Recently, financial news has been inundated with stories of falling stock exchange levels amid calls from debt-stricken eurozone countries asking for bailouts. European shares have fallen sharply as fears grow about their debt levels and the health of the US economy. This is not Armageddon but it looks like the omens are not favourable for the euro (at least in the short term). The big picture concerns not only the cost of bailing out individual eurozone members but it is really and truly about the prospects of the euro. The saying goes that as soon as more countries ask for a bailout, contagion spreads across the entire region threatening a domino effect.
Nostalgically, we can recall that on 1 January 1999, 11 European countries took a bold step forward by entering the euro club. At the stroke of midnight, the national currencies of these 11 countries became denominations of a single currency. Clearly, the launch of the euro was a truly historical event, not only in view of the complexity of the task and its careful preparations, but mainly in that it promised to bring in far-reaching economic and political consequences for the participating countries and for the international monetary system as a whole. It was seen as a powerful financial tool to streamline markets and reduce costs across its members.
Now, 11 years down the line, we can safely say that it did increase cross-border competition and improve market integration. Members saw a visible improvement in the efficiency of the markets for goods, services and capital. Perhaps it was not a perfect solution but it certainly helped in many ways to reduce transaction costs, improve price transparency and lower price pressures. It was no panacea for the champion currency, the dollar, but it swiftly gained popularity particularly in financial trading markets. The sheer size of the euro area economy, which is comparable to the US economy, should augur well for it to gain more strength and ensure price stability. Alas, not all the 27 members opted for the single currency and, typically, Britain has always strongly resisted entry. Now that the honeymoon is over we have started to see cracks in the system.
The first patient in the sick bay was the ubiquitous Greek nation. Last month ‘s eurozone summit saw Germany ‘s Angela Merkel treading a fine line between showing European solidarity and keeping her voters happy. It is a sad story that saw the Greeks being granted the first tranche of a €110 billion bailout in May last year; since then its debt has soared to €340 billion, nudging 160 per cent of gross domestic product and rising. But the medicine did not work sufficiently well and the patient needed further monetary assistance. Brussels prescribed another bailout of a similar size to keep it afloat until 2014. The ultimate aim is to relieve Greece’s debt burden, currently at €340 billion, to reduce it to about €255 billion, in the hope of boosting recovery prospects. That represents another €85 billion in loans on top of the first bailout of up to €120 billion.
Under the plan, the private sector will provide €135 billion over the next 30 years through a variety of measures including a debt buy-back programme. As well as the buy-back scheme, private sector creditors will be offered three other ways to help cut Greece ‘s debt mountain by €13.5 billion. Greek Prime Minister Papandreou scraped enough votes to win a crucial vote of confidence, which will help him pass the latest austerity measures in Parliament, so Brussels and IMF now have no choice but to cough up the cash. The stakes are high for the long-suffering Greek people, who are expected to swallow a further dose of austerity, but economists warn us they are even higher for the European Commission, the European Central Bank and the IMF. The concern, starkly expressed by the IMF in its latest health check on the euro area, is that a default in Greece could have knock-on effects, not just on the rest of the single currency zone, but could also lead to a second global economic crisis.
We know that others contenders followed suit starting with Ireland, Portugal and Cyprus, and waiting in the anteroom are both Italy and Spain. To make matters worse, we are now joined by Cyprus travails after the serious accident that took out the island nation ‘s main power station. Moody ‘s promptly downgraded Cyprus ‘ credit rating by two notches. As well as cutting its rating on Cyprus from A2 to Baa1, the credit rating agency also slapped a negative outlook on the country, meaning that another downgrade may be in the offing. Another credit rating agency Fitch commented that it does not rule out additional funding pressures arising for Cyprus banks, given that quite a few are subsidiaries of ailing Greek banks.
Enter Italy as the next candidate on the catwalk of ailing nations. It ‘s economy is on the verge of a bailout but is strongly resisted by Prime Minister Berlusconi who said that Italy ‘s banks were “solid and solvent” and the economy was “solid”. His government is proposing a medical cure with a sour taste of a €43 billion austerity package introducing in its wake a long promised labour market and competition reforms. It is joke as it is common knowledge that Italian politicians promise a lot but do not always deliver. Regrettably, the country is saddled with the second highest debt figures (after Greece) amounting to 120 per cent of its GDP. It is no big consolation that only one half of Italian debt is owned by Italian institutions and individuals. There are telltale signs that grey clouds are hovering over the Italian peninsula due to heavy losses on the Milan stock market and a sharp rise in yields on bonds. Sifting the chaff from the wheat we can see that Italy is registering zero growth and has big productivity problems. It has large debt servicing costs, which can only get higher as markets continue to doubt the implementation of remedial austerity measures. It goes without saying that it is not time for palliatives but for deep surgery.
The sombre state of affairs is reflected in European Commission President Jose Manuel Barroso who recently described the bond markets treatment of Italy and Spain as “a cause of deep concern”. It is not an inspiring thought when one considers how an Italian 10-year bond is now yielding 6.02 per cent, compared to 6.14 per cent for the Spanish equivalent. Financial advisers rule that any bond yield above six per cent is considered unsustainable in the long term. Quoting Justin Gallagher of RBS in Sydney, he said, “The implications for the Italian market and economy going through something similar to Greece are pretty frightening.” This saga reminds us that it does not rain but it pours as in less than two weeks after an agreed second bailout for Greece, the debt malady is spreading.
Markets did not find any consolation when discovering that the US economy is itself balanced on a razor sharp edge. Moody’s Investors Service said the US credit rating might be cut. The nation, rated AAA since 1917, was placed on negative outlook, New York-based Moody’s said in a statement when it confirmed the rating. It warned last week that a negative outlook was “more likely” as lawmakers reduced the size of spending cuts being negotiated to win approval on a plan to increase US borrowing limit by $2.1 trillion. This eleventh hour deal averted a first-ever US financial default. The deal to raise the US’ debt ceiling until 2013 comes with a commitment to automatic spending cuts of $2.4 trillion in public expenditure reductions over the next decade. Commentators agree that US debt ceiling debate has really eroded confidence among consumers and businesses in addition to creating uncertainty among political leaders and that it took leaders a while for them to shed their partisan agenda. Consequently, the damage is real as analysts say the dollar status is now under scrutiny after the fallout of this week’s bitter wrangling in Congress to agree on a bipartisan austerity deal (no tax cuts please). Coupled with disappointing economic data as mentioned earlier on Italian and Spanish bond yields, it is not an exaggeration to state that risk appetite plummeted. This is further reflected by the rallying price of gold and the sudden drop in oil prices. James Dailey, portfolio manager at Team Asset Strategy Fund is confident that “we are not in a bear market psychology yet, but we are definitely in a solid correction psychology.”
To conclude on the euro prognosis, one may consider that the Greek acceptance of the second rescue pact marked the end of an act in this euro tragedy but not the end of the play. The unexpected downgrading of Cyprus is another omen that contagion is spreading albeit slowly. Will it reach Malta “shores? One hopes not... perhaps the pre-Budget document is full of with magic potions to scare away any contagion that may threaten to invade our beaches this winter. Only magic will prevent the domino effect from reaching our islands.
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Mr Mangion is a partner in PKF, an audit and business advisory firm.