By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (forthcoming August 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
In Oscar Wilde’s Importance of Being Earnest, Lady Bracknell memorably remarks that: “To lose one parent… may be regarded as a misfortune; to lose both looks like carelessness.” The Euro-zone’s need to rescue three of its members (Greece, Ireland and Portugal) with three others increasingly eyed with varying degrees of concern (Spain, Belgium and Italy) smacks of institutionalised incompetence.
European Debt Crisis Returns
In little over a year since the announcement of Greece’s debt problems, the European debt crisis has ebbed and flowed with markets oscillating between euphoria (resolution) and despair (default or restructuring). The European Union’s (“EU”) “confidence boosting”, short term “liquidity enhancement” programs, unfortunately, have failed to resolve deep-seated structural problems.
The most recent concern about the peripheral countries was triggered by concern about Greece. Having repeatedly failed to meet economic targets prescribed by the EU, European Central Bank (“ECB”) and International Monetary Fund (“IMF”), Greece needs additional financing or a fresh bailout to meet its financial commitment. An immediate concern was the suggestion that a further tranche of Euro 12 billion might be withheld making its impossible for Greece to meet its commitments to repay lenders on a maturing bond in mid-July.
The debate has several separate and conflicting dimensions. The first is whether Greece can or will implement the required actions to rehabilitate its economy and finances at tremendous cost to its population. A related issue is whether the plan, entailing further austerity, even it is implemented will actually succeed. The second is whether commercial lenders, who helped fuel Greece’s debt binge, should accept some losses, bearing some of the cost of the restoration of Greece’s finances. The last is the cost of any default or major restructuring to Greece and the Euro-zone. On the last two issues there are divisions between Germany (investors should take their share of losses) and France and the ECB (lenders should be spared to avoid financial Armageddon). The same issues are relevant ultimately for all the other deeply troubled Euro-zone members.
While an immediate crisis has been avoided, the stage is now set for a slow, “Wagnerian” drift towards a future debt restructuring for some of these peripheral countries and, perhaps, an European banking crisis. Greek interest rates of around 18% (for 10 years) and 30% (for 2 years), Irish and Portuguese rates of over 12-13% (for 2 years) and around 10% (for 10 years) testify to this trajectory. Markets put the chance of a Greek default at 80 per cent chance. The chance for an Irish and Portuguese default is around 40-50 per cent.
Greek Death Watch
The peripheral countries may not be able to ever pay back the debt they have incurred. Greece has a sovereign debt of Euro 340 billion, more than Euro 30,000 per person of its population of 11.3 million. Bailout programs, designed to rehabilitate over indebted economies, have failed, despite protestations from politicians and central bankers that things are “on track”.
The basic plan was temporary loans, combined with some fiscal and structural steps by the countries, would restore growth, competitiveness, financial health and access to commercial financing sources at acceptable costs. The plan was always a case of wishful thinking.
In Greece, the austerity program has led to a deep recession with Gross Domestic Product (“GDP”) falling by 4.5% in 2010 and forecast to fall by over 3.0% in 2011, a result worse than the IMF plan forecast. Unemployment, currently around 15%, is expected to rise further. Greek public finances have deteriorated as tax revenues have fallen faster than government spending. The 2009 budget deficit was revised from 13.6% of GDP to 15.4% and public debt went from 115% of GDP to 127%. Slow progress means that the 2010 budget deficit came in at 10.5% of GDP, against a target of 8.1%. Debt is now close to 145% of GDP, a level above that expected to be reached by 2013 under the EU/ IMF “rescue” plan.
Despite some progress, structural reforms are proving difficult and slow to implement. A plan to privatise Euro 50 billion of assets looks optimistic, with a number of even Euro 15 billion looking difficult to achieve.
In 2009 current Prime Minister George Papandreou vowed to scrap an agreement to sell a stake in Greece’s biggest phone company during an election campaign. In June 2011, under pressure from the EU, Greece, under Papandreou, triggered an option to sell 10% of Hellenic Telecommunications Organization (“OTE”) to Deutsche Telekom AG (“DT”)to raise desperately needed cash. The price was less than one-third of what DT, Europe’s largest phone company, paid for shares in OTE in 2009.
The OTE transaction underlines the difficulties facing Greece and other peripheral countries such as Ireland that are seeking to raise as much as Euro 70 to 100 billion from asset sales and privatisations.
