Collapse of the EU: Debt and more debt

“Our sense is that if we do not act boldly and if we do not act together, the economy around the world runs the risk of a downward spiral of uncertainty, financial instability and potential collapse of global demand… we could run the risk of what some commentators are already calling the lost decade” – IMF Head Christine Lagarde on Europe’s debt crisis.

The fundamental problem in the EU is its abysmal monetary policy failure. This has led to the burden of unsustainable debt, which in turn triggered broader economic collapse amongst the so-called ‘lesser States’, like Portugal, Ireland, Greece, Spain and Italy (PIIGS States). This economic crisis of monumental proportions now threatens to envelope even the ‘greater States’, like Germany and France.

For years, EU States have been plagued by debt accumulation. These States would borrow (at de facto concessionary interest rates) in order to overcome the inability to generate adequate income. The lack of growth and development, combined with burgeoning debt, has led to the current solvency/liquidity crisis. This is nothing but a reflection of the unmanageable monetary situation in the EU.  As a result, some of Europe’s largest banks now hold toxic quantities of sovereign debt and are threatened with extinction through serious default. Even France’s Societe General Bank is plagued with insolvency worries. Sadly EU States keep addressing the solvency crisis through ill-fated fiscal policies, and the liquidity crisis through additional debt, thereby ignoring the EU debt crisis simply because there is no cohesive, politically acceptable solution.

Eurozone ‘vision’

The much-heralded ‘vision’ of a Eurozone had many conceptual flaws from its inception. The centre (Brussels) completely lacked control over social spending, and the binding agreements and treaties to stay within EU member Government spending targets were disregarded, even by the larger EU States.

The growing gap in competitiveness amongst the ‘greater’ and ‘lesser’ States also resulted in the ‘lesser’ States’ market growth being hindered. It is only now that the EU is trying to implement policies that enable the ‘lesser’ States to become more economically competitive. There are strong possibilities that some of the PIIGS States will exit the EU or while some critics point out that we can witness the resuscitation of the Deutschmark in the coming years. Indeed, the future looks very, very uncertain.

The EU Social Welfare State mechanisms have also contributed to the current crisis by making the whole of Europe less competitive relatively than the rest of the world. Which is why Britain, although not subject to the EU Monetary policy, cannot escape negative growth indicators, because of its regional alliance.

Nick Clegg, UK’s Deputy Prime Minister, recently urged European Council President Herman Van Rompuy to focus on growth, warning that if Europe does not become more competitive it will end up in a spiral of perpetual decline.

Another factor which contributes to the current crisis is the enlargement of the EU, when 10 former East Bloc nations were integrated a decade ago, resulting in the fragmentation of the homogeneity of the Eurozone. Currently counting 27 members (with Croatia to join in 2013), enlargement has made the European institutions unmanageable and hard to govern.

The doomed Euro

However, the weight of the monetary policy failure falls solely on the doomed Euro currency. Consistently, EU States failed to realise that the monetary union between fast-growth States and slow-growth States will only end in monetary disintegration. Slow-growth States never caught up with their counterparts; in fact they lagged behind even more causing grave economic friction.

Even recent discussions regarding the establishment of a central EU treasury which has the power to issue new debt, thereby guaranteeing that the PIIGS States pay lower interest rates while the Northern States pay more, seems a pipe dream at this juncture. The hope is that the EU States will emerge stronger from this crisis with durable financial and monetary regimes.

However, the most likely short-term outcome, as predicted by Daniel Gross from the Center for European Policy Studies, is that ‘Germany and the other AAA States must agree on some sort of Eurobond regime. Otherwise the Euro will implode’.

Given France’s and Germany’s stout opposition to the Eurobond, the future looks very bleak. Anyone with a sound financial background, will wonder why it took so long for member States to realise that the Euro was a flawed concept. Establishing a single currency over a group of countries that valued national sovereignty over growing economies (economies which adopted varying fiscal policies) seemed to herald doomsday from inception. After all, former British Prime Minister Margaret Thatcher rejected the currency as unworkable and a threat to sovereignty. “One thing was evident to me from the beginning,” said Guy Verhofstadt, Leader of the European Parliament’s Alliance of Liberals and Democrats and Belgian Prime Minister from 1999 to 2008, “A state can exist without a currency, but a currency cannot exist without a state.”

Herein lies the truth of the Eurozone calamity... there might, in the not too distant future, no European Union, over which the Euro can rule. Michel Sapin, France’s Finance Minister from 1992-1993, stated that the problem lies in the failure of the economic government of the EU. The idea that countries can share a single currency irrespective of divergent economic policies seems unfathomable.

Confidence collapse

Italy – the third biggest economy in the Eurozone - faced a collapse in investor confidence recently, and even Silvio Berlusconi’s announcement that he would step down once austerity measures were pushed through in Parliament, failed to change the tide, with interest rates reaching levels which triggered bailouts in Portugal, Greece and Ireland. Italy’s bond yields surged past the critical 7% mark, thereby moving the EU crisis into a dangerous new phase.

During this crisis, German Chancellor Angela Merkel stated that: “It is time for a breakthrough to a new Europe... Because the world is changing so much, we must be prepared to answer the challenges. That will mean more Europe, not less Europe.” But what exactly does ‘more Europe’ entail? Only a new Europe, without the remnants of the failed old systems and mechanisms can truly save the day. Feeble austerity measures will not suffice as a long term solution.

