European Disease

Who Believes the Patch-Up?

Here is an excellent summary on the European debt crisis, reprinted from the SMH, originally published in the New York Times.  (And whilst you read this, keep in mind that it is only a matter of time before world capital markets start to look at debt levels in New Zealand.  All it would take is for government spending to ratchet up a few notches and the debt would be out of control--that is, getting back into balance and then surplus will never happen, without a grand default.  The New Zealand electorate has absolutely no appetite to see any serious reduction in government spending.  Keep the cash coming, baby.)

It's all connected: a spectator's guide to the Euro crisis

October 29, 2011

The global financial system is highly interconnected. So problems in one part of the world can reverberate almost everywhere else - risking a cascade of default, contagion, contracting credit and collapsing economic activity. Exhibit A now is Europe. European Union leaders met this week to at last deal with a debt crisis rattling investors worldwide who once thought lending to euro zone countries was virtually risk-free. The graphic here helps you see the intertwined complexities.

It starts with the euro
In 1999, most countries in the European Union adopted the euro as a common currency. This union allowed poorer countries such as Portugal, Italy, Ireland, Spain and Greece to borrow money at the same low interest rates as rich and financially prudent Germany, even though their inflation rates were higher. That gave them a strong incentive to borrow.

And goes bad in Greece
Greece financed a large public-welfare state and built up huge debt for its size that it has scant hope of repaying now. In 2010, European financial institutions began bailing out Greece (later Ireland and Portugal, too); lenders were prodded to agree to modest, voluntary debt write-downs, or "haircuts". But Greece still needs money. And its credit bill grows ever larger as lenders charge more and demand government cutbacks, which in turn have provoked civil unrest. After years of propping up the spendthrift Greeks, the Germans are fed up. The problem is, a chaotic Greek default could hurt all European banks and pension funds that have extended Greece credit down the years, and maybe cause a wider bank panic. So bailouts continue - for now, at least:

BEST CASE Bailouts in the form of new European credit eventually work. Greece pays down its hefty debts for years to come.

MORE LIKELY Bailouts don't work. Greek debt grows in an anaemic or shrinking economy. The country defaults, either in a negotiated, orderly manner or chaotically, forcing lenders to take big losses either way. But damage could be contained if countries in the euro zone can erect a financial firewall to backstop the credit of the four other shaky nations: Ireland, Portugal, Spain and Italy. This is what the European Union agreed to on Thursday, after France prodded a more reluctant Germany.

WORST CASE? See below.

Threatening contagion
If the firewall fails to materialise, or inspire investor confidence, or proves inadequate, it would be easy to imagine a run on banks, because the single currency makes it easy to shift money across borders from risky economies to safer ones. That and the lack of central banks in each country - those went away with the arrival of the euro - make the euro zone "the ultimate contagion machine", said Kenneth Rogoff, the Harvard economist and co-author of This Time is Different: Eight Centuries of Financial Folly.

That could unfold quickly
If nothing is done to prevent it, a chain of events . . . could unfold:

GREECE DEFAULTS In reaction, investors become more concerned about their exposure to other risks in the region, especially the other four most troubled economies. Borrowing costs rise for Ireland, Italy, Portugal and Spain, adding to their debt loads.

MONEY TAKES FLIGHT Investors fear that richer creditor nations may not bail out other shaky countries. And given the ease of shifting money across borders in the euro zone, a flood of money from risky economies to safer ones such as Germany can take place in a matter of hours.

FRANCE NEXT? Meanwhile, the Italian government, which is barely solvent, is unable to protect domestic banks if there is a loss of confidence in them. French banks, heavily burdened with all manner of Italian debt, totter. Exposure to French banks could lead to losses beyond the Continent.

And reach American shores
American lenders and money-market funds are already moving their money out of European banks, which are baulking at lending to one another, writes economist Laurence Kotlikoff. "This is exactly what happened before the bankruptcy of Lehman Brothers Holdings in 2008," he says. US banks are heavily exposed to Spain, Ireland and Italy. (US banks' exposure to Greece is smaller and less direct.) On top of this, US exports to the European Union - collectively the biggest US trading partner - could suffer if the crisis slowed European growth and caused the euro to depreciate against the dollar.

Unless bailouts are big enough
The troubled euro zone could, by some estimates, require about $1.3 trillion to $2.06 trillion in bailouts - an amount perhaps bigger than the Spanish GDP or more than half the size of the German economy. The bailout fund set up last year by euro zone countries goes by the ungainly title of European Financial Stability Facility. The fund has only about $600 billion on hand. Here are total European bank exposures to the five most distressed economies, according to the Bank for International Settlements, compared with the size of each economy:

One of many crisis unknowns
Bank secrecy, government secrecy, a paucity of global financial statistics: all contribute to large information voids that leave experts uncertain. Here is a sampling.

WHO'S EXPOSED TO BAD DEBT? Some banks are more forthcoming than others - there is no consistent disclosure. US money market funds are thought to have significant investment in European banks. So-called stress tests of big banks earlier this year are now widely believed to have understated the level of bank risk. Meanwhile, banks say that they have been struggling to lessen their exposure to bad debt.

WHO INSURED BAD DEBT? Banks and hedge funds sell insurance against investor losses from default by their borrowers. These "bets" that losses won't occur are called credit default swaps. With defaults in Greece and elsewhere a real possibility, issuers of these swaps could be on the hook for losses that once seemed unlikely. How those billions would be covered is unknown; who, precisely, insured Greek debt is also unknown.

WHERE ARE THESE ECONOMIES HEADED? Signs are not good. Some economists argue that government austerity measures being put in place to cut public debt also dampen economic growth: a hobbled private sector is not hiring, and now neither is the government. A slow economy generates less in taxes; the debt - which doesn't go away unless there's a default - is not paid down. "When you have a financial crisis, growth is slow for a long time," Rogoff said.

HOW MUCH IS CHINA OWED? Chinese exposure can only be guessed; whether China will participate in bailouts is uncertain. The same holds true for other big global creditors such as Saudi Arabia and other petro-states.

Additional reporting: Seth Feaster, Nelson Schwartz and Tom Kuntz.
The New York Times