SSL In The Money

PERHAPS one of the most significant moments in European history occurred when the euro became the legal tender for seventeen nations in the region. However, in more recent times, riots and rejected austerity plans in member nations have dominated the news, shaking markets and confidence in the global economic recovery in what is termed the Euro-zone crisis.

With the introduction of the euro came the European Central Bank’s (ECB) directives via the implementation of monetary policy of the countries that use the common currency. This monetary union has yielded several advantages such as increasing the competitiveness of member nations by making prices more transparent, reducing transaction costs for business, boosting inward investment and lowering retail prices. At the same time, it is blamed for increasing unemployment and stifling growth, by denying national governments the flexibility to adjust their interest rates in the light of local conditions. Moreover, the average Debt-to-Gross Domestic Product (GDP) ratio of the Euro-zone countries has ballooned to stand at 85.1 per cent at the end of 2010.

This lack of independence to tailor monetary policy has affected the weaker Euro-zone nations, namely the PIIGS — Portugal, Italy, Ireland, Greece and Spain, particularly following the global financial crisis. Not surprisingly, the more vulnerable nations have all required European Union (EU)-International Monetary Fund (IMF) bailouts recently.

In November 2010, European governments sought to quell market turmoil threatening the euro by granting Ireland an 85 billion euro aid package. Ireland was, however, not the first to barely escape a default. In May 2010, Greece accepted an international aid package worth 110 billion euro over three years, which included a promise to cut its budget deficit to three per cent of GDP by 2014.

Although more than a year has passed, Greece is still struggling to reach an acceptable agreement for all stakeholders. The country must, this week push harsh austerity reforms worth an additional 28 billion euro through a divided parliament, stirring massive protests in the streets of Athens. Without approval for the measures, the EU and IMF will not disburse the fifth tranche of Greece’s 110-billion bailout programme and the prospect that Greece could become the first Euro-zone nation to default has raised concerns over other heavily indebted European nations.

Around the same time Greece received its package, Portugal, with a national debt equal to 85 per cent of its annual GDP, was also on the verge of dishonouring its debt. However, Euro-zone Finance Ministers unanimously approved a 78 billion euro bailout for the country, making it the third Euro-zone member to secure a rescue package.

The question on the minds of many is will Spain and Italy be next on the list? Despite a relatively low debt level compared to its Euro-zone neighbours, Spain’s accumulated public debt amounted to 679.78 billion euro or 63.6 per cent of GDP at the end of the first quarter of 2011, up from 55 per cent a year earlier and its highest level since 1988. Italy’s is even more colossal, standing at approximately 1,800 billion euro, the fourth highest public debt in the world after the US, Japan and Germany. Interestingly, Standard & Poor’s (S&P) downgraded Italy’s credit rating outlook from stable to negative a few weeks ago, a move some describe as hitting the start button on the default stopwatch.

The fact is that, while Portugal and Greece are relatively small, the real worry is Italy and Spain. A Greek default, with the nation having a public debt of 330 billion euro, has already caused a lot of unrest in the international markets. With Italy’s public debt being almost six times that of Greece, an Italian default, would be extremely difficult, if not impossible, to address with a bailout plan and could possibly have catastrophic consequences on the world economy.

Unfortunately, the close linkages between Europe’s major banks mean that a crisis in any one Euro nation increases the probability of systemic risk to the entire continent. The European financial system remains highly vulnerable if the Greek and other government bonds owned by financial institutions are devalued in the restructuring of sovereign debt. The IMF, which is providing approximately a third of the cost for the rescues, recently stated that Contagion to the core euro area, and then onwards to emerging Europe, remains a tangible downside risk.

In recent weeks Europe’s debt problems have weighed heavily on global markets, with major indices reacting daily to news about Greece’s progress toward a second bailout. Notably, the Dow Jones Industrial Average (DJIA) slipped below the psychological 12,000 mark recently as concerns mounted. If Greece defaults, the fear is that investors will lose faith in the financial strength of other nations that have borrowed heavily or hold billions in Greek debt. That could lead to a credit crunch, when banks virtually stop lending to each other, similar to that which occurred during the financial crisis merely three years ago. However, this time the repercussions may be even greater as few European countries have the fiscal freedom to commence new stimulus packages or fund further sovereign bailouts or Bank recapitalisations.

With the interconnectivity of markets, the impact of such defaults aren’t limited to Europe. The US is a major participant in the IMF which has undertaken tens of billions of dollars in bailouts. In addition, the Euro-zone collectively is not only a major trading partner of the US but also to other key markets across the globe. Consequently, below par economic growth in Europe hurts economic growth worldwide.

Moreover, with economic data indicating a slowdown in the pace of the rebound in the US and other powerhouses such as China, the global economic recovery is expected to be tepid at best. However, it is hoped that the Euro-zone leaders will be able to effectively address the region’s sovereign debt crisis as the global economy seeks to avoid a protracted recession.

Deirdre Witter is an Investment Analyst at Stocks & Securities Ltd. You may contact her at dwitter@sslinvest.com.