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The Eurozone Debt Crisis Has Only Begun

Commentary by Dan Steinbock (EUC Visiting Fellow, Feb-Mar 2011)

Dan Steinbock 

Since last fall, European leaders have been debating on how they could strengthen the European financial system before the European Financial Stability Facility (EFSF) expires in the year 2013. However, markets will not wait.

In the fourth quarter of 2008, growth in the Euro area contracted less sharply than in the United States, or in advanced and emerging Asia.

By late 2009, after initially being hit harder than other regions, Asia rebounded faster from the depths of the crisis, while the financial crisis was taking a harsh toll on both Europe’s advanced and emerging economies.

As the European economies struggle to recover, they were unfortunately set back by the advent of the sovereign debt crisis in 2010. This debt crisis however has its roots way back to the formative years of forging an economic and monetary union.

In 1995 the European leaders agreed on the Growth and Stability Pact. However, one European economy after another, starting with France and Germany, has violated the criteria of the agreement.

Before the onset of the euro crisis in spring 2010, the Pact’s 3% budget deficit limit was violated almost 100 times, whereas the public debt ceiling of 60% was never taken seriously.

It was this neglect and the subsequent soaring debt that sparked the great euro zone debt crisis – which is likely to escalate in the aftermath of Japan’s nuclear disaster, the uprisings in North Africa and the Middle East, as well as rising energy and commodity prices.

 

The Turmoil of May 2010

In 2010, the average gross public debt in the euro zone amounted to 84% of GDP. And of all 17 euro zone economies, only tiny Luxembourg had a budget deficit of less than 3% of GDP. In brief, today none of the member states could join the euro zone.

In early May 2010, 10-year yields on Greek government debt topped 10%, while the spread on 5-year credit default swaps exceeded 900 basis points. After months of uncertainty and volatility, the EU and the International Monetary Fund (IMF) announced a €110 billion support package for Greece.

Through the European Financial Stability Facility (EFSF), the European leaders could – theoretically – raise up to €440 billion from individual EU member states, and a further €60 billion supranational facility administered by the European Commission. Up to €250 billion of IMF money was also made available.

As the Greek support package failed to stop the run on the sovereign debt of Spain, Portugal and Ireland, the European Stabilization Mechanism (ESM) was created for the rest of the euro area member states in October 2010.

At the time, the €750 billion euro rescue fund was described as “colossal.” In retrospect, it was too little too late. Unsurprisingly, the markets have not bought the idea.

 

Volatility likely to continue after March 25

After all, the assumption was that the EFSF would purchase bonds of the euro zone countries, which find it difficult to finance themselves in the market, and would then issue AAA-rated bonds.

Currently, France and Germany are the only major Eurozone economies  that have an AAA rating, while other guarantors are countries, whose solvency is not adequate or which are insolvent.

In mid-February, the Eurozone leaders decided to double the effective lending capacity of future bailout funding. In other words, the permanent euro area rescue fund will have an initial capacity of €500 billion, instead of the existing €250 billion.

The announcement came ahead of the March 25 deadline for concluding negotiations on the permanent rescue fund. It was a move in the right direction, but the funding remains inadequate – as indicated by the rising yields on the bond market.

As long as the countries to be rescued have been small euro economies, the problems have been averted. Greece, Ireland, and Portugal account for only 2.5%, 1.7% and 1.9% of the euro area gross domestic product, respectively. However, the problems are deepening. In two years, the debt level of Greece, for instance, will amount to some 165% of its GDP, while its interest rate may soar to 8% of its GDP annually.

Ireland has already gone the way of Greece and, Portugal with its soaring borrowing costs and looming political crisis may well be next. And if the spotlight shifts to Spain, which contributes 11.5% of the Eurozone GDP, the pressures will escalate dramatically.

 

The Pact for Euro

In the future, the euro zone debt crisis is likely to prompt new waves of downgrades, which may not spare even the region’s highest-rated borrowers, Germany and France.

In such circumstances, France could lose its top AAA rating.

In turn, Germany is amidst of a series of seven elections in the 16 federal states, which will continue until September. The polls do not favor Chancellor Angela Merkel’s Christian Democratic Union (CDU) and its coalition partner, the Free Democratic Party (FDP); Germans are skeptical of the euro and favor a tougher line on ailing euro-zone economies.

During the past few weeks, Merkel and President Sarkozy have advocated the so-called Pact for Competitiveness, which conditions the financial support of the large euro economies on structural reforms in troubled euro nations.

After the plan backfired, it was watered down. In its original form, it would have meant harmonization of tax rates (read: end to Ireland’s 12.5% tax rate, which is only half of the euro zone average), debt containment (which would cause immense complications in the deficit-countries) and the adjustment of retirement ages (which is politically difficult to implement in much of the euro zone).

In its current form, the diluted Pact for Euro is acceptable to most euro zone countries, but it is unlikely to result in effective reforms.

 

Toward Comprehensive Reforms

The European turmoil centres on soaring levels of debt, insolvent euro zone countries, “too big to fail” banks, as well as eroding competitiveness. In the long-term, a comprehensive solution in Europe requires the following:

  • In the coming years, the debt must be contained with an effective stabilization fund (read: about €1,500-2,000 billion).
  • The European zombie banks must be restructured, and systemically critical banks should be recapitalized.
  • An enduring solution requires the debt restructurings of the insolvent euro zone economies.
  • Since the 1990s, the competitiveness and innovation of the entire euro area has been steadily eroding; it should be upgraded as well.

According to the Lisbon Review survey (spring 2010), which ranked major countries and regions based on their overall economic competitiveness, the ranking of East Asia is now higher than that of the United States and significantly ahead of the EU 27 economies, including France and the UK.

What is needed in Europe is more competition across industries and product markets, especially in the labor-intensive service sectors. Flexible labor markets are also vital. Global competition requires deepening European integration to sustain economies of scale. In order to counter the problems of aging, immigration should be liberalized. Finally, R&D expenditures remain too low and investments in innovation should be increased.

Overcoming the euro zone debt crisis requires bold, decisive and imaginative leadership. Due to centrifugal pressures, Europe is now driven either toward deepening integration (through common fiscal policy), or toward greater fragmentation.

Today, the share of the four leading European economies is about 24% of G20 GDP. Even relatively benign scenarios indicate that it will decrease to about 10% by 2050. A fragmented euro area would fare even worse.

 

Dan Steinbock is Research Director of International Business at India, China and America Institute (USA), and Fellow at Shanghai Institutes for International Studies (China). Currently, he is Visiting Fellow at Singapore EU Centre.