SERIOUS MONEY:THE DOWNWARD pressure on world stock markets that began some months ago continues to grow in intensity as rising recession risks across the western world can no longer be ignored.
The source of the turmoil has moved back and forth across the Atlantic in recent months, as a lame economic recovery in the US has collided with a debt crisis in the euro zone. Indeed, the focal point for the latest bout of turbulence centres on Greece and its government’s inability to meet the ambitious targets prescribed under the EU-IMF adjustment programme.
Unfortunately, the focus on Athens has seen most commentators, investors and even policymakers view the euro zone’s problems through the narrow prism of sovereign debt. In this light, profligate government spending precipitated the build-up of sovereign debt to unsustainable levels. Successful fiscal consolidation in the troubled nations of Greece, Ireland and Portugal will bring the crisis to and end, many analysts believe.
Such a view, however, is extraordinarily naive. The crisis should be seen not as a sovereign debt crisis but more appropriately a balance of payments and external debt crisis.
The availability of low-priced credit from banks in the euro zone’s core following the launch of the single currency more than a decade ago allowed the periphery to run large and persistent external deficits, sparking a disturbing increase in the level of foreign debt, both public and private.
The dependence on foreign debt made each of the peripheral nations vulnerable to a sudden reversal in capital flows. A reassessment of risk premiums, as the Great Recession took hold, led to a stunning increase in interest rates and, one by one, the governments of the peripheral states had no option but to seek assistance.
Fiscal consolidation as prescribed by the EU-IMF adjustment programmes may well be desirable and necessary in each case but, on its own, the reversal of primary budget deficits will not be sufficient to bring the crisis to an end. The large current account deficits still present in Greece and Portugal, in particular, must be eliminated if foreign debt loads are to stabilise. Without currency devaluation, that looks nigh on impossible.
Foreign lenders, in their search for yield in a low-return world, lent freely to the peripheral countries in the years leading up to the crisis. Current account deficits were allowed to grow to alarming levels with little if any consideration for the true nature of the risks involved.
The Greek external deficit relative to GDP expanded by more than eight percentage points to almost 15 per cent from 2003 to 2008; the Portuguese deficit widened by more than six percentage points to 12.6 per cent over the same five-year period, while the Irish external position went from near-balance to a deficit of 5.6 per cent.
External imbalances were to be expected following the launch of the single currency, as relatively poor countries played catch-up with their wealthier brethren. However, borrowed funds were used primarily to finance current consumption, rather than productive capital investment designed to boost export potential, such that a significant proportion of the foreign lending may never be repaid.
The focus on sovereign debt is understandable in the case of Greece, since it was its unsustainable public debt position that sparked the confidence crisis. Nevertheless, non-financial private sector debt ratios still managed to jump from 52 to almost 90 per cent of GDP between 2002 and 2009. The Portuguese ratio surged by more than 50 percentage points to 178 per cent over the same period, while the non-financial private sector in Ireland outdid everyone with the ratio increasing by more than 100 percentage points to almost 200 per cent.
An external financing crisis duly erupted in each country, as the borrowing capacity of both private and public sectors reached exhaustion, with net external debt approaching 100 per cent of GDP. The situation has since stabilised in Ireland, as a large trade surplus has allowed the current account to move into positive territory. Not surprisingly, yields on Irish debt have decoupled from their troubled brethren.
Unfortunately, the news from both Greece and Portugal remains grim. Chronic trade deficits persist in both, while foreign debt and interest payments abroad continue to grow.
A large double-digit percentage point reversal in the trade account as a share of GDP is required to stabilise the level of foreign debt in both cases. Such a development is highly unlikely given the low value-added and uncompetitive nature of the respective export sectors, not to mention the slowdown in external growth.
Without a herculean reversal in the export sector’s fortunes, the necessary external adjustment could only take place through a depression-like collapse in domestic demand, throwing fiscal consolidation off course and resulting in no fall in aggregate debt levels.
Both Greece and Portugal are stuck in a debt-deflation trap and the harsh reality cannot be disguised – both countries are insolvent. The prospect of eventual euro exit should not be dismissed lightly.
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