an insurance scheme to prevent further runs on banks. (Note: Last week's EU summit was the first step towards a banking union. EU leaders agreed that the European Central Bank will act as supervisor. This is a step in the right direction. A deposit guarantee might be discussed at future summits.)
Two problems immediately come to mind with the move towards a fiscal union. Firstly, the existing currency union has been a disaster because weaker countries have been tied to the same currency as stronger countries (Germany) and so have been at a competitive disadvantage. A fiscal union of course would really only work if the political will of member countries aligns with the fiscal requirements set by the head body. As we have already seen in Greece, this is no easy task.
Secondly, the concept of EuroBonds (for those unclear on what a EuroBond is, think of it as the same as an Australian Government bond, which is issued by the government to raise money to finance debt repayments and government spending commitments – except of course it would be issued by the EuroZone) means that member countries become jointly and severally liable for each other's debts. In other words, if Greece defaults (as would be likely if this arrangement was ever put in place) then Germany in particular, being the largest economy in the region, would bear the brunt of the financial losses. So while a number of countries in the region are keen on this idea, it is little wonder that Germany is reluctant to entertain this concept. We also need to remember that although Germany's economy is strong, it still has a debt to GDP ratio of around 80%, and this could easily blowout to 100%+ should it have to backstop further losses, which in turn could threaten its own solvency.
- Live and Let Die
The second option of course is to let the weak economies (Greece in the first instance) exit. On the one hand this has many benefits:
- It would allow the member country to restore its old currency. Past experience has shown that a dramatic devaluation would take place which would rapidly improve industry competitiveness (all other things being equal, buyers will flock to where prices are lowest) and restore growth.
- Would stop further bailouts
On the other hand the exit has some clear disadvantages:
- Citizens suffer from immediate wealth diminution as Euro's are converted to a much weaker currency.
- Companies would effectively lose access to capital markets for some period of time until trading nations were comfortable that risks had eased and growth restored. (But they have virtually lost access already anyway...)
- A Greek default would result in immediate losses to the Troika that have funded bailouts to date, and other creditors (mainly banks and other EZ countries) that have provided loans to Greece.
But it is also clear that the biggest risk is not from Greece exiting but that other countries follow in quick succession (Italy, Spain etc.) where the sheer quantum of losses could have catastrophic effects (banks collapsing, business failures, personal bankruptcies etc.) on the entire financial system that could reverberate around the world.
In balancing up these options, it is clear that there is no easy solution. While we still lean towards an orderly exit, we acknowledge that the risks are acute either way.
Not only is the Eurozone crisis worsening, but growth in China has slowed markedly over the last six months. Although the United States has been the one bright spot in the developed world, it is difficult to see this momentum continuing in the face of what will inevitably be 1) much weaker demand for its exports given the issues with its major trading partners; 2) necessary fiscal drag required to reduce its own public debt burden, and 3) declining real wages limiting consumer spending. This in turn does not augur well for emerging market economies that typically rely heavily on growth in developed economies. We can only draw the conclusion that global growth prospects have deteriorated further since our last report. We expect global growth forecasts, currently estimated by the IMF at 3.5% for 2012, to be revised downwards in coming months.
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