Claims by the intelligentsia of the EU and ECB that Greece is “solvent” assume that most of the desirable bits of Greece, the Parthenon, other antiquities and the nicer Aegean Islands, can be sold to some Russian and Chinese oligarchs.
Ireland’s initial self imposed and subsequently EU mandated austerity has had similar effects to that in Greece. GDP has fallen by around 20% from its highest point and unemployment is in the mid-teens. According to optimistic commentators, living standards have deteriorated only to the levels of the early 2000s. Emigration out of Ireland has risen, reversing the trend of recent years.
Ireland’s problems are exacerbated by its ailing banks, whose property loans made at the height of the country’s boom have unravelled. The decision to originally guarantee the banks’ borrowing and also de facto nationalise many of the banks is looking increasingly ill advised. Having already committed around Euro 50 billion, if Ireland commits an additional Euro 50 billion (a not unlikely figure) to support the banks, Irish government debt would increase to Euro 195 billion (130% of GDP). Given projected budget deficits, Ireland’s debt would easily reach around Euro 240 billion (160% of GDP) over the next 5 years. This probably underestimates the real extent of Celtic indebtedness as Gross National Product (“GNP”) (which is about 15-20% lower than GDP) is the more relevant benchmark, given the structure of the Irish economy.
Portugal’s fate, under its still to be settled austerity program required to obtain it own bailout, is unknown but unlikely to be fundamentally different. The early signs are not good. In the course of bailout talks in April 2011, Portugal indicated that its deficit for 2010 was actually 9.1% of GDP, above the 8.6% previously indicated and 25% above the government’s target of 7.3%.
A continued concern is the risk of the contagion affecting Spain – which may be “too big to fail” but may be also “too big to save”. While economic fundamentals are better than some countries that have required bailouts, Spain remains vulnerable.
The Iberians have adopted the “best” of Greece, Portugal and Ireland – low rate of growth, poor competitiveness, significant structural issues within its economy and also potential problems of its banking system. Spain experienced a significant real estate boom in the lead-up to the crisis. Banks, especially the smaller cajas, community savings banks, remain vulnerable as the bulk of the expected property price correction and resulting loan losses are yet to occur. The Bank of Spain’s estimate of bank recapitalisation requirements of Euro 15-20 billion conflicts sharply with Moody’s forecast of Euro 120 billion.
There are other worrying sign of Spain’s potential problems. Reminiscent of announcements by Greece early in 2010, the Spanish Prime Minister claimed that China had committed around Euro 9 billion in Spanish bonds. When the Chinese denied any such commitments, the Spanish sought to explain it away as being a problem of translation. Suggesting significant internal political tensions about policy, Spain’s Prime Minister Zapatero indicated that he would not contest the next election creating a decision making vacuum, strikingly similar to that in Portugal. Most worryingly, Spanish Finance Minister Elena Salgado bravely told Bloomberg on 11 April 2011: “I do not see any risk of contagion. We are totally out of this.”
Observers are closely watching Spain’s ability to continue to raise needed funds from commercial lenders. Steady increases in the cost of borrowing for Spain, now in the 5-6% range for 10 years, and decreasing support for debt issues are evidence of increasing pressure. Spanish banks are increasingly dependent on funding from official entities, such as the ECB, reflecting concerns about their finances.
A Sea of Troubles
The problems faced by the troubled peripheral economies include low rates of growth and high levels of indebtedness with rising debt servicing costs. The combination of reduction of government spending and higher taxes is literally strangling these economies. The austerity programs prescribed by the economic automatons of the EU, ECB and IMF, as a condition of the bailouts, reinforce this pernicious slide into economic oblivion.
The peripheral countries are trapped in a vicious cycle. A weak economy increases budget deficits which, in turn, drives higher government debt. This requires even greater cuts in government spending and higher taxes to reverse the deterioration in public finances, leading to further contraction in the economy. This drives a deteriorating credit rating outlook, reduced access to commercial financing and higher funding costs which contributes to a further declines. As some of these countries are also heavily dependent on external financing from banks and investors, around 60-70% for Greece, Ireland and Portugal, a financing crisis becomes almost inevitable.
The difficulty of escaping this maelstrom is evident by the rising proportion of tax revenue committed to making interest payments on government debt. Greece currently needs over 30% of its tax revenue to meet interest payments. The comparable figures for Ireland, Portugal and Spain are 18%, 14% and 10% respectively. Italy, another vulnerable nation, currently requires 17% of its tax revenue to meet interest commitments.
