Global Trends by Martin Khor

Monday 3 May 2010

Europe's turn to face debt crisis

In the past developing counties including in East Asia faced debt crises and suffered from IMF loan conditions.  Today a debt crisis has emerged in Western Europe that threatens the chances of a global recovery.


The global economy is slipping into a new crisis, with Greece being the epi-centre and  several other European countries already experiencing contagion effects.

It is quite surprising that Western Europe, considered a model of good economic governance, is now having to deal with a debt crisis.  Years and decades ago debt crises hit Africa, Latin America, Asia, as well as Russia and Eastern Europe.

The developing countries affected had always been accused of causing their own problems, with the faults variously attributed corruption, mismanagement, bad governance and crony capitalism.

Greece is accused of fiscal irresponsibility, building up huge government debts and cooking the books to hide the extent of its deficits.

But it is increasingly difficult to ignore structural factors that contributed to the financial crises through the years.

If the lessons had been learnt from the Asian crisis that started in 1997, perhaps this European crisis would not have happened.  On the other hand, it is also vital to learn from Europe's crisis so that Asia and other developing regions will not fall into new financial crises.

In Africa and Latin America, governments had taken too much foreign loans, crises developed when they did not have enough foreign exchange to service the debts.  In many cases this was due to the fall in the countries' commodity export prices, the rise in their oil import prices, increased trade deficits or economically unfeasible projects.

These crises exploded the myth that foreign loans to governments were safe as they could not default.  The pendulum then swung and it was thought to be safe to lend to the private sector as it would use the loans for profitable ventures.

The Asian crisis arose when too much foreign funds went to local companies.  This was made possible by financial liberalisation and deregulation.  Thailand, South Korea and Indonesia relaxed the rules that had prevented locals from taking loans denominated in foreign exchange, and companies took foreign loans of over US$100 billion in each of these countries

The relaxation of rules also enabled foreign funds and firms to engage in currency speculation and manipulation.  The resulting collapse of the Thai baht had contagion effects on Indonesia and South Korea. The three countries' currencies depreciated and they faced default on their foreign loans and had to turn to the IMF.

Malaysia's currency also depreciated sharply but it did not face a default situation because some regulations on foreign loans to local companies had been retained.

The Asian crisis exploded the myth that foreign loans to companies were safe because the private sector will make correct loan calculations and invest in profitable projects.

Now the European crisis is exploding the myths that European countries are well governed economically, that there is no or little risk in loans to their governments, and that countries within the Eurozone are especially safe as any nation in trouble will be helped by the others.

Many European governments have built up large debts and the loans have to be rolled over or new bonds have to be issued to service old loans and fund new budget deficits.

Greece has been struggling to obtain fresh credit to avoid a default on loans due this month.  It tried to raise new cash through the market but the interest has been priced so high due to the risks perceived that the government was unable to afford to take market loans.

For months, Greece has sought a loan package (at less than market rates) from Eurozone countries and the IMF but the terms and amount were still being haggled over, with Germany in particular insisting on stringent policy conditions.

Speculators have been blamed, including by some European governments, for making the situation worse by accentuating the increase in risk premium on Greek debt and the decline in the Euro.

Last week the credit rating agency Standard and Poor downgraded Greek government debt (to junk status) as well as the debt of Portugal and Spain   This triggered panic until moves for a final Eurozone-IMF package calmed the situation at the week's end.

The package is now expected to be Euro 120 billion to cover three years' needs. Even then a number of economists have concluded that eventually Greece needs a restructuring of its debts, with creditors and bond-holders taking a “haircut” or a partial repayment.  According to them, it is better for an orderly debt workout up-front now rather than a prolonged crisis and a possible messy default and unilateral restructuring later. 

The fallout of a Greek default can be serious as European banks have $189 billion exposure to Greek loans.  They also have claims of $240 billion on Portugal and $851 billion on Spain, according to a Financial Times article.    

There are concerns that the crisis may spread to other countries through contagion. According to OECD data, in 2010 the public debt to GDP ratios are 95% for Greece, 63% (Portugal), 42% (Spain) and 38% (Ireland).  The public budget deficits are 9.8% of GDP (in Greece), 7.6% (Portugal), 8.5% (Spain) and 12.2% (Ireland).

Meanwhile these countries are preparing austerity measures that are bound to cause a lot of pain. In return for the loan package, Greece is asked to drastically cut government spending, salaries and allowances, freeze government jobs, overhaul the pension scheme and close state entities.      

The angry reaction to this news in violent street demonstrations over the weekend shows how difficult it will be for Greece to agree to these terms.  When the measures are implemented, the reactions will be stronger.

Asia can learn from this evolving European crisis. It cannot be expected that governments can almost automatically roll over their debts or successfully float new bonds at reasonable interest rates.

Governments have to be disciplined in managing public finances and in limiting deficits and debts. There also has to be the re-regulation of finance to avoid excessive leverage, speculation and unethical practices.