The President of the European Commission José Manuel Barroso, underscored a new Europe when he stated: “We are witnessing fundamental changes to the economic and geopolitical order that have convinced me that Europe needs to advance now together or risk fragmentation. Europe must either transform itself or it will decline. We are in a defining moment where we either unite or face irrelevance.”

Former Belgian Prime Minister Guy Verhofstadt also reiterated: “The call for a more federal Europe has never been stronger than today, not out of conviction, but out of necessity... I hope we make the jump [if not] we’ll end up in the ravine.”

Does this mean that the core EU member States must push towards a deeper economic integration, including on tax and fiscal policies? Will this not exacerbate the problem? With the real possibility of one or more countries leaving the Eurozone, ‘more Europe’ seems less likely to be adopted as a concrete option.

Recession in the offing?

Analysts believe that the renewed turmoil in the Eurozone is pointing to a deep recession in Europe. “It’s unavoidable that there will be an outright contraction in the fourth quarter of 2011, and a 60%-70% chance of another decline in the first quarter of next year,” said Nick Parsons, Head of Strategy at National Australia Bank. The surge in Italian bond yields were eventually capped by the European Central Bank, which intervened to buy limited quantities of Italian debt, but the crisis is far from over. Critics point out that the ECB will eventually have to ‘act as a lender of last resort to bring interest rates down to pre-crisis levels’.

To many, the ECB is seen as the only institution with the necessary capacity to rescue Italy, because the EU lacks the resources to bail out such a large economy. Ben May, of Capital Economics, opines that Italy would need a € 650 Billion bailout plan to keep it out of financial markets for the next three years. “The European Financial Stability Facility will not be able to provide a bailout of this size,” he said.

However, can this be achieved, especially if the ECB itself is riddled with mounting debts, with its future threatened? Sony Kapoor, Director of Brussels-based think-tank Re-Define states: “We may be fairly close to the point where an existential threat to the Eurozone, and hence the ECB, is on the horizon. This could easily spiral out of control.”

Today seven EU States are on the edge of bankruptcy and the unthinkable may happen soon – First World Europe asking the IMF and China for rescue loans. The IMF cannot be viewed as a substitute for European Banks or a centralised European treasury. Bearing the potential losses on emergency loans, arising from defaults, can prove disastrous to the IMF since the Fund itself operates on monies allocated to it by other sovereign nations such as a USA and China.  The IMF’s growing exposure to the Eurozone will undoubtedly trigger panic amongst the fund’s principal contributors, who extend funds based on reviewable quota system. It will also discourage emerging markets such as India from investing in the IMF more. After all it is the logic of economic sovereignty that countries outside the EU will strive to protect their own financial resources and local economies.

As Gao Xiqing, President of China Investment Corporation, emphasised: “We’re not saviours. We have to save ourselves.” US politicians are also pushing the Obama administration to focus on the local economy and be a ‘strong, world economic leader’ before becoming a ‘lender of the last resort’. Constant borrowing from non-EU countries will only fuel Europe’s out-of-control debt, apart from extending the risk factor amongst non EU member States, through the momentum of globalisation and economic interdependency.

Threat to emerging markets

The greatest fear is that the economic gloom will not only thwart the noble endeavours of other First World nations, but also undermine the emerging markets of developing countries the world over. Countries that are attempting to reform their local economies and herald an era of prosperity will inevitably feel the might of globalisation’s iron fist, as economic depression dominates Europe, “scaring the [entire] world,” as US President Barak Obama opined. Sri Lanka too will begin to feel the crushing blow of the Eurozone crisis in the near future as the export and tourism sectors will be hit by the ripple effect of economic depression. Recently the Central Bank of Sri Lanka unveiled its pioneering Sixth Strategic Plan, based on the theme ‘Raising the Bar’. The plan was formulated to maintain economic and price stability, as well as financial system stability, and to contribute to the overall economic prosperity of Sri Lanka.

Such a plan was conceptualised amidst the backdrop of a sluggish world economy (such a pace will continue in 2012) due to the Eurozone crisis. The new plan comes at a time when we as a nation need to arm ourselves with concrete economic, monetary and fiscal policies and strategies to combat the Eurozone recession. As an emerging Asian economy, Sri Lanka boasted many feats in 2011, amidst catastrophic global conditions. Our growth was estimated at a staggering 8.3%, inflation was steady, we boasted low interest rates for lending, had a stable exchange rate, our Sovereign Credit Ratings, Doing Business Index and FDI were on the rise, we posted low unemployment rates and our GDP exceeded $ 59 billion – the list is endless.

It would indeed be tragic if such achievements were undermined by the collapse of the EU, to which we hold strong bonds through trade and global economic cooperation. Thus, the doomsday of Europe will herald the doomsday of the world economic order, of which Sri Lanka is an integral part. We will be marked by the ghosts of the ‘lost decade’.

(The writer is a Chartered Accountant, Managing Director/CEO of Chemanex PLC and Director of CIC Holdings PLC and Commercial Bank PLC. He is also Chairman of The Finance Company PLC and serves on the Boards of many other public and private companies in Sri Lanka and abroad. He is a member of the Monetary Policy Consultative Committee of the Central Bank.)