Ireland illustrates the problem. Assuming its debt peaks at Euro 240 billion (160% of GDP) then financing it at 4% per annum (well below current market rates) would cost nearly Euro 10 billion a year in interest payments, equal to 80 per cent of the government’s income tax revenue. As most of this interest is paid to external creditors, Euro 10 billion in interest every year requires Ireland to grow its GDP (Euro 150 billion) by at least Euro 10 billion each year (6.7%) just to stand still. Unless growth reaches this level, the economy would start to shrink.
Economic growth is unlikely to reach the levels needed to make the current debt burdens on these over-indebted nations sustainable in the near term. This creates new financing problems for these countries, which prevent them from reducing their reliance on bailouts.
For example, Greece’s rehabilitation plan agreed in May 2010 assumed that around 50% of its 2012 borrowing requirement would be raised form commercial sources. Always unlikely, this is now impossible because of the absence of purchasers of Greek debt and the high cost of such financing.
Greece and possibly the other bailout recipients will need open-ended financing commitment from the EU, ECB and the IMF to avoid default. It is possible that over time Greece, Ireland and Portugal alone will need anywhere up to Euro 500 billion in financing to meet maturing debt and also additional financing for its budget shortfalls.
The scale of the problem can be seen from the fact that the most heavily indebted Euro-zone nations (Greece, Ireland, Portugal, Spain and Italy) have to re-finance maturing debt of around Euro 1.6 trillion in the period to 2014.
Banks and businesses located in these countries also need to re-finance existing debt. Maturing corporate bonds and banks loans for corporations in these countries total in excess of Euro 1 trillion during the period to 2014. Problems at the sovereign debt level inevitably affect their ability to finance and the cost of the funds.
Banks located in the peripheral countries face significant challenges. Other than Irish and (perhaps) Spanish banks, the financial institutions have not been a major factor in the sovereign debt problems. However, the sovereign’s problems have hurt the bank’s credit ratings and ability to borrow.
In Greece, public confidence in the government’s ability to protect savings has eroded. Greek corporations and households have withdrawn more than Euro 40 billion from domestic banks (17 % of the banking system’s deposit base) since 2009. Facing difficulties in accessing funds, these banks are heavily dependent on liquidity support from governments and the ECB, perhaps equivalent to almost 20-25% of their total liabilities.
The position is also acute in Ireland where support in excess of Euro 130 billion has been required. Irish banks’ loan to deposit ratios are above 160%, making them heavily dependent on government support for survival.
The funding problems of the banks push up lending costs for businesses. Funding difficulties reduce availability of credit. As banks shrink their balance sheets, the lack of credit adversely affects credit and economic growth, setting off a cycle of business failures and higher loan losses with further cycles of credit tightening.
The longer these economies stay weak, the more difficult and intractable the problem becomes. The governments become unable to adjust public finances rapidly enough to maintain funding access and market confidence. The spiral increasingly gets out of control forcing a debt restructuring or default.
There are numerous channels of contagion. Continued problems of the peripheral economies requiring bailout will lead to the markets becoming reluctant to finance other weak Euro-zone countries, such as Spain and, perhaps, Italy. This may be at the sovereign level or funding for banks, leading to increased reliance to official funding. Concern about access to commercial funding or its cost can quickly become self-reinforcing, resulting in rapid loss of financing ability.
In the second phase, institutions with actual or suspected exposure to the troubled borrower are targeted, with loss of funding access as concern about their financial condition emerges. This process continues until a complete seizure in money markets results.
Some aspects of this feedback loop are already apparent. US money market funds have exposure to European banks totalling about 40% of their total investments of US$2,700 billion. Investors traditionally viewed money market funds as highly secure, near cash equivalents. This perception was destroyed when Lehman Brothers filed for bankruptcy protection in September 2008 resulting in investor losses. These memories and concern about the European debt problems have already led to investors reducing exposure modestly to money market funds with exposure to European banks.
In addition, unsecured lending in the inter-bank money markets has slowed as concerns about risk increase. This is reflected in the increase in the use of collateral to secure inter-bank deposits and loans.
When global markets lose confidence and optimism, things can turn quickly. Greece’s slide from a cherished, solvent member of the European familia took less than six months – in November 2009 Greece was borrowing at low rates; by May 2010 it required a bailout. As investors and markets focus, again and belatedly, on debt-laden and structurally weak economies, contagion effects may gain momentum rapidly. Increasing concern about Spain and Italy testifies to the potential speed of any contagion.