Global Trends by Martin Khor

Monday 11 July 2011

Rich economies enmeshed in crises

A string of bad economic news in the past week shows the rich countries in a deepening crisis --- increased joblessness in the United States, no solution in sight for the Greek debt crisis and contagion to other European countries.


There was more bad news about the global economy last week.  It looks as if the major developed economies are facing worsening problems that will not go away.

This does not augur well for the developing world, as it is still dependent on the richer economies.

An economic slowdown in the United States was indicated by last week’s data of a rise in unemployment to 9.2% and only 18,000 new non-farm jobs created in June.

President Obama’s on-going battle with the Republicans to get Congressional approval to increase the government’s debt limit and avert a default is also likely to end with an agreement to slash government spending. That will have a depressing effect on the economy.

But if the US has problems, Europe is in the grip of a far worse crisis.  The Greek debt problem with its accompanying political turmoil is its most visible part.

However, the Greek tragedy may soon be dwarfed if it spreads through contagion to its bigger   neighbours.

Last Wednesday, the rating agency Moody’s in a controversial move downgraded Portugal’s credit standing four notches to junk status. This had a contagion effect on Spain and Italy; the interest to be paid on their bonds jumped to new highs.

The real fear is that Italy, which has Europe’s third biggest economy, will be drawn into the crisis. Last Friday, the yield of Italy’s ten-year bond jumped to 5.27%, with its highest premium over German bonds.

This reduction of confidence means the country has to pay more to obtain new loans. Stock prices of Italian banks also fell almost 6% in one day.

A spread of the crisis to Italy, after the bailouts needed for Greece, Ireland and Portugal, would magnify the European crisis manifold due to the size of its economy and its debt.

Nearly 900 billion euro of government debt is maturing in the next five years, in a country where debt is equivalent to 120% of GDP. If the yields on Italian bonds keep rising, the cost of servicing them may become intolerably high. 

The risk of the European crisis spreading will remain so long as the crisis in Greece is not solved.

There is now a widespread assessment that the country faces a solvency problem, not just a liquidity problem.  A systemic solution is needed, such as an orderly debt workout, in which creditors are paid only a part of their outstanding loans to Greece, under an arbitration system.

However, major European countries fear this would result in big losses for their banks that hold Greek loans. They thus seek other ways out, such as a “bailout” (new loans from the European governments and European Central Bank and the IMF) to take over from expiring loans, coupled if possible by private banks and other creditors also giving new credit.

Their objective is to avoid a Greek “default”, because that will have problems of its own.  For example, if Greek loans undergo a “credit event” (the new euphemism), this would trigger the need for bond insurers to pay out to holders of credit default insurance.

Unfortunately, it is not only a direct default and a debt restructuring that qualifies as a default in the eyes of the credit rating agencies.  Arrangements by governments to get the private creditors to take a “haircut” (partial loss on their loans) are also considered a default.

Even a “voluntary” roll-over of the loans that are maturing, or the swapping of their existing loans for new bonds with longer maturity, as had been proposed by France or Germany for their banks holding Greek bonds, is considered by credit rating agencies a selective default, that could trigger unwanted consequences.

The first bailout for Greece last year (financed by Europe and the IMF) has proved inadequate and the country now needs at least another Euro 115 billion.   If the banks and other private creditors do not come up with some of that (through the roll-overs or debt swaps), the European governments, European Central Bank and IMF have to come up with the full amount, or see Greece default.

But there is little appetite among the public in Germany and many other countries to contribute to a new bail-out for Greece.

The other problem is that to qualify for a new bail-out, the Greek government is asked to adopt more austerity measures (such as cuts in spending, salary and pensions; tax increases; sale of public assets) on top of existing tough measures.

This has sparked massive street protests that indicate that the unpopular measures are unacceptable beyond a point.  The public demand will be that those who gave the loans should bear the costs, not ordinary people who are not to blame.

If the government is unable to get its reforms through, the cry for default will increase.  But even if it defaults unilaterally, and clears its insolvency problem, Greece still needs new loans to cover its budget deficit.  According to one view, it can attract new credit because its old debts are now cleared.

But another view, more influential at the moment, is that the market having suffered from a default will not give new loans to Greece.  It is unlikely that Greece will declare a default at this stage.  But it may be forced to do so sometime in future if there is no alternative financing or if the public opposition to more austerity becomes too strong for any Greek government.

Last week, the uncertainty surrounding the Greek situation reached a new high, especially with  conflicting messages from Germany and France which have been trying to arrange a roll-over or debt swap, and the European Central Bank, which opposes any “selective default” or “credit event”.

The inability to get a European act together on Greece has affected confidence in the eurozone and increased the risk of contagion spreading to Spain and Italy.

Thus, neither the US nor Europe can be expected to boost the global economy.  Instead, their crises may contribute to a weakening of the global economy.  As for Japan, it is understandably pre-occupied with post-tsunami reconstruction.

As the effects of the previous fiscal and monetary stimulus taper off, and nothing equivalent to take its place, it is difficult to be optimistic about the economic prospects of the major developed economies in the next couple of years.